Life-Cycle Model of Consumption

Consumption smoothing is the idea that households like to keep their flow of consumption relatively steady over time. When income is unusually high, the household saves (or pays off existing loans); when income is unusually low, the household borrows (or draws down existing savings). Consumption smoothing is a key ingredient of the life-cycle model of consumption, which is discussed in more detail in the toolkit. If your company has a good year and you get a big bonus, you will increase consumption spending not only this year but also in future years. To do so, you must save a portion of your bonus to pay for this higher consumption in the future. By the same logic, if your income decreases, your consumption will not decrease as much. People who became unemployed during the Great Depression did not reduce their consumption of services and nondurable goods to zero. Instead, as far as was possible, they drew on their existing savings, borrowed, and postponed purchases of durable goods. Consumption of durable goods, in other words, resembles investment rather than consumption of nondurable goods and services. This makes sense because durable goods resemble investment goods that are purchased by households. Like investment goods, they yield benefits over some prolonged period of time. As an example, consider automobile purchases during the Great Depression. Although 5.4 million cars were produced in 1929, only 3.4 million were produced in 1930—a reduction of more than 37 percent in a single year. Instead of buying new cars, households simply held onto their existing cars longer. As a consequence of the boom of the 1920s, there were a lot of relatively new cars on the road in 1929: the number of cars less than 3 years old was about 9.5 million. Two years later, this number had fallen to 7.9 million. [2] This reduction in activity in the automobile industry was matched by a reduction of inputs into the production process. By early 1933, there were only 4 workers for every 10 who had been employed 4 years previously. Equipment purchases for the transportation sector were so low that capital stock for this sector decreased between 1931 and 1935. In the turmoil of the Great Depression, many small car producers went out of business, leaving a few relatively large companies—such as Ford Motor Company and GM—still in business. Similar patterns arose as the economy recovered. Investment, in particular, was astonishingly volatile. It decreased by about one-third in 1930 and again in 1931, and by over two-thirds in 1932, but rebounded at an astoundingly high rate after 1933. Consumption, meanwhile, grew at a slower rate than GDP as the economy recovered.