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Learning Your Earning: Are Labor Income Shocks Really Very Persistent?

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Author Info
Fatih Guvenen (University of Rochester)

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Abstract

The current literature offers two views on the nature of the income process. According to the first view, which we call the “restricted income profiles” (RIP) model (MaCurdy, 1982), individuals are subject to large and very persistent shocks, while facing similar life-cycle income profiles (conditional on a few characteristics). According to the alternative view, which we call the “heterogeneous income profiles” (HIP) model (Lillard and Weiss, 1979), individuals are subject to income shocks with modest persistence, while facing individual-specific income profiles. While labor income data does not seem to distinguish between the two hypotheses in a definitive way, the RIP model is overwhelmingly used to specify the income process in economic models, because it delivers implications consistent with certain features of consumption data. In this paper we study the consumption-savings behavior under the HIP model, which so far has not been investigated. In a life-cycle model, 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 allowing us to estimate the prior uncertainty from consumption behavior later in life. This procedure implies that 40 percent of variation in income growth rates is forecastable by individuals at time zero. The resulting model is consistent with several features of consumption data including (i) the substantial rise in within-cohort consumption inequality (Deaton and Paxson 1994), (ii) the non-concave shape of the age-inequality profile (which the RIP model is not consistent with), and (iii) the fact that consumption profiles are steeper for higher educated individuals (Carroll and Summers 1991). These results bring new evidence from consumption data on the nature of labor income risk.

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Paper provided by EconWPA in its series Macroeconomics with number 0507004.

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Length: 35 pages
Date of creation: 07 Jul 2005
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Handle: RePEc:wpa:wuwpma:0507004

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Related research
Keywords: Labor income risk Incomplete markets Inequality Consumption-savings decision Kalman filter.

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Find related papers by JEL classification:
D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
D91 - Microeconomics - - Intertemporal Choice and Growth - - - Intertemporal Consumer Choice; Life Cycle Models and Saving
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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Cited by:
(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. 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!]
  2. 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:
  3. 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)
  4. 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!]
  5. 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:
  6. Fatih Guvenen, 2007. "An Empirical Investigation of Labor Income Processes," NBER Working Papers 13394, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  7. 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!]
  8. Fatih Guvenen, 2007. "An empirical investigation of labor income processes," IFS Working Papers W07/13, Institute for Fiscal Studies. [Downloadable!]
  9. Burhanettin Kuruscu, 2006. "Training and Lifetime Income," American Economic Review, American Economic Association, vol. 96(3), pages 832-846, June.
  10. 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)
  11. Mark Huggett & Gustavo Ventura & Amir Yaron, 2007. "Sources of Lifetime Inequality," NBER Working Papers 13224, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  12. James Feigenbaum & Geng Li, 2008. "Lifecycle dynamics of income uncertainty and consumption," Finance and Economics Discussion Series 2008-27, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  13. James Feigenbaum & Geng Li, 2008. "A Nonparametric Characterization of Income Uncertainty over the Lifecycle," Working Papers 359, University of Pittsburgh, Department of Economics, revised Jul 2008. [Downloadable!]
  14. 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!]
  15. 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)
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