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Consumption Dynamics and Welfare Under Non-Gaussian Earnings Risk
Recent empirical studies document that the distribution of earnings changes displays substantial deviations from lognormality: in particular, earnings changes are negatively skewed with extremely high kurtosis (long and thick tails), and these non-Gaussian features vary substantially both over the life cycle and with the earnings level of individuals. Furthermore, earnings changes display nonlinear (asymmetric) mean reversion. In this paper, we embed a very rich “benchmark earnings process” that captures these non-Gaussian and nonlinear features into a lifecycle consumption-saving model and study its implications for consumption dynamics, consumption insurance, and welfare. We show four main results. First, the benchmark process essentially matches the empirical lifetime earnings inequality—a first-order proxy for consumption inequality—whereas the canonical Gaussian (persistent-plus-transitory) process understates it by a factor of five to ten. Second, the welfare cost of idiosyncratic risk implied by the benchmark process is between two-to-four times higher than the canonical Gaussian one. Third, the standard method in the literature for measuring the pass-through of income shocks to consumption—can significantly overstate the degree of consumption smoothing possible under non-Gaussian shocks. Fourth, the marginal propensity to consume out of transitory income (e.g., from a stimulus check) is higher under non-Gaussian earnings risk.
The order of coauthors has been assigned randomly using AEA's Author Randomization Tool. We thank Fatih Karahan for contributions to some of the early results in this paper. For helpful comments, we thank Dirk Krueger, Gonzalo Paz-Pardo, Richard Rogerson, Ayşegül Şahin, Rob Shimer, and conference participants at the Gerzensee Conference on Heterogeneity and Macroeconomics of Labor Markets. Ozkan acknowledges financial support from the Social Sciences and Humanities Research Council of Canada. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.
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