Question

Suppose John Bucky follows the life-cylce hypothesis: he smooths consumption as much as possible. His income grows over his lifetime. Assuming no initial wealth, and a real interest of zero, graph con- sumption, income, wealth and savings for John over his life cycle if he is a borrower in the initial stages in his life (up to some period Ti).

Answer 1

Below figure shows the consumption pattern of John who follows Life Cycle Hypothesis:

Retirement aya SAVINGS cs,y C-SMOOTHING BORROWNG DIS- SAVING Т. Time C = Consumption S= Saving Y= Income

As John smoothes out the consumption, the consumption line is, therefore, a horizontal straight line. Initially, John is the borrower with almost no income. As he borrows more, his income increases. After Time T1, he starts saving some proportion of his income. This is important to maintain same amount of consumption even after his retirement. So, from T1 to T2 he saves money for the retirement period.

After retirement, he uses the saved money for the same amount of consumption as he did in the working age. As a result, the curve slopes down and after T2, dissavings occurs and at the end the income again becomes equal to the initial wealth.