Stochastic Life Cycle Theory With Varying Interest Rates and Prices

Abstract

The article addresses issues concerning the stochastic life cycle theory. Incorporating the assumption of rational expectations has produced some striking new predictions from many familiar economic theories. One of the benefits of the said development is that the new predictions provide additional means of testing well documented theories without necessarily requiring new data. This brings forth two main effects relating consumption and income. Moreover, the optimum path of consumption depends on the expected real interest rate, while realized consumption depends on real interest rate innovations as well as income innovations. The arguments representing consumption as a first-order autoregression is not inconsistent with conventional life cycle theory, but merely a logical prediction of the theory when expectations are formed rationally.