Consumption dynamics and welfare under non-Gaussian earnings risk

Fatih Guvenen, Serdar Ozkan and Rocio Madera

Journal of Economic Dynamics and Control, 2024, vol. 169, issue C

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
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
http://www.sciencedirect.com/science/article/pii/S0165188924001374
Full text for ScienceDirect subscribers only

Related works:
Working Paper: 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)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:169:y:2024:i:c:s0165188924001374

DOI: 10.1016/j.jedc.2024.104945

Access Statistics for this article

Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

More articles in Journal of Economic Dynamics and Control from Elsevier
Bibliographic data for series maintained by Catherine Liu ().