What is consumption smoothing?

Consumption smoothing is the idea that individuals maintain the same standard of living over time by adjusting their spending and saving across different stages of their lives.

Definition and Example of Consumption Smoothing

Consumption smoothing is defined as the tendency of households to adjust their spending habits over time to consume similar levels of goods and services throughout their lives. This idea is based on the assumption that many people prefer a steady level of consumption, rather than consuming more during periods when they earn more money and consuming less during periods when they earn less.

For example, suppose you are saving for retirement. You know that you plan to retire someday. Unless you have a pension, you understand that you will have to generate your own income. Therefore, you maintain a lower level of consumption during your working years. As a result, you build enough cash reserves to sustain the same standard of living when your income stops.

How Consumption Smoothing Works

Instead of spending all the extra money you have when you have a good month, or saving it all to indulge in a bad month, consumption smoothing refers to adjusting your spending and saving as needed so that your standard of living does not change significantly from one period to another.

For example, suppose your monthly income ranges from $4,000 to $5,000 over the year. Instead of spending all $5,000 when you receive it, you only spend $4,500. You save the other $500 to use in months when your income drops to $4,000.

This is simply how consumption smoothing works. You “smooth” your spending over time by saving in good times and borrowing (either from yourself or from lenders) in bad times.

In fact, saving and borrowing are the two main strategies that individuals use to smooth their consumption. For instance, your family might create a monthly budget setting aside some money for emergencies, unplanned expenses, and future goals. Then you use the savings when it comes time to pay for one of these items. If you don’t have the money at any time, you may resort to credit card debt and loans to cover these expenses (so that you don’t have to change your standard of living).

Notable Events

The idea of consumption smoothing has been supported by a few economists over the years. The first is Franco Modigliani. Franco developed the life cycle theory, which explains how individuals maintain a steady level of consumption over time by borrowing when income is low and saving when income is high.

Consumption smoothing was also supported a few years later by economist Milton Friedman in his paper “The Permanent Income Hypothesis” published in 1957. In this theory, Friedman argued that people spend money based on what they believe their income will be over their lifetime, rather than their current annual income. So, if you are going to school to become a doctor, for example, you are likely to spend more than you would if you were getting a degree in the arts, even if your current income is the same, because you assume your future income will be enough to support that.

Consumption smoothing can also be used in economics to explain consumer response to price increases or inflation. If a household perceives a rise in the price of some goods and services in the economy, they may smooth consumption by spending less in other areas.

Source: https://www.thebalancemoney.com/what-is-consumption-smoothing-5210793