Capital income risk and the dynamics of the wealth distribution

Understanding rising wealth inequality requires a comprehension of the evolution of wealth distributions. We quantify a model of idiosyncratic labor income and interest rates to match the evolution of the wealth distribution of the NLSY 79 cohort in the US from 1986 to 2008. We allow for economic growth, stochastic labor income and stochastic interest rates. Individuals differ in their financial ability, i.e. in their average financial returns. Aggregating over individuals balances a stationary long-run wealth distribution (for low interest rates) with exploding wealth distributions (for high interest rates). The baseline calibration fits the wealth distribution in 2008 up to 96.1% with an empirically plausible distribution of labor income and the standard deviation of model interest rates being lower than the empirical standard deviation. As our average fit over the entire sample period is also very good, models of this type can be employed to understand how quickly wealth distributions could become more equal if certain policy measures were introduced.11We would like to thank Dan Cao, Michael Graber, Jeremy Lise, Andrey Launov, Mi Luo, Jean-Baptiste Michau, Luigi Pistaferri, Markus Poschke, Elisabeth Pröhl, Philip Sauré, Shenghao Zhu and seminar participants at the University of Basel, the Econometric Society Winter Meeting in Barcelona, the CRD, the Hong Kong University of Science and Technology and at the National University of Singapore for comments and discussions. Special thanks go to Joachim Hubmer and Benjamin Moll for detailed discussions. We are deeply indebted to Jess Benhabib for many discussions and comments. Comments by the editor, an associated editor and two reviewers improved the manuscript considerably. Excellent research assistance was provided by Paul Strasser and, especially, Tobias Heilmann (né Nagel).