Life circle theory of saving

Category: Investment, Theories, Wealth

Last Updated: 02 Apr 2020

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The life Circle Theory of Saving teaches about the modalities, guidelines, and strategies in which families, governments, institutions should save, plan and manage their financial assets to p and cut across their entire life time. In the case of a family or household, it posits on how they should manage their financial assets in a transferable manner to cut across different times in their life circle, taking into cognizance the need to save and provide for retirements, as well as their children’s education, buy insurance, among other needs. According to Zvi, B, Jonathan, T. Wiillen P. (2004), this also relates to a companies assessment as to what to choose as the default asset allocation for a compulsory retirement saving plan.

This theory poses various questions to people and deals with such fundamental issues as to how much of their earned income they should save for the future; how to invest what they save; the type of risk they must provide insurance, incase of any eventuality; are they to buy a house or rent one; is it better to get a fix rate mortgage or bargain for an adjustable one. As Zvi B. (May 2007) observed, the theory not only concerns families, but government policy makers and firms that provide life circle serves, and even educator who help counsel the public to make informed choices.

LIFE CIRCLE THEORY AND AGGREGATE SAVING IN AN ECONOMY

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This concept of life circle theory is useful in understanding the aggregate saving in an economy. According to Hayashi, F. (2007), aggregate saving is calculated as average saving for all age brackets in the population of a particular nation. This is expected to be the same or equal to the aggregate savings in the national account. In practical terms, saving is the difference between disposable income and consumption. It therefore goes that if households are able to increase their aggregate savings they will be in a better position to save and plan well for their life circle.

Floden, M. (Date not available) defines aggregate saving in a general equilibrium model in an economy, as a situation, “Where infinitely lived households face volatile income paths, holds a risk-free asset, and face a liquidity constraints”. In any economy, when individual income, or organizational income varies, or differs, then the aggregate equilibrium capital will be larger than when it is constant. He posits further that when income is stochastic, the equilibrium capital stock is always larger than when it is constant.

National savings largely depends on the rate of growth and development of national income. However, the purpose of life circle theory is not to provide clear cut answers, instead it is to give a framework for individuals, policy makers and financial planners to provide solutions to the questions posed- as indicated above. The huge variation in household income and in the aggregate savings in the economy will determine how planners (as well as families) will fine tune their advise to suit whatever purpose they want to serve.

DEFINITION OF INCOME.

The Wikipedia gave various definitions of income, but basically, income, defined in general terms, is the money that is received as a result of normal business activities of an individual; or money received from employment by way of employment by way of salary, wages, tips, as well as profits, dividends from financial investments, as interests, capital gains, or other sources as in social security or premiums.

Income also is the money received from labor, services rendered, sale of property or goods or from investment made. There are diverse elaborate definitions of income, but we shall make do with the above definition for the purpose of this paper.

PERMANENT INCOME AND LIFE CIRCLE MODELS.

In the view of Roberts, S. (date not available), this is a situation where people base their consumption on what they believe to be their regular income. So, they try to maintain a fairly constant and stable standard of living, even though their earnings may vary either on monthly or yearly basis. This happens in a way that their spending pattern are fairly constant irrespective of increases or decreases in their earned income. This hypothesis was developed by Milton Friedman in 1957.

If people perceive that a change in income is temporary, their spending may not change, but if they observe it is permanent, it may vary slightly on the average.

DEMOCRAPHIC FUNDAMENTALS AND FLOW OF SAVING

The demographic fundamentals as it relates to flow of savings in life circle theory is based on the premise that young people borrow money, they middle aged class save their money, while the old people (elderly) run down or spend their savings. Consequently, a nation with large population of middle age will have high savings, especially as people prepare to retire.

Concerning the relationship between the demographic fundamentals and the bond marker, when the savings supply is high as a result of the high population of the middle age savings, the price of stocks and bonds falls. Also, when the supply is low, yield equally increases.

INTEREST RATE EFFECT ON SAVING AND LIFE CIRCLE MODEL.

Naturally, interest rate, which is the rate of the fee paid on borrowed asset, would always adjust to level up with investment and savings. Increase in interest rate affects how much income left for consumption. If the interest rate is increased it means less money for consumption and investment, whereas, it is increased there will be likelihood of slight increase or constant level of consumption and investment.

It goes therefore to say that a rise in saving would bring about a fall in interest rate, thereby encouraging investment. Inn life circle theory, the lower the interest rate, the more likely consumption will increase, as well as investment. Both in individuals as well as institutions.

According to an extensive review by Modigliani, FF Albert, A. (March 2005), in a world congress of the Economic Society in Barcelona in 1990. In trying to assert a comprehensive and standard evidence on saving and growth in a developing economy, he said that, “Both growth and demographic structures are powerful predictors of national saving, with little or no role for the level of national income”.

WEALTH EFFECT ON LIFE CIRCLE MODEL

The level of wealth in an economy bears a simple relation to the length of the retirement p, which is the middle age, the very class that saves money the most. It is also true to say that the consumption of a household is also dependent solely on the present value of their lifetime income. For example, if two investors separately have the same total wealth (monetary wealth) working life, and are equally expectant of some sources of income in their remaining working life, their consumption decisions will be similar or same, not minding their income profile.

REEFERENCE

1. Albert, A. Modighiani, F, (March 2005). The Life Circle Hypothesis of Saving: Aggregate Implication and Tests. American Economic Review. 53 (1) 55-84. Angus Deaton. “Research Programme in Development Studies and Center for Health and Wellbeing. Princeton University. www.princeton.edu/

2. Floden, M.www.ideas.repec.org/p/hhs/hastef/0591.html

3. Hayashi, F. (2007) Understanding Savings: Evidence from the United States and Japan. MA. MIT Press, 55 Haywad Press. Page 305. ISBN-10: 0-262-08255-1

4. Zvi, B. Jonathan T. Willen P. (2004). The Theory of Life- Circle Saving and Investment. Public Policy Discussion Paper. No. 07-3

5. Zvi B. (May 2007)

6. www.wikipedia.com

7.Robert S. Permanent-Income hypothesis, published in

www.wikipedia.org