Chapter 10. The Life Cycle Consumption Model

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.

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.

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.

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.