205
Retirement is only enjoyable when
we have funds to replace our income.
Franco Modigliani said that our
awareness of this makes us save over
time to allow for constant consumption.
See also: Economic man 52–53 ■ Borrowing and debt 76–77 ■
The Keynesian multiplier 164–65 ■ Rational expectations 244–47
POST-WAR ECONOMICS
Keynes’s theory makes three
empirical predictions. First, richer
households will save more than
poorer ones. Second, over time,
as the economy grows, the amount
people spend will rise less quickly
than income, since households will
be growing richer and so spending
proportionately less of their income.
Third, following on from this, richer
economies will become increasingly
“lethargic:” when consumption falls
in ratio to income, it reduces the
multiplier and the economy begins
to stagnate.
Lifetime savings
However, the theory’s predictions
did not match well with reality.
The ratio between household
consumption and income over the
long run turned out to be stable
across a wide range of countries,
rather than decreasing with
growth. It fluctuated over short
periods of time but did not move
consistently in any particular
direction. After World War II
economists predicted stagnation,
but economies everywhere boomed.
Two solutions to the mystery gained
acceptance. Both proposed that
rational individuals do not consume
blindly out of their current income,
but look to the future and develop
expectations about how much
they need to save. In 1954, Italian
economist Franco Modigliani
suggested this relates to stages in
life. When people are economically
active, they save toward old age.
When they are older, they use up
their savings. They try to keep
consumption constant, smoothing
its path over time. This is known
as the life-cycle hypothesis.
Three years later US economist
Milton Friedman (p.199) proposed
the related theory that people
smooth their consumption over time
around their “permanent income”—
an expectation of future earnings,
based mostly on current wealth.
Any extra income is “transitory”
and will be saved. This is known as
the permanent income hypothesis.
More recent developments
in consumption theories have
suggested that in fact consumers
tend to use “rules of thumb”
and other forms of “non-rational”
behavior when making decisions
about how much to spend or save. ■Franco Modigliani
Franco Modigliani was born
in Rome, Italy, in 1918. He
initially studied law at the
University of Rome, but
switched to economics. In
1938, Mussolini passed a
series of anti-Semitic laws,
and Modigliani—a fervent
antifascist—left for Paris and
then New York with his wife,
the antifascist activist Serena
Calabi. He supported his
growing family by bookselling
while studying. He took a
series of teaching posts
before becoming a professor
of economics at the
Massachusetts Institute of
Technology (MIT). In 1985,
he won the Nobel Prize for
his pioneering analyses of
savings and financial markets.
After his death in 2003, the
economist Paul Samuelson said
that he had been the “greatest
living macroeconomist.”Key works1954 Utility Analysis and the
Consumption Function (with
Richard Brumberg)
1958 The Cost of Capital,
Corporation Finance and the
Theory of Investment (with
Merton Miller)
1966 The Life Cycle
Hypothesis of SavingSuccessive generations
seem to be less and
less thrifty.
Franco Modigliani