What Is Consumption Smoothing?

Consumption Smoothing Explained in Less Than 4 Minutes

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At the most basic level, consumption smoothing is the idea that individuals maintain the same standard of living over time by adjusting their spending and saving throughout different phases of their lives.

Consumption smoothing is often achieved through a variety of methods, including borrowing money when income is low, saving when income is high, and using insurance to protect yourself from any income shocks that could arise. Here’s a more in-depth look at how consumption smoothing works in everyday life, along with some examples.

Definition and Example of Consumption Smoothing

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

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).

Other common tactics used to smooth consumption include buying health, life, or disability insurance. Such coverage will help ensure that your family’s lifestyle won’t drastically change if you die, are suddenly disabled, or develop a chronic illness—all life events that would otherwise drastically impact your income.

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.

Key Takeaways

  • Adjusting one's spending and savings habits over time to maintain the same level of consumption across different phases is known as consumption smoothing. It helps support individuals when unexpected expenses pop up or income changes in retirement.
  • This process supports the idea that as your income rises and falls—and as prices fluctuate—you’ll choose to smooth out your standard of living over time.
  • Consumption smoothing assumes that individuals will spend less when their income is high so they can maintain the same standard of living when income is low.