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The Life Cycle Consumption Model
Question
The Life Cycle Consumption Model
1. The following four scenarios describe the income earning potential of a 20-year old individual.
I. For 10 years you make $250,000 per year and then you retire for the next 50 years. II. You earn the same wage for 45 years and then you retire for 15 years. III. You spend 10 years in school, 35 years making a salary that rises each year, and then you retire for 15 years. IV. You earn $10,000 per year for 35 years, and then earn $100,000 per year until you die at age 80.
Assume your goal is to retire with no wealth and you want to consume about the same amount across all 60 years of your working age life. Under which of the following scenarios listed above will the individual accumulate debt during some portion of their life?
A.
B.
C.
D.
Explanation: In scenario I you accumulate your wealth early and then live off of this wealth for the rest of your life. You have no debt. In scenario II you slowly accumulate wealth through your working career and then live off of this wealth in retirement. You have no debt. In scenario III you take on debt while you are in school. In scenario IV you take on debt during your low earning years. In scenarios III and IV you rationally take on debt to smooth your consumption.
The following four scenarios describe the income earning potential of a 20-year old individual.
I. For 10 years you make $250,000 per year and then you retire for the next 50 years.
II. You earn the same wage for 45 years and then you retire for 15 years.
III. You spend 10 years in school, 35 years making a salary that rises each year, and then you retire for 15 years.
IV. You earn $10,000 per year for 35 years, and then earn $100,000 per year until you die at age 80.
Question
The Life Cycle Consumption Model
2. Assume your goal is to retire with no wealth and you want to consume about the same amount across all 60 years of your working age life. Under which of the following scenarios listed above will the individual always consume an amount that is less than their income?
A.
B.
C.
D.
In scenarios I and II the individual will consume less than income because their highest earning years are early in life and they wish to save for later in life to smooth their consumption. In scenarios III and IV the individual will consume more than their income in their early years because their highest earning years are later in life and they wish to smooth consumption.
Question
The Life Cycle Consumption Model
3. Assume your goal is to retire with no wealth and you want to consume about the same amount across all 60 years of your working age life. All else the same, you will be able to consume more each year if
A.
B.
C.
D.
Higher interest rates will result in more interest earned for any given amount of wealth, and therefore your wealth will grow at a faster rate. If you work fewer years then you will have less wealth and so have less consumption. If you spend more years in retirement then you will want to save more each year, and so consume less. If you spend more years in school, then you have fewer income earning years. It is possible that more years in school will result in higher income when you graduate but your consumption will then also depend on how much debt you had to incur in order to complete your education.
Question
The Life Cycle Consumption Model
4. . Assume your goal is to retire with no wealth and you want to consume about the same amount across all 60 years of your working age life. Additionally, each year you work you receive a raise equal to cost of living plus 5%. You expect to work for 45 years and spend 15 years retired. Which of the following is true?
A.
B.
C.
D.
Most years you will consume below your annual salary in order to save and accumulate wealth for your retirement. Given you will earn a raise each year, you can accumulate some debt in your early years, pay it off, and then accumulate wealth for retirement. You cannot consume your salary every year, or more than your salary every year if you hope to accumulate wealth for retirement and smooth your consumption.