Markov-Switching Model of Family Income Quintile Shares

Abstract

This paper examines the impact of unemployment and inflation on family income shares. Unemployment and inflation are decomposed into their structural (long-term), cyclical (short-term), anticipated and unanticipated components, respectively. I propose a new framework to analyze family income quintile shares by using a two-state Markov-switching model, also known as Hamilton’s regime-switching model. The benefit of using a Markov-switching model is that it permits capturing complex dynamic behavior of non-linear time series macroeconomic variables. The switching mechanism follows a first-order Markov chain of unobservable state variables and subsequent estimated conditional transition probabilities. This paper applies a two-state regime-switching process to capture the asymmetrical effects of unemployment and inflation on family income shares. The two states of family income quintile shares are state 1 (lower income) and state 2 (upper income). This approach differs from previous studies because it examines income inequality within each quintile rather than between quintiles. It is well documented in the literature that there is income inequality between lower and higher income quintiles. Therefore, the analysis of income inequality within the quintile allows for greater insight into changes in family income share corresponding to changes in the state variables. The general findings are that unemployment has adverse effects on lower income shares while inflation acts like a progressive tax on higher income shares.