Social Security Payment

You can review both the household’s intertemporal budget constraint and the concept of discounted present value in the toolkit. To see how this budget constraint works, consider an individual who knows with certainty the exact number of years for which she will work (her working years) and the exact number of years for which she will be retired (her retirement years). While working, she receives her annual disposable income—the same amount each year. During retirement, she receives a Social Security payment that also does not change from year to year. As before, suppose that the real interest rate is zero. Her budget constraint over her lifetime states that total lifetime consumption = total lifetime income = working years × disposable income+ retirement years × Social Security payment. Our numerical example earlier was a special case of this model, in which disposable income = $34,000,working years = 45,retirement years = 15, and Social Security payment = $18,000. Plugging these values into the equation, we reproduce our earlier calculation of lifetime income (and hence also lifetime consumption) as ($45 × $34,000) + (15 × $18,000) = $1,800,000. The Life-Cycle Model of Consumption Economists often use a consumption function to describe an individual’s consumption/saving decision: consumption = autonomous consumption+ marginal propensity to consume × disposable income. The marginal propensity to consume measures the effect of current income on current consumption, while autonomous consumption captures everything else, including past or future income. The life-cycle model explains how households make consumption and saving choices over their lifetime. The model has two key ingredients: (1) the household budget constraint, which equates the discounted present value of lifetime consumption to the discounted present value of lifetime income, and (2) the desire of a household to smooth consumption over its lifetime.