Heterogeneous Life-Cycle Profiles, Income Risk and Consumption Inequality
Was the increase in income inequality in the US due to permanent shocks or merely to an increase in the variance of transitory shocks? The implications for consumption and welfare depend crucially on the answer to this question. We use CEX repeated cross-section data on consumption and income to decompose idiosyncratic changes in income into predictable life-cycle changes, transitory and permanent shocks and estimate the contribution of each to total inequality. Our model fits the joint evolution of consumption and income inequality well and delivers two main results. First, we find that permanent changes in income explain all of the increase in inequality in the 1980s and 90s. Second, we reconcile this finding with the fact that consumption inequality did not increase much over this period. Our results support the view that many permanent changes in income are predictable for consumers, even if they look unpredictable to the econometrician, consistent with models of heterogeneous income profiles.
Published in the Journal of Monetary Economics, 56(1), pp.20-39.
Published version: January 2009 [download pdf]
The JME website has the article and the discussion by Jonathan Heathcote
One-but-latest version: August 2008 [download pdf]
First version: February 2006 (titled: Predictable Life-Cycle Shocks, Income Risk and Consumption Inequality)
The previous version (August 2007) is also available as as CEPR discussion paper 5881 or IZA discussion paper 3239 or here. In previous versions, there was a mistake in the interpretation of the age effects in inequality. A note on "Age Effects and the Pre-Sample Evolution of Income and Consumption Inequality” explains this issue.