Life cycle theory is a framework used to understand the financial and economic behavior of individuals and firms over the course of their lifetimes. It suggests that individuals and firms go through a series of stages, each with its own financial and economic characteristics. These stages are often described as being like the stages of human development, with early stages characterized by low income and high expenses, and later stages characterized by higher income and lower expenses.
One of the key insights of life cycle theory is that individuals and firms do not have constant levels of saving and consumption over time. Instead, they tend to save more in the early stages of their lifetimes, when they have relatively low income, and consume more in the later stages, when they have relatively high income. This is often referred to as the "life cycle hypothesis."
One of the main factors driving this pattern of saving and consumption is the need to finance large expenses that arise at different stages of the life cycle. For example, individuals may need to save in order to finance their education, while firms may need to save in order to finance investments in new capital equipment.
Another factor that plays a role in the life cycle of individuals and firms is the presence of uncertainty. Life cycle theory suggests that individuals and firms may be more likely to save in the presence of uncertainty, as a way to hedge against the risk of unexpected expenses or income shocks.
One of the key implications of life cycle theory is that it can help to explain why saving and consumption patterns may differ across different age groups or stages of the business cycle. For example, young individuals may be more likely to have higher levels of consumption and lower levels of saving, while older individuals may have lower levels of consumption and higher levels of saving. Similarly, firms in the early stages of their lifetimes may be more likely to have higher levels of investment and lower levels of profits, while firms in later stages may have lower levels of investment and higher levels of profits.
Overall, life cycle theory provides a useful framework for understanding the financial and economic behavior of individuals and firms over the course of their lifetimes. It helps to explain why saving and consumption patterns may vary across different age groups and stages of the business cycle, and it highlights the role of factors such as the need to finance large expenses and the presence of uncertainty in shaping these patterns.
