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Is the simple life cycle model practical in the current scenario?

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Drawbacks of simple life-cycle model

While the simple life-cycle model takes into account a varying degree of productivity at different ages, it doesn’t focus on other forces at work. As a result, the simple life-cycle model can’t entirely explain the income and wealth distribution in the U.S. The same is evident in the low Gini coefficient. A Gini coefficient varies between zero and one with zero being perfect equality and one being perfect inequality. Various researchers have calculated Gini coefficient for their life-cycle models based on U.S. data which ranges from 0.42–0.58 while actual wealth Gini as per few researchers is 0.78. The inequality in the U.S. isn’t entirely explained by the simple life-cycle model. The model explains around 75% of the income and wealth inequality in the U.S. if we take ratios of model Gini and the actual Gini.

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Being a large capitalist economy with relatively smoothly functioning markets, some degree of inequality is expected. Capitalism rewards merit and in turn gives rise to inequality. Dr. Bullard cautioned the audience not to distort this portion of inequality through monetary and fiscal policy.

The role of smoothly functioning markets

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While capitalism and smoothly functioning markets cause some degree of inequality, smoothly functioning markets also fix the consumption inequality by making credit widely available. In simple terms, new entrants and the relatively young section of population can take on debt to smooth lifetime consumption. Further, households can save in their peak earning years (in the middle of adult life) to move income into retirement years. This has let foundations to the U.S. household debt market.

According to international monetary fund, the household debt to gross domestic product (or GDP) ratio was 80.5% in 4Q13, making the household debt market worth around $13 trillion. Much of this $13 trillion of household debt is incurred by relatively young in the form of mortgages.

In the simplest form of the life-cycle model, all households will consume uniformly across their lifetime making the consumption Gini zero (perfect equality). Policymakers should be very careful when designing fiscal and monetary policies that may have an impact on the U.S. credit markets.

While not entirely, the life cycle model conforms to the above phenomenon. The Gini coefficient for consumption as per the lifecycle model is lower than that for income and wealth.

Can inequality rise in the life-cycle model?

The new and the old entrants are relatively unproductive and the situation won’t change much in the future. However, new technological developments may help peak earners become more productive leading to relatively higher income levels for peak earners. Some researchers believe that the technology change helps all households and not just the peak earners.

The case of unbanked households

Some households don’t follow the “work every day” and “plan out your life” aspects of life cycle explained in the earlier parts of the series.  Instead, some households work intermittently, earning money where and when they can. As a result, these households generally have lower income levels and higher unemployment. These households rely a lot on cash due to limited access to credit markets and the banking system. Dr. Bullard quoted that around 10% of the U.S. households are unbanked and 20% are nearly unbanked. Adding this group to the life cycle group, Dr. Bullard provided answers to the three questions posed in the first section in this series.

To learn about Dr. Bullard’s answers for the three questions posed in the first section, continue reading the next section in this series.

About James Bullard

James Bullard is the chief executive officer (or CEO) and the 12th president of the Federal Reserve Bank of St. Louis (or St. Louis Fed) since April, 2008. He joined the St. Louis Fed in 1990 as an economist at its research division. He worked as vice president and deputy director of monetary analysis research division prior to becoming the president and CEO. He was a voting member of Federal Open Market Committee (or FOMC) in 2010 and 2013. The FOMC is the monetary policy setting body whose actions affect both equity (VOO) and fixed income (BND) securities including Treasuries (TLT), high-yield bonds (HYG), and investment grade bonds (LQD).

Dr. Bullard also holds the position of honorary professor of economics at Washington University in St. Louis.

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