Franco Modigliani

Franco Modigliani was a Neo-Keynesian economist who received the Nobel Prize in 1985. Modigliani was born in 1918 in Rome, Italy and later came to the United States at the outbreak of World War II. He is best known for his contributions to consumption theory, financial economics, and for the theory he developed, called the Modigliani-Miller Theorem of corporate finance.

Early Life and Education

Franco Modigliani was born on June 18, 1918, in Rome, Italy to a physician father and social worker mother. When Franco was 13, his father passed away from complications from surgery. For a few years following his father's death, he struggled to excel academically. However, after changing high schools, he thrived, graduating early to attend the Sapienza University of Rome.

Modigliani initially studied law, but later immigrated to the United States, where he received his doctorate in economics from the New School for Social Research. He taught at Bard College at Columbia University before serving as a professor at the University of Illinois at Urbana-Champaign, Carnegie Mellon University, and the Massachusetts Institute of Technology.

Modigliani served as president of the American Economic Association, the American Finance Association, and the American Econometric Society. He also worked as an advisor to Italian banks and politicians, the U.S. Treasury, the Federal Reserve System (FRS), and sat on the board of several European banks. He was awarded the Nobel Prize in Economics in 1985 for his development of models of private consumption and corporate finance. 

Notable Accomplishments

Modigliani’s early contributions were in the field of socialism and centrally-planned economies, for which he was given an award by Italian fascist dictator Benito Mussolini. His most notable contributions to economics include his life-cycle consumption theory and the Modigliani-Miller Theorem of corporate finance. He also made important contributions to the theories of rational expectations and the non-accelerating inflation rate of unemployment (NAIRU). 

Life-Cycle Consumption Theory

One of Modigliani's early contributions to economics was the life-cycle consumption theory, which says that individuals primarily save money during their early years to pay for their later years. The idea is that people prefer a relatively stable level of consumption, borrowing (or spending down savings passed on to them) while young, saving during middle age when earnings are high, and spending down savings in retirement. This introduces age demographics as a factor that helps to determine a Keynesian consumption function for the economy.

Modigliani-Miller Theorem

His other major contribution, in cooperation with Merton Miller, was the Modigliani-Miller (M&M) theorem, which formed the foundation for capital structure analysis in corporate finance. Capital structure analysis helps companies determine the most effective and beneficial ways to fund their companies through a mixture of equity and debt.

The Modigliani-Miller theorem argues that if financial markets are efficient, this mixture will make no difference for the value of the firm. This theorem would go on to form the basis of much of modern corporate finance.

Published Works

In his early career in Italy, and then in the United States, Modigliani wrote extensively on the possibility of rational management of a command economy by a central planner. While a student in Rome, he won a national essay contest for a paper arguing in favor of government control of the economy.

He wrote a series of papers before World War II in favor of fascist principles of economic management by the state, later transitioning to favor market, socialist-style central planning of prices and production in a 1947 paper. This work was published in Italian and was less influential than his other work until it was translated into English in the mid-2000s. 

Modigliani made a fundamental contribution to the theory of rational expectations in a 1954 paper, which argued that people adjust their economic behavior based on the impact that they expect government policy to have on them. Ironically, rational expectation theory would be developed by other economists into a major and wide-ranging criticism of the effectiveness of Keynesian macroeconomic policy (which Modigliani championed).

In a 1975 paper, Modigliani argued that monetary policymakers should target output and employment in setting policy. The appropriate target, he proposed, would be the non-inflationary rate of unemployment, which he estimated at about 5.5%. Ironically, though his paper was explicitly opposed to monetarism and in favor of Keynesianism, his idea would go on to be developed into the theory of the non-accelerating inflation rate of unemployment (NAIRU), which would become a powerful critique against Keynesian macroeconomic policy.

Franco chronicled his life as an economist in his 2001 autobiography Adventures of an Economist. Two years after its publication, Franco passed away.

The Bottom Line

Franco Modigliani was a Nobel Prize-winning Italian economist highly regarded for his contributions to economics. His life-cycle consumption theory explained how people borrow, spend, and save during different stages of their lives. The Modigliani-Miller Theorem, co-developed with Merton Miller, argues that a firm's value is not affected by its equity and debt mix when financial markets run efficiently. His theories not only revolutionized the field of economics but also various industries such as corporate finance.