Consider an example in which you’re saving for retirement. You know you plan on retiring one day. And unless you have a pension, you know you’ll have to generate income on your own. So, you maintain a lower level of consumption during your working years. As a result, you build up enough cash reserves to afford the same standard of living when your income stops.
How Consumption Smoothing Works
Instead of spending all of your extra money when you have a good month, or saving it all so you can splurge during a bad month, consumption smoothing suggests that you’ll adjust your spending and saving as needed so your standard of living doesn’t change dramatically between one period and the next. For instance, suppose your monthly income varies from $4,000 to $5,000 over the course of a year. Instead of spending all $5,000 when you have it, you only spend $4,500. You save the other $500 so you can use it in the months your income dips to $4,000. This is essentially how consumption smoothing works. You “smooth out” your spending over time by saving in good times and borrowing (either from yourself or lenders) in bad times. In fact, saving and borrowing are two main tactics that individuals use to smooth their consumption. For example, your family may create a monthly budget in which you set aside money for emergencies, unplanned expenses, and future goals. Then, you dip into your savings when it’s time to pay for one of these items. If you ever don’t have the money, you may take on credit card debt and loans to cover them (so you don’t have to alter your standard of living).
Notable Happenings
The idea of consumption smoothing has been reinforced by a few economists over the years. The first was Franco Modigliani. He developed the life-cycle hypothesis, which explains how individuals keep their consumption steady 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 article, “The Permanent Income Hypothesis,” published in 1957. In this theory, Friedman argued that people spend money based on what they think their lifetime income will be, rather than their current yearly income. So if you’re going to school to be a doctor, for example, you’ll likely spend more than you would if you were getting an arts degree—even if your current income is the same—because you assume your future income will be high enough to support it. Consumption smoothing can also be used in economics to explain consumers’ responses to increasing prices or inflation. If a household recognizes an increase in the price of certain goods and services throughout the economy, they may smooth out consumption by spending less in other areas.
