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What Is Consumption Smoothing?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 14 November 2016
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    Conjecture Corporation
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Consumption smoothing is a strategy that calls for balancing the ongoing purchase of goods and services with the need to also create financial reserves that help to ensure a more stable financial outlook in the years ahead. As it relates directly to households, this approach involves placing limits on spending so that an equitable standard of living is enjoyed in the here and now, even as a portion of income generated by the household is invested or otherwise set aside for retirement. The idea is to balance spending with saving and investing in a manner that allows the household to continue enjoying a similar standard of living during the retirement years. While not considered a particularly easy task, consumption smoothing does help to create reserves that allow retirees to be relatively free of financial worries and better suited to deal with unanticipated expenses, such as medical expenses after some sort of accident.

One of the tools that is used in creating and maintaining an effective consumption smoothing strategy is known as liquidity constraint. This simply refers to exercising reasonable restraint in spending income as it is generated and received by the household. Rather than using all of the income now to enjoy a higher standard of living, the goal is to create a reasonable budget that provides for the purchase of essentials and possibly a few luxuries while also consistently diverting a portion of that earned income into some sort of interest bearing investment.

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Households can make use of a number of accounting software packages in order to create workable budgets that aid in creating nest eggs for the future. Within this family of software options, consumption smoothing software can be very helpful in terms of setting goals for saving and investing a portion of the monthly income consistently. The software can also be used to help track the progress of those saving and investing efforts, which in turn helps consumers be aware of how successful their efforts happen to be at any given point in time.

While consumers make use of consumption smoothing as a way of ensuring an equitable standard of living in later years, economists can also use this concept to evaluate how residents in a given nation are managing to balance their current spending with saving and investing in the future. Data of this type is very helpful in identifying the current financial situation of the nation and can help governments and other organizations to make accurate projections for the future. This includes positioning governmental agencies to either encourage currently positive trends or take steps to motivate consumers to rethink how they spend money if the balance is considered unhealthy in light of current economic conditions.

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