Consumption Dynamics and Welfare under Non-Gaussian Earnings Risk

Fatih Guvenen, Serdar Ozkan and Rocio Madera

No 11135, CESifo Working Paper Series from CESifo

Abstract: Recent empirical studies document that the distribution of earnings changes displays substantial deviations from lognormality: in particular, earnings changes are negatively skewed with extremely high kurtosis (long and thick tails), and these non-Gaussian features vary substantially both over the life cycle and with the earnings level of individuals. Furthermore, earnings changes display nonlinear (asymmetric) mean reversion. In this paper, we embed a very rich “benchmark earnings process” that captures these non-Gaussian and nonlinear features into a lifecycle consumption-saving model and study its implications for consumption dynamics, consumption insurance, and welfare. We show four main results. First, the benchmark process essentially matches the empirical lifetime earnings inequality—a first-order proxy for consumption inequality—whereas the canonical Gaussian (persistent-plus-transitory) process understates it by a factor of five to ten. Second, the welfare cost of idiosyncratic risk implied by the benchmark process is between two-to-four times higher than the canonical Gaussian one. Third, the standard method in the literature for measuring the pass-through of income shocks to consumption—can significantly overstate the degree of consumption smoothing possible under non-Gaussian shocks. Fourth, the marginal propensity to consume out of transitory income (e.g., from a stimulus check) is higher under non-Gaussian earnings risk.

Keywords: idiosyncratic earnings risk; higher-order earnings risk; non-Gaussian shocks; incomplete markets models; consumption insurance (search for similar items in EconPapers)
JEL-codes: E24 J24 J31 (search for similar items in EconPapers)
Date: 2024
New Economics Papers: this item is included in nep-dge and nep-lma
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Journal Article: Consumption dynamics and welfare under non-Gaussian earnings risk (2024)
Working Paper: Consumption Dynamics and Welfare Under Non-Gaussian Earnings Risk (2024)
Working Paper: Consumption Dynamics and Welfare Under Non-Gaussian Earnings Risk (2024)
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Persistent link: https://EconPapers.repec.org/RePEc:ces:ceswps:_11135

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