Nobel prize winner Franco Modigliani - Essay Example

first Institute 9 March 1985 Nobel Prize winner Franco Modigliani Franco Modigliani is well known as the Nobel Prize winner of 1985 for his groundbreaking work on Macroeconomics and monetary theory, in other words, the theory of saving and the theory of corporate finance. He received the Sveriges Riksbank Prize in Economic Sciences along with his colleagues at Sweden. Modigliani was born in Rome on 18 June 1918, where he received his schooling and further education in law. Though his father was a pediatrician, Modigliani chose not to enter the field of medicine due to his fear or suffering and blood. Instead, he opted to study law because that was the most famous field of education during that time in Italy. While studying law, he won first prize in an essay competition that was on economics; and this laid foundation for him to pursue economics in future. However, he had known that economics would not provide much opportunity for him in Europe because of fascist movements. Modigliani left Italy because of the fascist movements and the pact between Hitler and Stalin. From Rome, he moved to Paris and then to the United States just before the World War II began. He left for the United States to pursue his studies on Economics after realizing that his efforts in Europe would be futile due to political turmoil. He joined the New School for Social Research in New York that provided him the scholarship to study. There, he completed his PhD in social science in 1944 and worked as assistant professor in mathematical economics and econometrics in 1946. Between 1946 and 1960 he was associated with University of Chicago, University of Illinois, Carnegie Institute, Harvard University and Northwestern University. In 1948, he was awarded the Political Economy Fellowship of the University of Chicago. In 1960 he joined the Massachusetts Institute of Technology where he worked relentlessly on studying and analyzing the macroeconomics issues and their role on economic development of the nation. His association with Carnegie Institute till 1960 was very fruitful for Modigliani because it is there that he laid foundation for his groundbreaking work on Life Cycle Hypothesis as well as work on Corporate Finance. At MIT, as a visiting professor, Modigliani also worked on various other important and futuristic aspects of international finance, international payment system, impact of inflation, into various fields of finance such as credit rationing, the term structure of interest rates and the valuation of speculative assets. Modigliani, along with his student Richard Brumberg in 1954, formulated the life-cycle hypothesis of saving that was later developed by Modigliani and Albert Ando in 1963 with the use of many empirical studies. Modigliani’s work on this hypothesis was revisited again in 1980. This hypothesis debates upon Maynard Keynes’ General Theory or the consumption theory that directly relates current consumption with current income. Contrary to Keynesian theory, the life-cycle theory postulates that individual consumption in any time period depends on: resources available to the individual; the rate of return on his capital; and the age of the individual (Dwivedi, 159-160). On broader level, this hypothesis relates to the national economy in the way that national saving is directly linked with national income and mass of national wealth will be in proportion with the length of life span of working. This hypothesis made along with Brumberg was not empirically proven, and hence did not gain significance until Modigliani proved this hypothesis along with Ando and other associates. Modigliani’s hypothesized that in general, individuals tend to keep their expenditure and lifestyle constant, irrespective of their varying levels of income. This means, individuals tend to save more money when their earnings are higher and save less when their earnings drop. When their income is higher, they tend to spend more without assessing potential risks in future to their incomes; however, if they understand the possible uncertainties future beholds in terms of their earning potential and spending, they tend to save more for the future by spending less in current times. Individuals’ spending pattern, thus, largely depends upon economic growth of the nation, and is directly proportional to national savings. This will also help in predicting consumer spending patterns, which will be of great importance for understanding national economic trends. Thirdly, age is a determining factor in national savings trend because country that has more of younger population in earning groups has greater potential for national savings than the one housing more of retired personnel. This means in a growing population, the number of younger people in the earning age group will be far greater than the older population; with more number of people in earning age group, the national economy is also growing because economic growth depends upon growth in earnings per person. If economy is not growing, then wealth is not created. Modigliani’s hypothesis on life-cycle saving has given birth to and established the fact that individuals and nations have to be better prepared to the uncertain situations. Furthermore, this hypothesis highlights that temporary changes in taxation and financial policies have least impact on consumption pattern during lifetime of an individual. These temporary changes will not have any impact on inflation control, either. From macroeconomists’ perspective, the life-cycle hypothesis provides sufficient base to understand consumption and savings behavior. Another breakthrough proposition made by Modigliani was in conjunction with Merton Miller on corporate finance, known as the Modigliani and Miller Theorem or the capital structure irrelevance proposition in 1958. This study laid the foundation for Corporate Finance. This study was based on financing pattern of firms for business purposes as well as debt repayment. Their theorem proposed that firms did not decide their need and extent of investment on the basis of their capital structure or the means to acquire finance. This theorem proposes that in a competitive market with rational investors and ignoring the effects of taxes, the way in which firms are financed is irrelevant in the sense that the total market value of firms will be independent of their financial structure; and the market value of shares will be independent of dividend policy (Hossain, 203). The M-M Theorem has been critiqued as well as modified by many economists, including Merton. The life-cycle hypothesis proposed by Modigliani and Brumberg utilized a number of empirical tests conducted in the United States during the period between 1929 through 1959, excluding 1941-1946 years. Modigliani was greatly inspired by empirical tests based on Keynesian model, as revealed in an interview with Barnett. Modigliani and Ando’s work in 1963 on the hypothesis was developed based on data collected related to individual income, age, inherited wealth, and number of years of the individuals’ life. This study was based on statistical analysis of time-series; while their earlier hypothesis was at microeconomics level, the latter development had macroeconomic implications. The other seminal work on corporate finance along with Miller was based on market value maximization using empirical evidence related to cost of capital and considering certain income groups (Modigliani & Miller, 262). This study was much more complicated that eventually provided a breakthrough platform for corporate finance and investment patterns for industries. To sum up, the Italy-born and the U.S citizen, Franco Modigliani’s works in the field of macroeconomics has been pioneering contribution that the economies of the world have benefited. He has produced several works of which the life-cycle hypothesis on savings and the cost of capital, corporate finance and theory of investments have been most appreciated and rewarded the Nobel Prize in 1985. Both these works have been adopted by the US and UK economies. These theories have provided proposals to various firms in the consumer, investment and government sector to predict consumer behavior, investment pattern and corporate finance. Works cited Dwivedi, DN. Macroeconomics: Theory and Policy. 3rd Ed. TataMcGrawHIll: New Delhi. "Franco Modigliani - Autobiography". Nobelprize.org. 9 Mar 2011 Retrieved March 9, 2011 from, http://nobelprize.org/nobel_prizes/economics/laureates/1985/modigliani.html Hossain, Moazzem. Franco Modigliani (1918- ): A Founder of the Life Cycle Hypothesis and Laureate of 1985. Frontiers of Economics: Nobel Laureates of the Twentieth Century. Ed. Abu N.M Wahid. Greenwood Publishing Group: Connecticut, 2002. Modigliani, Franco and Merton H Miller. The Cost of Capital, Corporation Finance and the Theory of Investment. The American Economic Review. Vol.48, No.3, 1958. pp:261-297. Read More