Franco Modigliani (June 18, 1918 – September 25, 2003) was an Italian-born American economist. He was awarded the Nobel Prize for Economics in 1985 for his work on household savings and the dynamics of financial markets. The Modigliani-Miller theorem, which he co-authored with Merton Miller, represented a breakthrough in the theory of corporate finance, with important implications for understanding investment decisions.
Modigliani also developed the Life-Cycle Hypothesis as a counter to the classical Keynesian model of spending, which stated that people increase their spending as their income increases. Modigliani proposed that consumers would aim for a stable level of income throughout their lifetime, saving during their working years and spending during their retirement. Unlike Milton Friedman's model which assumed that people would save for their descendants, Modigliani claimed that people save only for their own retirement. The idea that people save for their old age is not a new one. Modigliani's contribution was in constructing a formal model that allowed macroeconomic implications to be made. The Life-Cycle Hypothesis has thus proved as a useful tool in analyses of the effects of different pension systems. For a society to maintain its prosperity, all members must be encouraged to contribute as best they can to benefit the society as a whole, and the society must also care for their needs. As life expectancy rates have risen in many nations so have the numbers of older people, requiring a clear understanding of how to provide financial support for everyone, whether through pensions or individual savings. Modigliani's work has been valuable both in terms of analysing savings trends in the society as a whole, and in terms of understanding how best to provide for members of society as they age.
Franco Modigliani was born on June 18, 1918 in Rome, Italy, the son of Enrico Modigliani and Olga Flaschel. His father was a famous physician and his mother a volunteer social worker. He received his basic education in Rome, and, despite the sudden loss of his father in 1932, an event that was quite traumatic to young Franco, he graduated early from the best high school and at the age of 17 enrolled at the University of Rome. Although his family wanted him to follow his father’s steps and become a physician, he chose law as his main educational track.
In 1939, Modigliani married Serena Calabi, through whom he came in touch with the antifascist movement. He went briefly to Paris, where he studied at the Sorbonne. He received his Doctor Juris degree from the University of Rome, in June 1939. He moved with his wife to the United States just a few days before the start of the World War II.
In 1939, Modigliani was awarded a free tuition fellowship by the Graduate Faculty of Political and Social Science of the New School for Social Research. There he completely turned his interest toward economics and econometrics. He obtained his Ph.D. working under Jacob Marschak, whose ideas played an important role in the formation of Modigliani's own approach to economics. In 1946, Modigliani became a naturalized citizen of the United States.
Modigliani served as an instructor at New Jersey College for Women in 1941, and an instructor in economics and statistics at Bard College in 1942. In 1944, he returned to the New School as a Lecturer and a Research Associate at the Institute of World Affairs. There he published his first contributions to the study of saving.
In 1948, Modigliani joined the University of Illinois at Urbana-Champaign faculty. At the same time he was awarded the prestigious Political Economy Fellowship of the University of Chicago. During that time he started to collaborate with Richard Brumberg, with whom he developed his "Life Cycle Hypothesis of Saving." Modigliani stayed in Chicago for only a year (1949-1950), and at the University of Illinois until 1952.
In 1952, Modigliani joined the staff at the Graduate School of Industrial Administration of Carnegie Mellon University, staying there until 1960. From 1960 to 1962 he was professor of economics at Northwestern University. In 1962, he accepted position of a professor at the Massachusetts Institute of Technology, where he stayed for the reminder of his career. He became professor emeritus in 1988.
In the late sixties, Modigliani worked on the designing of a large scale model of the U.S. economy, sponsored by the Federal Reserve Bank. He also actively participated in the shaping of economic policies in Italy. He was a member of the National Academy of Sciences and the American Academy of Arts and Sciences. He also served as president of the Econometric Society, the American Economic Association, and the American Finance Association.
Franco Modigliani was awarded the Nobel Prize for Economics in 1985 for his work on household savings and the dynamics of financial markets.
Modigliani died in Cambridge, Massachusetts, U.S. on September 25, 2003, at the age of 85.
Modigliani and his colleague Richard Brumberg, who unfortunately died suddenly in 1955, developed the Life-Cycle Hypothesis, which attempts to explain the level of saving in the economy. Modigliani objected to the classical Keynesian model of spending, which stated that people increase their spending as their income increases. The higher their income, the more money people spend.
Modigliani instead proposed that consumers would aim for a stable level of income throughout their lifetime, for example by saving during their working years and spending during their retirement. Milton Friedman also worked on his own theory of savings, which he published three years after Modigliani. The two theories differ in the time frame involved: Modigliani hypothesized that people plan for their own retirement, whereas Friedman claimed that they save money for their descendants as well.
The Life-Cycle Hypothesis has long-term implications in economic science. The idea that people save for their old age is of course not a new one. Modigliani's contribution was in constructing a formal model that he integrated into well-defined economic theory, and in his drawing macroeconomic implications from the model. It showed that aggregate saving depends primarily upon the rate of growth of the economy. It also revealed that aggregate saving depends on economic as well as demographic factors, like age structure of the population and the life expectation. The Life-Cycle Hypothesis has thus proved as a useful tool in analyses of the effects of different pension systems.
Modigliani and Merton Miller published their famous The Cost of Capital, Corporate Finance and the Theory of Investment in 1958. The paper urged a fundamental objection to the traditional view of corporate finance, according to which a corporation can reduce its cost of capital by finding the right debt-to-equity ratio. According to Modigliani and Miller, however, there was no right ratio, so corporate managers should seek to minimize tax liability and maximize corporate net wealth, letting the debt ratio chips fall where they will. Modigliani and Miller also claimed that the real market value of a company depends mostly on investors' expectations of what the company will earn in the future, not the company's debt-to-equity ratio.
The way in which Modigliani and Miller arrived at their conclusion made use of the "no arbitrage" argument, that is the premise that any state of affairs that will allow traders of any market instrument to create a riskless money machine will almost immediately disappear. They set the pattern for many arguments in subsequent years based on that premise.
The Modigliani-Miller theorem forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle.
The theorem was originally proved under the assumption of no taxes, but can also be extended to a situation with taxes. Consider two firms that are identical except for their financial structures. The first (Firm U) is unlevered: that is, it is financed by equity only. The other (Firm L) is levered: it is financed partly by equity, and partly by debt. The Modigliani-Miller theorem states that the value of the two firms is the same.
Paul Samuelson, a good friend of Modigliani and a fellow Nobelist, said, "Franco Modigliani could have been a multiple Nobel winner. When he died he was the greatest living macroeconomist. He revised Keynesian economics from its Model-T, Neanderthal, Great Depression model to its modern-day form" (Sales 2003).
Modigliani’s theory of life cycles helped explain the varying rates of savings in societies dominated by younger or older population. His models were successfully used in predicting the future effects of various pension plans. In addition, the methods Modigliani invented for calculating the future value of a company became basic tools in corporate decision making and finance.
Modigliani influenced many generations of students, among others Robert C. Merton, the 1997 winner of the Nobel Prize in economics.
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