![]() The intertemporal consumption smoothing motive can arise in many settings, but an early and famous example is the Milton Friedman’s permanent income hypothesis. 3 (summer, 1995).įor a study that demonstrates the long-term effects on consumption smoothing of financial access: Nidhiya Menon, “Consumption Smoothing in Microcredit Programs,” (Manuscript, Brandeis University, August 2003).įor a detailed account of how the poor manage their resources and why they need formal financial services: Daryl Collins, Jonathan Morduch, Stuart Rutherford, and Orlanda Ruthven, Portfolios of the Poor, (Princeton: Princeton University Press, 2009).įor more financial inclusion terms, please visit the Financial Inclusion Glossary.įor more information on CFI’s Financial Inclusion 2020 campaign, sign up for updates here. Intertemporal consumption smoothing is using savings or borrowing to make consumption less volatile than income (or sometimes wealth). In other words, when faced with income shocks, households with access to microfinance experience the shock with half the severity of those without access.įor a look at how poor families manage risk through income and consumption smoothing, and what the associated costs are, a good place to start is with Jonathan Morduch’s “Income and Consumption Smoothing,” The Journal of Economic Perspectives, Vol. ![]() Spotlight Fact: Research has shown that access to financial services can reduce a household’s consumption variability by about 50 percent. Consumption smoothing can refer to short, medium, or life-cycle time horizons. However, these same households smooth consumption when making payments in other years, primarily by transferring funds among liquid accounts. But like it or not, its something we all do on a routine basis in our short-term. Consumption smoothing is a financial planning concept developed and tested by economists. As explained in Portfolios of the Poor, “One of the least remarked-on problems of living on two dollars a day is that you don’t literally get that amount each day…you make more on some days, less on others, and often get no income at all.” Savings and loans allow people to tap into past income (through savings) or future income (through loans), helping them smooth consumption. Designing Microfinance to Enable Consumption Smoothing: Evidence from India. Consumption Smoothing is a coinage only an economist could love. ![]() For many financially excluded households, income and consumption are volatile. Theories indicate that financial integration should allow economies to better share risk and thus improve consumption smoothing. Word of the Week – Consumption Smoothing: Reduction in the variability in consumption by households, often through the use of financial services.Ĭonsumption smoothing is often cited as a benefit of access to financial services. Introduction A growing theoretical and empirical literature analyzes the effects of shocks on households’ living conditions in developing countries, and on the coping strategies adopted to overcome them. This is a worse consumption plan than cutting your consumption immediately and using that new and lower plan going forward.Access to financial services creates calmer waters by smoothing consumption Leaving your consumption unchanged in the present would therefore require even larger cutbacks in the future. In contrast, if you experience a permanent negative shock to consumption there won't (in expectation) be a good time to make up for the lost income. Because of declining marginal utility of consumption this is a worse consumption plan than keeping your consumption fixed in good times and bad. If you cut back on consumption in the face of these temporary shocks you'd end up with consumption that is higher than average in better times. Well also hear from the creator of the 401 (k) about why it started and when it makes sense to use as a tool for retirement. The idea is that if income contains permanent and temporary shocks then maximizing the NPV of lifetime utility will make you ignore temporary shocks and consume a fixed fraction of your permanent income.Įssentially, you know temporary shocks are temporary. We will try to apply the life-cycle hypothesis to personal finance. Earlier papers that emphasize a small, highly persistent. The model thus provides a theoretical justication for the exis-tence of long-run consumption risk, which is difcult to establish empirically, as pointed out by Harvey and Shepard (1990) and Hansen, Heaton, and Lee (2005). The intertemporal consumption smoothing motive can arise in many settings, but an early and famous example is the Milton Friedman’s permanent income hypothesis. Long-Run Risk through Consumption Smoothing Yaron (2004). Intertemporal consumption smoothing is using savings or borrowing to make consumption less volatile than income (or sometimes wealth).
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