Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/300063 
Year of Publication: 
2024
Series/Report no.: 
CESifo Working Paper No. 11135
Publisher: 
CESifo GmbH, Munich
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.
Subjects: 
idiosyncratic earnings risk
higher-order earnings risk
non-Gaussian shocks
incomplete markets models
consumption insurance
JEL: 
E24
J24
J31
Document Type: 
Working Paper
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