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The Life-Cycle Hypothesis, introduced by Franco Modigliani, explains how individuals strategically plan consumption and saving decisions over their entire lifetimes rather than basing choices solely on current income. It proposes that people aim to maintain stable consumption throughout their lives by adjusting their saving and spending behavior across different life stages.

According to the Life-Cycle Hypothesis, individuals borrow during early career years when income is low, save significantly during peak earning years in midlife, and withdraw savings during retirement. This pattern maintains a steady consumption trajectory despite fluctuations in lifetime income, supporting the relationship between income consumption and saving across time.

The hump-shaped curve depicts lifetime income, which rises sharply during middle age and declines afterward. In contrast, the consumption curve remains relatively flat, illustrating the hypothesis's core principle that individuals maintain stable spending despite income fluctuations by strategically managing borrowing and saving.

The Life-Cycle Hypothesis assumes individuals make rational decisions and can accurately predict their lifespan, future income, inflation, and interest rates. It also presumes unrestricted access to credit markets. These assumptions rarely hold universally in practice, especially given behavioral biases and unforeseen life events.

The Life-Cycle Hypothesis largely overlooks unexpected economic or personal shocks such as unemployment, health crises, or market volatility. Real-world deviations from the model often necessitate supplementary approaches incorporating behavioral and institutional factors to more accurately predict actual consumption and saving behavior.

The Life-Cycle Hypothesis prioritizes wealth and expectations of future income in consumption decisions because individuals plan intertemporally to optimize financial well-being. By anticipating future income changes and managing current wealth through borrowing and saving, people can achieve consumption smoothing and maintain their desired standard of living across all life stages.

The Life-Cycle Hypothesis provides foundational insight into aggregate savings behavior and retirement planning, helping policymakers design pension and social security systems. Understanding how individuals plan consumption across their lifetimes enables governments to create policies that support adequate retirement income and encourage appropriate saving patterns.