Consumption Insurance, Earnings Risk and Illiquid Housing Wealth

Households appear to smooth consumption in the face of income shocks much more than implied by the standard incomplete market model with one fully liquid asset and permanent plus temporary income shocks. However, it is well known that for most households, illiquid housing represents the most important form of wealth holdings. Moreover, the last decade has witnessed the development and estimation of richer models of earnings dynamics. In this paper we extend the basic SIM model to include a second illiquid asset and a more complex earnings process based on recent empirical estimates. We show that under the assumed earnings process with lower persistence that increases with age, the insurance coefficient against persistent shocks increases by about 20 percentage points compared to the baseline permanent shocks model, overshooting its empirical counterpart in Blundell, Pistaferri and Preston (2008). The presence of illiquid housing reduces it by about 4 percentage points aligning the model more closely to the data. We conclude that both housing and a richer specification of income risk are important for understanding insurance against shocks, with the latter playing a quantitatively more important role.