Question

Briefly list the four main ways in which a household’s consumption smoothing can be limited. Then expand thoroughly on what you know about these restrictions to consumption smoothing. Use graphs whenever necessary.

Answer 1

Consumption smoothing ensures a proper balance of spending and saving during lifetime of an individual to optimise their lifetime standard of living.

ways of consumption smoothing:-

1. Insurance- By purchasing insurance plans one save money for any unforeseen circumstances. Insurance is important because it allows people to translate consumption from periods where their consumption is high( low marginal utility) to the periods when their consumption is low(high marginal utility).

2. Pension plan- Employes often save for retirement through their employers, typically through a defined benefit retirement plan also known as pension plan

3. Saving- through saving an individual saves money when his income is high and consumption is low for his future which facilitates consumption smoothing.

4. Investment- besides saving, insurance, and pension plan there is investment method for consumption smoothing. In case of surplus income one can invest in various ways such as gold, bonds, real estate etc. instead of making unnecessary consumption.