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Life Cycle Theories of Savings and Consumption

Implications For Aggregate Savings And Consumption Patterns

The life-cycle hypothesis suggests that population aging will initially lead to an increase in national savings as the proportion of the population in the maximum savings years increases. Cantor and Yuengart (1994) estimate that saving by the baby boom generation may add as much as 1.4 percent to the national savings rate between 1990 and 2010. As the population continues to age and the relative proportion of the population of those reaching retirement age grows relative to the middle-aged population, however, the life-cycle hypothesis predicts a reduction in aggregate savings.

The existence of public and private pension systems complicates the private savings patterns that would be predicted by the life-cycle hypothesis in the absence of these systems. In 1974, Martin Feldstein argued that the effect of Social Security on aggregate private savings is theoretically indeterminate. On the one hand, savings may decline because Social Security benefits reduce the need to save for retirement (the benefit, or asset substitution, effect). Conversely, the availability of Social Security benefits may encourage early retirement from the labor force. If so, a shorter working life and longer time spent in retirement would require increased savings rates (the induced retirement effect). As noted earlier, a substantial literature has attempted to identify which effect dominates, but this literature remains inconclusive.

The vast majority of the research on the life-cycle theory has focused on patterns of savings behavior. Savings, however, are only half of the story. To adequately interpret whether observed savings patterns are consistent with the life-cycle theory, it is also necessary to examine consumption patterns. And, as with savings, it is necessary to account not only for out-of-pocket consumption but also expenditures made on behalf of older persons in retirement (e.g., health care expenditures). As the population ages, the life-cycle consumption patterns of older persons—in particular, the greater allocation of expenditures to health care—will shift the composition of aggregate private household demand. In addition, public expenditures will shift in response to population aging (e.g., away from education expenditures for the young toward expenditures for pension payments and health care insurance). The economy has experienced the interaction of life-cycle consumption patterns and demographic change before, the baby boom generation swelled the demand for housing and education services in the 1950s and 1960s. Shifts in aggregate demand due to the aging of the baby boomers will be far less disruptive because, in contrast to the arrival of the baby boom generation, the economy and public policy will have many years to anticipate and adapt to population aging.

Collectively, these shifts in patterns of household and government spending will change the composition of aggregate demand in the economy. Population aging will also shift patterns of aggregate private savings, private pension wealth, and Social Security wealth. Given the prominence of the life-cycle hypothesis among economists, it is interesting that so little work has been conducted on life cycle consumption behavior of older persons. Debates about the out-of-pocket health care costs of older persons are a reflection of the intersection between economic resources, consumption needs, and public policy. The formulation of public policy for the elderly population needs to recognize this intersection and to be informed by careful research that explicitly accounts for the effects of life-cycle events on economic status in old age. The life-cycle hypothesis provides an integrated conceptual framework for the development of income maintenance and health care policy for older persons, and indicates clearly that income and health care policies should not be considered in isolation.



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Additional topics

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