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American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to The American Economic Review. http://www.jstor.org Life Cycle, IndividualThrift, and the Wealth of Nations By FRANCO MODIGLIANI* This paper provides a review of the theory Yet, there was a brief but influential inter- of the determinants of individual and na- val in the course of which, under the impact tional thrift that has come to be known as of the Great Depression, and of the interpre- the Life Cycle Hypothesis (LCH) of saving. tation of this episode which John Maynard Applications to some current policy issues Keynes suggested in the General Theory are also discussed. (1936), saving came to be seen with suspi- Section I deals with the state of the art on cion, as potentially disruptive to the econ- the eve of the formulation of the LCH some omy and harmful to social welfare. The thirty years ago. Section II sets forth the period in question goes from the mid-1930's theoretical foundations of the model in its to the late 1940's or early 1950's. Thrift original formulation and later amendment, posed a potential threat, as it reduced one calling attention to various implications, dis- component of demand, consumption, without tinctive to it and, sometimes, counterintui- systematically and automatically giving rise tive. It also includes a review of a number of to an offsetting expansion in investment. It crucial empirical tests, both at the individual might thus cause "inadequate" demand and the aggregate level. Section III reviews and, hence, output and employment lower some applications of LCH to current policy than the capacity of the economy. This failure issues, though only in sketchy fashion, as was attributable to a variety of reasons in- space constraints prevent fuller discussion. cluding wage rigidity, liquidity preference, fixed capital coefficients in production, and I. Antecedents to investment controlled by animal spirits rather than by the cost of capital. A. The Role of Thriftand the Not only was oversaving seen as having Keynesian Revolution played a major role in the Great Depression, but, in addition, there was widespread fear The study of individual thrift and aggre- that the problem might come back to haunt gate saving and wealth has long been central the postwar era. These fears were fostered by to economics because national saving is the a widely held conviction that, in the future, source of the supply of capital, a major there would not be too much need for ad- factor of production controlling the produc- ditional accumulation of capital while saving tivity of labor and and its growth over time. would rise even faster than income. This It is because of this relation between saving combination could be expected to result, and productive capital that thrift has tradi- sooner or later, in saving outstripping the tionally been regarded as a virtuous, socially "(need" for capital. These concerns were at beneficial act. the base of the "stagnationist" school which was prominent in the 1940's and early 1950's. B. Early Keynesian Theoriesof the * Sloan School of Management, Massachusetts In- Determinants of Saving stitute of Technology, Cambridge, MA 02139. This article is the lecture Franco Modigliani delivered It is interesting and somewhat paradoxical in Stockholm, Sweden, December 9, 1985, when he that the present day interest and extensive received the Nobel Prize in Economic Sciences. The behavior owes article is copyright (0 The Nobel Foundation 1985, and research activity about saving published here with the permission of The Nobel its beginnings to the central role assigned by Foundation. Keynesian economics to the consumption 297 298 TIIE A MERICAN ECONOMIC REVIEW JUNE 1986 function as a determinant of aggregate de- having saved first or without exceeding their mand, and to the concern with oversaving as means. a source of both cyclical fluctuations and long-run stagnation. It is for this reason that C. Three Landmark Empirical Studies the early endeavor to model individual and aggregate saving behavior was dominated by In the second half of the 1940's, three the views expressed on this subject by Keynes important empirical contributions dealt a in the General Theory, and in particular by fatal blow to this extraordinarily simple view his well-known "fundamental psychological of the saving process. First, the work of [rather that 'economic'] law" (p. 96) to the Simon Kuznets (1946) and others provided effect that an increase in income can be clear evidence that the saving ratio had not counted on to lead to a positive but smaller changed much since the middle of the nine- change in consumption. Even when the anal- teenth century, despite the large rise in per ysis followed the more traditional line of capita income. Second, a path-breaking demand theory, it relied on a purely static contribution of Dorothy Brady and R. D. framework in which saving was seen as one Friedman (1947) provided a reconciliation of of the many "goods" on which the consumer Kuznets' results with budget study evidence could spend his income. Thus, income was of a strong association between the saving seen as the main systematic determinant of rate and family income. They demonstrated both individual and national saving, and, in that the consumption function implied by line with Keynes' "law," it was regarded as a family data shifted up in time as mean in- superior commodity (i.e., one on which "ex- come increased, in such a way that the saving penditure" rises with income) and most likely rate was explained not by the absolute in- a luxury, for which expenditure rises faster come of the family but rather by its income than income. Also, in contrast to other goods, relative to overall mean income. the "expenditure" on saving could be nega- Ways of reconciling these findings with the tive-and, accordingly, dissaving was seen as standard linear consumption function were typical of people or countries below some soon provided by James Duesenberry (1949) "break-even" level of income. All these fea- and me (1949), though within the empirical tures could be formalized by expressing con- tradition of the earlier period. Duesenberry's sumption as a linear function of income with "relative income hypothesis" accounted for a substantial positive intercept. This formu- the Brady-Friedman results in terms of im- lation appeared to be supported by the find- itation of the upper classes. This is an ap- ings of numerous budget studies, and even pealing explanation, though it fails to come by the newly developed National Income to grips with the budget constraint in the Accounts, spanning the period of the Great case of would-be dissavers below mean in- Depression, at the bottom of which saving come. Similarly, the " Duesenberry-Modig- turned small or even negative. liani" consumption function tried to recon- As is apparent, in this early phase the cile the cyclical variations of the saving ratio dominant approach could best be char- with its long-run stability by postulating that acterized as crudely empirical; little attention current consumption was determined not just was given to why rational consumers would by current income but also by its highest choose to "allocate" their income to saving. previous peak, resulting in a ratchet-like up- The prevailing source of substantial saving ward creep in the short-run consumption was presumably the desire of the rich to function. In my own formulation, primary bequeath an estate (Keynes' "pride" motive, stress was placed on reasons why the saving p. 108). Accordingly, the main source of the rate should move procyclically and on the existing capital stock could be traced to in- consideration that in an economy with stable heritance. Similarly, there was little evidence long-run growth, the ratio of the current of concern with how, and how long, "poor" to highest previous income could be taken people, or countries, could dissave without as a good measure of cyclical conditions. VOL. 76 NO. 3 MODIG,IA NI: LIFE CYCLE AND INDI VIDUA L T'IIRIFT 299 Duesenberry, on the other hand, put more that a representative consumer allocates to stress on consumers explicitly anchoring their consumption at any age, t, will depend only consumption on the previous peak. This for- on his life resources (the present value of mulation was brought to its logical conclu- labor income plus bequests received, if any) sion by Tillman Brown (1952) when he pro- and not at all on income accruing currently.