MODIGLIANI, FRANCO (Social Science)

1918-2003

Franco Modigliani was an Italian-born Jewish-American economist. He fled the fascist and anti-Semitic regime of Benito Mussolini (1883-1945) in 1939 and migrated to the United States with a doctor of law degree (1939) from the University of Rome. He earned a doctorate in economics from the New School University in New York in 1944, writing his dissertation on the Keynesian liquidity preference. In his dissertation, he reworked the Hicksian IS and LM curves to present a new version of Keynesian economics. His Keynesian paradigm laid the foundation for the Federal Reserve Bank econometric model. In 1962 Modigliani joined the economics department of the Massachusetts Institute of Technology, where he stayed for the rest of his career.

Liquidity preference explains unemployment without wage rigidity. It posits a relationship of money to prices. The price of money is anything that can be exchanged for it. Money in the future is also a price with a discount rate R = (1 + r)-1. Being flexible, the rate of interest will rise in tight money situations. People will raise cash by liquidating money instruments or through borrowing. Investment and savings will fall and be subsequently followed by a fall of income and employment. The demand for money will then fall to equal its supply. Essentially, Modigliani argued for a "rate of interest" to "output" adjustment consequent to a tight monetary policy, in contrast to classical economists, who argued for a "rate of interest" to "price of all goods" adjustment. By keeping policymakers on guard to supply an adequate quantity of money or to fix an appropriate interest rate, Modigliani made unemployment an equilibrating mechanism.


Modigliani rid the investment concept in corporate finance of its traditional utility and production analyses. The Modigliani-Miller hypothesis first argued that a firm trying to increase its value by moving from only equity to a mixture of debt and equity positions will encourage arbitrage among individual investors that would undo its actions, making value invariant to the debt/equity ratio. Second, the rate of return on equity is linearly dependent on the debt/equity ratio. If a firm’s stock is $1,000, debt is $400, interest on debt is 0.05, and the expected rate of return is 0.1, then its return on equity will be

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ment opportunities are also independent of the debt/ equity ratio. This three-part hypothesis abstracted from the effects of taxes and bankruptcy. The discussion was extended to a dividend invariance value model.

In Modigliani’s second best-known hypothesis, the life-cycle hypothesis of saving (LCH), consumers receive income, Y, up to the end of their working life, N. They accumulate savings during their working year, and consume, C, uniformly during their lifetime, L > N. Since lifetime consumption must equal lifetime income, assuming no bequest, we can express CL = NY, or C = (NI L) Y, in which case the terms in parentheses represent the marginal propensity to consume. Fitting the LCH to labor income and net assets, A, the equation C = .766 Y + .073A reconciled some anomalies of the post-World War II (1939-1945) period.

For his contributions to investment and consumption theories, Modigliani received the Nobel Prize in economics in 1985. He also contributed to economic policy debates, evolving the NIRU (noninflationary rate of unemployment) concept through the Phillips curve, and Okun’s unemployment versus the gross domestic product gap relationship, public deficits, and reinstated personal savings into the post-Keynesian debate on the equilibrium profit rate, creating the dual or anti-Pasinetti theorem.

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