Intertemporal consumption

Economic theories of intertemporal consumption seek to explain people's preferences in relation to consumption and saving over the course of their life. The earliest work on the subject was by Irving Fisher and Roy Harrod who described 'hump saving', hypothesizing that savings would be highest in the middle years of a person's life as they saved for retirement.

In the 1950s more well-defined models built on discounted utility theory and approached the question of intertemporal consumption as a lifetime income optimization problem. Solving this problem mathematically, assuming that individuals are rational and have access to complete markets, Modigliani & Brumberg (1954), Albert Ando, and Milton Friedman (1957) developed what became known as the life-cycle model. This model predicts that people consume an annuity of their expected lifetime income at all points in their life. Thus, the lifetime consumption profile was expected to be essentially flat, with people borrowing against future earnings during their early study and working life when income is low, saving greatly during their most productive working years and consuming saved assets during retirement. Windfall gains would be treated the same way as an unexpected increase in income - its lifetime annuity value would be consumed and the rest saved.

Attempts to test the life-cycle model against real world data have met with mixed success. In a review of the literature, Courant, Gramlich and Laitner (1984) note "but for all its elegance and rationality, the life-cycle model has not tested out very well." The main discrepancies between predicted and actual behaviour is that people drastically 'underconsume' early and late in their lifetime by failing to borrow against future earnings and not saving enough to adequately finance retirement incomes respectively. People also seem to 'overconsume' during their highest earning years, the elderly do not consume from their assets as would be expected (particularly from their household equity) and also treat windfall gains in a manner inconsistent with the life-cycle model. Specific alterations to the theory have been proposed to help it accommodate the data; a bequest motive, capital market imperfections such as liquidity constraints, a changing individual utility function over time or a particular form of expectation as to future income.

Behavioural economists have proposed an alternate description of intertemporal consumption, the behavioural life cycle hypothesis. They propose that people mentally divide their assets into non-fungible mental accounts - current income, current assets (savings) and future income. The marginal propensity to consume (MPC) out of each of these accounts is different. Drawing upon empirical studies of consumption, superannuation and windfall gains they hypothesize that the MPC is close to one out of current income, close to zero for future income and somewhere in between with respect to current assets. These differing MPCs explain why people 'overconsume' during their highest earning years, why increasing superannuation contributions does not cause current savings to be reduced (as the life-cycle model implies) and why small winfall gains (which are coded as current income) are consumed at a high rate but a higher proportion of larger gains is saved.