Consumption Dynamics and Welfare Under Non-Gaussian Earnings Risk

Fatih Guvenen, Rocio Madera and Serdar Ozkan

No 2024-007, Working Papers from Federal Reserve Bank of St. Louis

Abstract: CORRECT ORDER OF AUTHORS: Fatih Guvenen, Serdar Ozkan, and Rocio Madera. The order of coauthors has been assigned randomly using AEA’s Author Randomization Tool. 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)
Pages: 52 pages
Date: 2024-04-01, Revised 2024-07-27
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 (2)

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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:fip:fedlwp:98700

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DOI: 10.20955/wp.2024.007

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