0:00:00.104,0:00:02.033 ♪ [music] ♪ 0:00:13.415,0:00:16.206 - [Narrator] What is [br]the lifecycle theory of savings? 0:00:16.206,0:00:19.633 It's the theory about how a person[br]chooses to spend and save 0:00:19.633,0:00:21.135 throughout her lifetime. 0:00:21.135,0:00:22.943 But before diving [br]into these choices, 0:00:22.943,0:00:26.264 we need to examine [br]a person's typical income over time. 0:00:26.704,0:00:29.803 Most people's incomes[br]don't stay flat their entire lives, 0:00:29.803,0:00:32.464 they change in predictable ways. 0:00:32.464,0:00:35.025 Here's a typical pattern[br]showing a person's income 0:00:35.025,0:00:36.195 over their life, 0:00:36.195,0:00:38.336 with their income[br]on the vertical axis 0:00:38.336,0:00:40.894 and time on the horizontal axis. 0:00:40.894,0:00:43.094 When you're young [br]and still in school, 0:00:43.094,0:00:44.574 you might make [br]a little bit of money 0:00:44.574,0:00:47.504 waiting tables [br]or occasionally mowing lawns. 0:00:47.504,0:00:50.845 Your first job out of school --[br]it's going to pay a lot more. 0:00:50.845,0:00:52.632 After a few years of experience 0:00:52.632,0:00:54.804 and hopefully [br]a few raises along the way, 0:00:54.804,0:00:57.074 you make more than you ever have. 0:00:57.074,0:00:59.894 Then, as you age, [br]you look forward to retirement 0:00:59.894,0:01:01.644 when your income falls. 0:01:01.644,0:01:03.245 But you're no longer working 0:01:03.245,0:01:05.735 and you could really enjoy[br]your golden years. 0:01:06.114,0:01:08.405 Now let's imagine [br]if your consumption followed 0:01:08.405,0:01:12.433 the same path as your income[br]and you never saved or borrowed. 0:01:12.433,0:01:14.105 You'd struggle when young, 0:01:14.105,0:01:16.905 and you'd be unable [br]to invest in an education. 0:01:16.905,0:01:19.105 Then, you'd spend [br]every cent you make 0:01:19.105,0:01:21.104 during your prime working years. 0:01:21.104,0:01:24.025 Well, that sounds like a lot of fun,[br]but without any savings, 0:01:24.025,0:01:26.555 your income will drop[br]suddenly when you retire, 0:01:26.555,0:01:28.536 and so will your consumption. 0:01:28.536,0:01:31.865 Your golden years [br]wouldn't be so golden. 0:01:31.865,0:01:35.715 So instead, people tend to follow[br]a lifecycle theory of savings. 0:01:35.715,0:01:38.454 A person can start out consuming [br]more than she makes, 0:01:38.454,0:01:40.375 borrowing to fill that gap, 0:01:40.375,0:01:43.093 and to pay for things [br]like an education. 0:01:43.093,0:01:45.224 Then during[br]her prime working years, 0:01:45.224,0:01:47.274 she makes more than she consumes, 0:01:47.274,0:01:48.784 paying down her debt 0:01:48.784,0:01:52.064 and saving the extra income[br]for retirement. 0:01:52.064,0:01:55.115 And when retirement comes,[br]she can spend those savings 0:01:55.115,0:01:58.204 and enjoy the golden years[br]even without working. 0:01:58.204,0:01:59.894 We call it "dissaving," 0:01:59.894,0:02:02.134 but that just means [br]spending your own savings. 0:02:02.704,0:02:06.613 Now, of course, many people deviate[br]from this exact path, 0:02:06.613,0:02:08.283 depending on details. 0:02:08.283,0:02:09.754 Most people, for example, 0:02:09.754,0:02:12.942 they consume less in college[br]than they do as professionals. 0:02:12.942,0:02:16.089 Ramen noodles are no longer [br]a staple of my diet, 0:02:16.089,0:02:19.478 but generally speaking, [br]many people follow a pattern 0:02:19.478,0:02:22.789 of borrowing, saving and dissaving 0:02:22.789,0:02:25.930 to smooth their consumption path [br]over their lifetime. 0:02:26.333,0:02:27.603 If you'd like to learn more 0:02:27.603,0:02:29.963 about the importance[br]of saving early and often, 0:02:29.963,0:02:31.573 click here. 0:02:31.573,0:02:33.301 Or, if you'd like [br]to test your knowledge 0:02:33.301,0:02:36.163 on lifecycle theory [br]of savings, click here. 0:02:36.163,0:02:38.032 ♪ [music] ♪ 0:02:39.322,0:02:40.329 Still here? 0:02:40.329,0:02:43.830 Check out Marginal Revolution [br]University's other popular videos.