Final answer:
Consumption smoothing is the practice of keeping consumption levels stable over time, regardless of income fluctuations, achieved through saving and dissaving. It reflects households' preference for a consistent consumption pattern rather than experiencing significant variations.
Step-by-step explanation:
The concept of consumption smoothing refers to the practice of maintaining a stable level of consumption over time, regardless of fluctuations in income. It is based on the premise that households prefer not to have their consumption vary greatly from period to period (such as month to month or year to year), and instead aim to keep it relatively even.
This behavior can be observed when a household receives an increase in income that is either temporary or permanent. According to consumption smoothing, for a temporary increase in income, the marginal propensity to consume is much smaller, meaning households will likely save a larger portion of this increase. Conversely, if the income increase is perceived as permanent, the propensity to consume is closer to 1, leading to a more balanced spread of the extra income over time.
Consumption smoothing can be achieved through saving and dissaving. Saving allows converting current income into future consumption, while dissaving means using existing wealth or borrowing against future earnings when income is lower than usual. Thus, a household might save part of their income during times of prosperity to be able to maintain their level of consumption during periods of lesser income.
A common example of consumption smoothing is that of a construction worker who earns a substantial income during certain months of the year and no income during the others. Instead of spending all the income in the high-earning months and depleting resources in the no-income months, the worker would save a portion of the income to spend during the months when no income is earned, thus achieving a stable monthly consumption level.