Final answer:
A higher smoothing parameter in the context of consumption smoothing means individuals aim to maintain a consistent consumption level, saving more during temporary income increases and adjusting consumption in proportion to permanent income changes.
Step-by-step explanation:
In the context of consumption smoothing, a higher smoothing parameter refers to the extent to which individuals prefer to maintain a stable level of consumption over time, regardless of volatility in their income. When people receive a temporary increase in income, they tend to save more of that income rather than increasing their consumption in line with the income spike, because they know the increase is not permanent. On the other hand, a permanent increase in income is likely to lead to a higher marginal propensity to consume, as individuals adjust their consumption to match the lasting higher income level.
The concept of consumption smoothing is closely related to the permanent income hypothesis, which suggests that people base their consumption on their long-term income expectations rather than their current income. This is demonstrated through the example of a construction worker who earns a substantial income only during certain months but spreads their consumption evenly throughout the year to maintain a stable standard of living.