In 1941, Modigliani left the New School to take a
professorship at New Jersey College for Women. In 1942, he became an
instructor in economics and statistics at Bard College, but returned
to the New School in 1944 to receive his Ph.D. It was also at the New
School that Modigliani became a lecturer and a research associate at
the Institute of World Affairs. During this period, Modigliani developed
the Duesenberry-Modigliani hypothesis on savings. After being awarded
the Political Economy Fellowship from the University of Chicago in 1948,
Modigliani moved to Chicago. That same year, Modigliani joined the faculty
at the University of Illinois to head the research venture on “Expectations
and Business Fluctuations,” which ultimately led to many of his
At the University of Illinois, Modigliani originated
the “Life Cycle Hypothesis,” which attempts to explain the
level of personal saving in the economy. Modigliani hypothesized that
consumers would aim for a stable level of income throughout their lifetime,
for example by saving during their working years and spending during
From 1952 to 1960, Modigliani joined the Canegie Institute
of Technology. Modigliani, along with Merton
Miller, formulated the important Modigliani-Miller theorem in corporate
finance and financial markets. This demonstrated that under certain
assumptions, the value of a firm is not affected by whether it is financed
by equity (selling shares) or debt (borrowing money).
From 1960 to 1962, he was the professor of economics
at Northwestern University. After many years of moving around, Modigliani
settled down in 1962 as a professor of economics at the MIT Sloan School
Franco Modigliani died on September 25, 2003, at the
age of 85.
The following press release
from the Royal Swedish Academy of Sciences
describes Modigliani’s work:
The Life-Cycle Hypothesis
One of the cornerstones
of the British economist J.M.Keynes' general
theory, presented in 1936, is the relationship
between consumption and national income.
According to Keynes, it is a "psychological law"
that "households increase their consumption as their income increases,
but not as much as their income increases". One consequence of
this "law" is that the proportion
of national income represented by saving
increases during periods of economic growth.
Keynes' theory of saving
was generally accepted by his contemporaries.
However, in 1942 Simon Kuznets showed that
the theory did not agree with empirical
facts: in the U.S., the long-term saving:
income ratio had not increased over time.
This supposed paradox became the object
of a number of studies during the years
that followed, and several new approaches
to the theory of saving were presented.
However, it was not until 1957, when Milton
Friedman formulated his "permanent
income" hypothesis, that a rational
explanation of the Keynes-Kuznets contradiction
was given within the framework of a general,
well-defined theory of consumer demand
over time. The characteristic feature of
Friedman's hypothesis is that a person's
income is assumed to consist of two parts,
one permanent and one transitory, and that
it is the permanent part that is the determinant
of decisions about consumption and saving.
Friedman argued that Keynes' proposition
was incorrect since it was derived from
empirical observations of cross-section
data referring to total, not to permanent,
income. Friedman's ideas were well received
by most economists, and for several years
the permanent income hypothesis played
a dominating role among existing theories
of aggregate saving.
Three years before Friedman published his theory of
saving, Franco Modigliani, together with Richard Brumberg, a student
of his who unfortunately died some years later, had already presented
the life-cycle hypothesis. Like Friedman, Modigliani and Brumberg assumed
that households strive to maximize their utility of future consumption.
The decisive difference between the two theories concerns the length
of the planning period. For Friedman, this period is infinite, meaning
that people save not only for themselves but also for their decendants.
In the Modigliani-Brumberg version, the planning period is finite: people
save only for themselves. From the postulate of utility maximization
it follows that consumption is evenly distributed over time and this,
in turn, implies that the individual during his active period, builds
up a stock of wealth which he consumes during his old age.
The life-cycle hypothesis is a purely microeconomic
theory. However, Modigliani has shown in a number of later works - some
of which were produced in collaboration with others - that the hypothesis
has a number of macroeconomic applications. A few of these are identical
with those of the permanent income hypothesis, for instance the idea
that the aggregate saving ratio is constant in the long term and that
capital gains affect consumption only slightly. However, some of the
macroeconomic implications differ completely from those of earlier theories.
The most central one is that aggregate savings depends primarily upon
the rate of growth of the economy. Other distinguishing implications
are that aggregate saving is endogenously determined by economic as
well as demographic factors, such as the age structure of the population
and the life expectation; and that an increase in the rate of economic
growth entails a redistribution of income in favour of younger generations.
