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Learning your earning: are labor income shocks really very persistent?

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Fatih Guvenen

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Abstract

The current literature offers two views on the nature of the labor income process. According to the first view, which we call the “restricted income profiles” (RIP) model, individuals are subject to large and very persistent shocks while facing similar life-cycle income profiles (MaCurdy, 1982). According to the alternative view, which we call the “heterogeneous income profiles” (HIP) model, individuals are subject to income shocks with modest persistence while facing individual-specific income profiles (Lillard and Weiss, 1979). In this paper we study the restrictions imposed by the RIP and HIP models on consumption data—in the context of a life-cycle model—to distinguish between these two hypotheses. In the life-cycle model with a HIP process, which has not been studied in the previous literature, we assume that individuals enter the labor market with a prior belief about their individual-specific profile and learn over time in a Bayesian fashion. We find that learning is slow, and thus initial uncertainty affects decisions throughout the life cycle. The resulting HIP model is consistent with several features of consumption data including (i) the substantial rise in within-cohort consumption inequality, (ii) the non-concave shape of the age-inequality profile, and (iii) the fact that consumption profiles are steeper for higher educated individuals. The RIP model we consider is also consistent with (i), but not with (ii) and (iii). These results bring new evidence from consumption data on the nature of labor income risk.

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Paper provided by Federal Reserve Bank of Minneapolis in its series Discussion Paper / Institute for Empirical Macroeconomics with number 145.

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Date of creation: 2006
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Handle: RePEc:fip:fedmem:145

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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Dirk Krueger & Fabrizio Perri, 2005. "Does income inequality lead to consumption equality? evidence and theory," Staff Report 363, Federal Reserve Bank of Minneapolis. [Downloadable!]
    Other versions:
  2. Giorgio E. Primiceri & Thijs van Rens, 2006. "Heterogeneous Life-Cycle Profiles, Income Risk and Consumption Inequality," Economics Working Papers 945, Department of Economics and Business, Universitat Pompeu Fabra, revised Aug 2007. [Downloadable!]
    Other versions:
  3. Amir Yaron, 2007. "The Research Agenda: Amir Yaron on Lifetime Inequality and Long Run Risks and Asset Pricing," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 9(1), November. [Downloadable!]
  4. Fatih Guvenen, 2007. "An Empirical Investigation of Labor Income Processes," NBER Working Papers 13394, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  5. Fatih Guvenen & Burhanettin Kuruscu, 2007. "Understanding the Evolution of the U.S. Wage Distribution: A Theoretical Analysis," NBER Working Papers 13096, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  6. Stéphane Bonhomme & Jean-Marc Robin, 2008. "Generalized nonparametric deconvolution with an application to earnings dynamics," CeMMAP working papers CWP03/08, Centre for Microdata Methods and Practice, Institute for Fiscal Studies. [Downloadable!]
  7. Abigail Wozniak, 2006. "Educational Differences in the Migration Responses of Young Workers to Local Labor Market Conditions," IZA Discussion Papers 1954, Institute for the Study of Labor (IZA). [Downloadable!]
  8. Fatih Guvenen, 2007. "An empirical investigation of labor income processes," IFS Working Papers W07/13, Institute for Fiscal Studies. [Downloadable!]
  9. Heathcote, Jonathan & Storesletten, Kjetil & Violante, Giovanni L, 2007. "Consumption and Labour Supply with Partial Insurance: An Analytical Framework," CEPR Discussion Papers 6280, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
  10. Burhanettin Kuruscu, 2006. "Training and Lifetime Income," American Economic Review, American Economic Association, vol. 96(3), pages 832-846, June.
  11. Fatih Guvenen & Burhanettin Kuruscu, 2006. "Ben-Porath meets skill-biased technical change: a theoretical analysis of rising inequality," Discussion Paper / Institute for Empirical Macroeconomics 144, Federal Reserve Bank of Minneapolis. [Downloadable!]
  12. Fatih Guvenen & Burhanettin Kuruscu, 2007. "A Quantitative Analysis of the Evolution of the U.S. Wage Distribution: 1970-2000," NBER Working Papers 13095, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  13. Mark Huggett & Gustavo Ventura & Amir Yaron, 2007. "Sources of Lifetime Inequality," NBER Working Papers 13224, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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