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Inferring labor income risk and partial insurance from economic choices

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  • Fatih Guvenen
  • Anthony Smith

Abstract

This paper uses the information contained in the joint dynamics of individuals’ labor earnings and consumption-choice decisions to quantify both the amount of income risk that individuals face and the extent to which they have access to informal insurance against this risk. We accomplish this task by using indirect inference to estimate a structural consumption-savings model, in which individuals both learn about the nature of their income process and partly insure shocks via informal mechanisms. In this framework, we estimate (i) the degree of partial insurance, (ii) the extent of systematic differences in income growth rates, (iii) the precision with which individuals know their own income growth rates when they begin their working lives, (iv) the persistence of typical labor income shocks, (v) the tightness of borrowing constraints, and (vi) the amount of measurement error in the data. In implementing indirect inference, we find that an auxiliary model that approximates the true structural equations of the model (which are not estimable) works very well, with negligible small sample bias. The main substantive findings are that income shocks are not very persistent, systematic differences in income growth rates are large, individuals have substantial amounts of information about their income growth rates, and about one-half of income shocks are effectively smoothed via partial insurance. Putting these findings together, we argue that the amount of uninsurable lifetime income risk that individuals perceive is substantially smaller than what is typically assumed in calibrated macroeconomic models with incomplete markets.

Suggested Citation

  • Fatih Guvenen & Anthony Smith, 2013. "Inferring labor income risk and partial insurance from economic choices," Staff Report 485, Federal Reserve Bank of Minneapolis.
  • Handle: RePEc:fip:fedmsr:485
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    References listed on IDEAS

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    1. Magnac, Thierry & Robin, Jean-Marc & Visser, Michael, 1995. "Analysing Incomplete Individual Employment Histories Using Indirect Inference," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 10(S), pages 153-169, Suppl. De.
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    3. Richard Blundell & Ian Preston, 1998. "Consumption Inequality and Income Uncertainty," The Quarterly Journal of Economics, Oxford University Press, vol. 113(2), pages 603-640.
    4. Smith, A A, Jr, 1993. "Estimating Nonlinear Time-Series Models Using Simulated Vector Autoregressions," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 8(S), pages 63-84, Suppl. De.
    5. Li, Tong, 2010. "Indirect inference in structural econometric models," Journal of Econometrics, Elsevier, vol. 157(1), pages 120-128, July.
    6. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2004. "Cyclical Dynamics in Idiosyncratic Labor Market Risk," Journal of Political Economy, University of Chicago Press, vol. 112(3), pages 695-717, June.
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    Cited by:

    1. Giulio Fella & Serafin Frache & Winfried Koeniger, 2016. "Buffer-Stock Saving and Households' Response to Income Shocks," CESifo Working Paper Series 6144, CESifo Group Munich.
    2. Fatih Guvenen & Fatih Karahan & Serdar Ozkan & Jae Song, 2015. "What Do Data on Millions of U.S. Workers Reveal about Life-Cycle Earnings Risk?," NBER Working Papers 20913, National Bureau of Economic Research, Inc.
    3. Andreas Fagereng & Luigi Guiso & Luigi Pistaferri, 2016. "Back to Background Risk," EIEF Working Papers Series 1602, Einaudi Institute for Economics and Finance (EIEF), revised Jan 2016.
    4. repec:aea:aejmac:v:10:y:2018:i:2:p:222-62 is not listed on IDEAS
    5. Luo, Yulei & Nie, Jun & Young, Eric, 2017. "Robustness, Low Risk-Free Rates, and Consumption Volatility in General Equilibrium," MPRA Paper 80046, University Library of Munich, Germany.
    6. Alejandro Badel & Mark Huggett, 2014. "Interpreting Life Cycle Inequality Patterns as an Efficient Allocation: Mission Impossible?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 17(4), pages 613-629, October.
    7. Manuel Arellano & Stéphane Bonhomme, 2017. "Nonlinear Panel Data Methods for Dynamic Heterogeneous Agent Models," Annual Review of Economics, Annual Reviews, vol. 9(1), pages 471-496, September.
    8. Benjamin W. Pugsley & Petr Sedlacek & Vincent Sterk, 2017. "The Nature of Firm Growth," Discussion Papers 1737, Centre for Macroeconomics (CFM).
    9. Thomas Philippon & Virgiliu Midrigan, 2011. "Household Leverage and the Recession," 2011 Meeting Papers 261, Society for Economic Dynamics.
    10. Jess Benhabib & Alberto Bisin, 2016. "Skewed Wealth Distributions: Theory and Empirics," NBER Working Papers 21924, National Bureau of Economic Research, Inc.
    11. Luo, Yulei & Nie, Jun & Wang, Gaowang & Young, Eric R., 2017. "Rational inattention and the dynamics of consumption and wealth in general equilibrium," Journal of Economic Theory, Elsevier, vol. 172(C), pages 55-87.
    12. Sauer, Robert M. & Taber, Christopher, 2017. "Indirect Inference with Importance Sampling: An Application to Women's Wage Growth," IZA Discussion Papers 11004, Institute for the Study of Labor (IZA).
    13. Melanie Morten, 2016. "Temporary Migration and Endogenous Risk Sharing in Village India," NBER Working Papers 22159, National Bureau of Economic Research, Inc.
    14. Erik Hurst & Benjamin J. Keys & Amit Seru & Joseph Vavra, 2016. "Regional Redistribution through the US Mortgage Market," American Economic Review, American Economic Association, vol. 106(10), pages 2982-3028, October.
    15. repec:oup:restud:v:85:y:2018:i:1:p:437-474. is not listed on IDEAS
    16. Hryshko, Dmytro, 2014. "Correlated income shocks and excess smoothness of consumption," Journal of Economic Dynamics and Control, Elsevier, vol. 48(C), pages 41-62.
    17. Luo, Yulei & Nie, Jun & Young, Eric, 2015. "Robust Permanent Income in General Equilibrium," MPRA Paper 63985, University Library of Munich, Germany.
    18. THELOUDIS Alexandros, 2017. "Consumption Inequality across Heterogeneous Families," LISER Working Paper Series 2017-18, LISER.
    19. Yu Zheng & Raul Santaeulalia, 2016. "The Price of Growth: Consumption Insurance in China 1989-2009," 2016 Meeting Papers 826, Society for Economic Dynamics.
    20. Giulio Fella & Serafin Frache & Winfried Koeniger, 2016. "Buffer-Stock Saving and Households' Response to Income Shocks," CESifo Working Paper Series 6144, CESifo Group Munich.
    21. Mengus , Eric & Pancrazi , Roberto, 2015. "The Inequality Accelerator," Les Cahiers de Recherche 1108, HEC Paris.
    22. Yongsung Chang & Jay H. Hong & Marios Karabarbounis, 2018. "Labor Market Uncertainty and Portfolio Choice Puzzles," American Economic Journal: Macroeconomics, American Economic Association, vol. 10(2), pages 222-262, April.
    23. repec:bla:sysdyn:v:32:y:2016:i:2:p:154-178 is not listed on IDEAS
    24. Christopher Busch & David Domeij & Fatih Guvenen & Rocio Madera, 2018. "Asymmetric Business-Cycle Risk and Social Insurance," NBER Working Papers 24569, National Bureau of Economic Research, Inc.
    25. Sarah Meyer & Mark Trede, 2016. "Explosive earnings dynamics: Whoever has will be given more," CQE Working Papers 4716, Center for Quantitative Economics (CQE), University of Muenster.

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    Keywords

    Labor economics ; Income;

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