Answer to Question #17300 in Macroeconomics for Rajib Sinha

Question

What are the implications of the life cycle hypothesis for the effectiveness of
monetary policy?

Answer 1

The LCH affects our understanding of the working of the economy and of the effectiveness of
fiscal and monetary policies. For instance, LCH provides a direct link between
monetary
policy, interest rate and consumption, because a change in the interest rate
affects the market
value of assets and therefore consumption. As for fiscal policy, LCH suggests
that
expenditures financed by deficit tend to be paid by future generations; those
financed by taxes
are paid by current generations (Modigliani, 1961). National debt is therefore
a burden: it
reduces the stock of private capital, which in turn reduces the flow of output,
if capital is
productive. Indeed, Modigliani (1966) provided the first test of this
proposition using
aggregate US wealth data.