The life cycle hypothesis has been used as a theoretical
basis for many empirical investigations. In particular, it has proved
an ideal tool for analyses of the effects of different pension systems.
Most of these analyses have indicated that the introduction of a general
pension system leads to a decline in private saving, a conclusion in
full agreement with the Modigliani-Brumberg hypothesis.
The underlying idea of the life-cycle hypothesis -
that people save for their old age - is of course not new; nor is it
Modigliani's own. His achievement lies primarily in the rationalization
of the idea into a formal model which he has developed in different
directions and integrated within a well-defined and established economic
theory, and secondly in the drawing of macroeconomic implications from
that model and in performing a number of empirical tests of these implications.
These achievements are important contributions to economic science.
The life-cycle model has had a great impact on the
development of later theoretical and empirical research. It represents
in fact a new paradigm in studies of consumption and saving, and is
today the basis of most dynamic models used for such studies.
The Modigliani-Miller Theorems
While the life-cycle hypothesis concerns household saving decisions,
the Modigliani-Miller theorems concern decisions about aspects of the
composition of the accumulated savings stock. Although closely related,
these two subjects are usually regarded as belonging to two different
disciplines: economics and corporate finance.
Up to the middle of the 1950's, the literature of corporate
finance consisted mainly of descriptions of methods and institutions.
Theoretical analysis was rare. It was not until Franco Modigliani and
Merton Milier, in 1958, presented their now-famous theorem, and at about
the same time James Tobin (Nobel Prize 1981) and others started to develop
the theory of portfolio selection, that a scientific theory emerged
concerning the connection between financial market characteristics and
the financing of investments, debts, taxes, etc. Once established, this
theory developed very rapidly.
The first Modigliani-Miller theorem concerns the question
of how the market value of a firm is affected by the volume and structure
of its debts. The central proposition of the theorem gives a clear answer
to this question: neither the volume nor the structure of the debts
affects the value of the firm provided that the financial markets work
perfectly, that there are no taxes and that there are no bankruptcy
Modigliani and Miller define the value of a firm as
the sum of the market value of the equity stock and the market value
of its debts. Their theorem states that this value is equal to the discounted
value of the flow of its expected future returns, before interest, provided
that the return on investment in shares of firms in the same risk class
is used as the discount factor. This implies that the value is completely
determined by this discount factor and by the return on existing assets,
and is independent of how these assets have been financed. It further
implies that average capital cost is independent of the volume and structure
of the debts and equal to the expected return on investment in shares
of firms in the same risk class.
In a later paper, Modigliani and Miller formulated
another theorem stating that, for a given investment policy, the value
of a firm is also independent of its dividend policy. A dividend increase,
for instance, certainly increases shareholder's incomes, but this is
neutralized by a corresponding reduction in share value.
The two Modigliani-Miller theorems hold good, irrespective
of individual differences between shareholders' valuations of risk,
leverage effects, durability of loans, etc. The logic of the theorems
rests in fact upon the assumption of perfect markets, namely that a
shareholder can always, through his own borrowing or lending, compose
his asset portfolio as he sees fit and that he can, without costs, give
it the composition he desires with respect to risk, leverage, etc. lf
for instance the risk level of a firm's assets is increased, the shareholders
can neutralize this by lowering the risk of other assets in their portfolios.
The Modigliani-Miller theorems have had important implications
for the theory of investment decisions. One is that such decisions can
be separated from the corresponding financial decision. Another implication
is that the rational criterion for investment decisions is a maximization
of the market value of the firm, and a third is that the rational concept
of capital cost refer to total cost, and should be measured as the rate
of return on capital invested in shares of firms in the same risk class.
The Modigliani-Miller theorems represent a decisive
break-through for the theory of corporate finance, and have had a great
impact on later research in this area. Thus the scientific value of
the authors' work is by no means limited to the formulation of the theorems,
but refers to a great extent also to the introduction of a new method
of analysis within the discipline of corporate finance. While the idea
of treating financial decisions as a market allocation problem is perhaps
not completely new, it was Modigliani and Miller who first used it for
stringent analysis, thereby laying down guidelines for further research
in this area.