A Parsimonious Income Process for Business Cycle Analysis

Alisdair McKay and Fatih Guvenen

No 1488, 2016 Meeting Papers from Society for Economic Dynamics

Abstract: In this paper, we estimate a parsimonious income process that is consistent with several key features of how income risk varies over the business cycle. In particular, the estimated process generates year-to-year income changes that (i) have flat and acyclical variance, (ii) have volatile and procylical skewness, (iii) have very high excess kurtosis, and (iv) imply a moderate rise in cross-sectional inequality over the life cycle consistent with the US data. Furthermore, and importantly, the process also captures the predictable nature of business cycle income risk: income changes during a business cycle episode is partly predicted by income levels before that episode. The estimated process features a mixture of normals as well as a factor structure, both of which are driven by a latent process capturing the business cycle.

Date: 2016
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