Working Paper

Consumption Dynamics and Welfare Under Non-Gaussian Earnings Risk

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;

JEL Classification: E24; J24; J31;

https://doi.org/10.20955/wp.2024.007

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2024-04-01

Number: 2024-007

Related Works

• Working Paper Revision (2024-07-27) : Consumption Dynamics and Welfare Under Non-Gaussian Earnings Risk
• Working Paper Original (2024-04-01) : You are here.