Unit 3 Aggregate demand and the multiplier model
3.9 Why is consumption relatively smooth?
Section 3.5 showed that, in the data, consumption is relatively smooth, particularly compared to investment. In the multiplier model we’ve developed so far, a key determinant of the size of the multiplier is the marginal propensity to consume (\(c_1\) in our model). We now consider why we would expect consumption to be relatively smooth. At the same time, we shall get some insights into what determines the marginal propensity to consume.
- consumption smoothing
- Actions taken by an individual, family, or other group in order to sustain their customary level of consumption. Actions include borrowing or reducing savings to offset negative shocks, such as unemployment or illness; and increasing saving or reducing debt in response to positive shocks, such as promotion or inheritance.
Most people would prefer to consume relatively similar amounts in each month or year, rather than having more than enough now and too little later, or too little now, even if they will have more than enough in the future. So they may save for the future when their current income is high. And if income is currently low but they expect it to rise in future, they may want to borrow. Spreading out consumption relatively evenly between time periods is called consumption smoothing.
Unit 9 of the microeconomics volume introduces a model—called the intertemporal choice model—which helps explain why consumption smoothing is desirable. This model predicts that although income fluctuates throughout our lives, our desired consumption is smoother.
One powerful motivation for wanting to save or borrow is to be able to purchase the necessities of food, rent, phone contract, and electricity in every period. Another reason for consumption smoothing is that the additional benefit we gain from increased consumption falls as our consumption level rises. For example, the first few bites of a dish are likely to be much more pleasurable than bites from your third serving. For these reasons, people generally prefer to consume the same in each period of time rather than having a lot sometimes and a little at other times.
The desire of households to maintain a constant level of consumption provides a basic source of stabilization in any economy. Keeping consumption steady means households have to plan. They think about what might happen to their income in the future, and they save and borrow to smooth the bumps in income. This behaviour occurs in agrarian societies faced by weather and war shocks, as well as among households in industrialized economies.
The life cycle model consumption
- life cycle model of consumption
- A model of consumption spending in which individuals’ current consumption depends not only on their current income, but also on their expected future income, and their assets, allowing for savings and debts.
One way to visualize this behaviour is to focus on predictable events. A young person thinking about their life ahead can imagine getting a job, then enjoying a period of working life with income higher than the starting salary, followed by years in retirement when income is lower than during working life. Figure 3.17 illustrates, using a stylized model of how consumption could be smoothed over the lifetime. This is called the life cycle model of consumption.
Figure 3.17 is an example of the ‘life cycle model’ of consumption, developed by Nobel prizewinner Franco Modigliani in the early 1960s—so it is also sometimes simply referred to as the ‘Modigliani model’.
Before starting work, we assume the individual’s income and consumption expenditure are the same. (We can think of the support received from their parents as an income, and their consumption can be lower if they still live at home.) On starting work they initially earn a similar income for themselves; later, income will rise. Use the analysis in Figure 3.17 to follow their income and consumption over time.
Figure 3.17 Consumption smoothing through our lifetime.
Income over time
Consumption expenditure
The individual borrows while young and repays later when income is high
A notable feature of Figure 3.17 is that consumption changes before income does.
The individual shown in Figure 3.17 anticipates receiving higher income after a promotion, and adjusts consumption upward ahead of time. That is only possible if, as the model assumes, the person can borrow (we come back to this assumption below). Maybe it is possible to convince the bank that the job is secure and prospects are good. If so, they can probably get a mortgage now, and live in a more comfortable house with a higher standard of living than would be the case if long-term earnings were to remain at the starting salary. The labels on Figure 3.17 show that the individual borrows while young and income is low, saves and repays the debt later while earning more, and finally runs down savings after retirement, when income is lower again.
In Figure 3.17, income changes over the lifetime, but consumption is kept constant at a level equal to average lifetime income. If you can forecast at the start of your working life what the path of your future income will be, you can calculate your average income, and work out how much you should borrow and save to smooth your consumption. But what happens when something unexpected occurs to disturb the lifetime consumption plan? What if you later encounter an unexpected income shock?
- You will need to make a judgement: Is the shock temporary or permanent?
- If the shock is permanent: You should calculate the long-run level of consumption you can now maintain, under the new pattern of forecast income. In a diagram like Figure 3.17, the horizontal line representing consumption will shift up or down (depending whether the shock is positive or negative) from now onwards.
- If the shock is temporary: Little will change. A temporary fluctuation in income has almost no effect on the lifetime consumption plan, because it makes only a small change to your average lifetime income.
In Portfolios of the Poor: How the World’s Poor Live on $2 a Day, Daryl Collins, Jonathan Morduch, Stuart Rutherford, and Orlanda Ruthven show how poor households manage finances to avoid living hand-to-mouth. ‘Smooth Operators’. The Economist. Updated 14 May 2009. Some of the stories can be read online.
To summarize, when individuals and households behave as in the model illustrated in Figure 3.17, shocks to the economy will be dampened because spending decisions are based on long-term considerations. They aim to avoid fluctuations in consumption even when income fluctuates.
Question 3.11 Choose the correct answer(s)
Suppose that Figure 3.17 represents your lifetime consumption plan, and that you are currently at the point where you start work. Under which of the following scenarios will the amount you borrow today increase?
- Winning the lottery is a large shock to average lifetime income so you can now maintain a higher long-run level of consumption. The amount you can borrow will increase.
- A lower retirement income would lower your average lifetime income, so you would borrow less.
- You would borrow more because an earlier promotion would make a substantial increase to your average lifetime income.
- This one-off accident is a temporary negative shock so it will only make a very small change to your average lifetime income. Your behaviour would not change (or if it did, it would be to slightly decrease the amount you borrow today).
Exercise 3.6 Lifetime consumption plans
Suppose that Figure 3.17 represents your lifetime consumption plan, and that you are currently at the point where you start work. For each of the scenarios in Question 3.11, draw a diagram to show the new path of income and path of consumption.
