Consumption and Work Effort over the Lifecycle

The presence of a hump shaped lifetime consumption profile is a well known puzzle from the perspective of a lifecycle model with complete markets—why don’t individuals simply smooth consumption over the length of their life? Recent literature that addresses this question [e.g. Carroll (1997) and Gourinchas and Parker (2002)] has emphasized the importance of precautionary saving in the face of income uncertainty. In addition to this, Fernández-Villarverde and Kruger (2001) have argued the importance of accumulation of consumer durables early in life. In this paper, we use a calibrated version of a standard general equilibrium lifecycle model to demonstrate the importance of uncertainty in the length of life, and the absence of a complete set of annuity markets, in generating lifecycle consumption profiles similar to ones estimated from data. Individuals in our model face no income uncertainty. Our model is one in which individuals hold assets that are claims to capital used in production. In addition, a worker’s productivity depends on his/her age, and individuals, who value leisure, will vary their work effort over their life in response to this. This turns out to have some secondary importance for the shape of the consumption profile. We also consider whether introducing old age transfer programs, such as a pay-as-you-go social security system, mitigate the consequences of a lack of annuity markets. Preliminary results indicate that they have relatively little effect.