Idiosyncratic Income Risk Research Articles

Idiosyncratic Income Risk and Aggregate Fluctuations

We study how the presence of idiosyncratic income risk affects aggregate fluctuations in the absence of binding borrowing constraints and/or cyclical income risk. Its impact is shown to be captured by the response of a consumption-weighted average of individual consumption risk to aggregate shocks. We analyze two example economies—an endowment economy and a New Keynesian economy—and show that, under plausible calibrations, the impact of idiosyncratic income risk on aggregate fluctuations is quantitatively small since most of the changes in consumption risk are concentrated among poorer (low-consumption) households. (JEL E12, E21, E24, E32)

Trust in Risk Sharing: A Double-Edged Sword

Abstract We analyse efficient risk-sharing arrangements when the value from deviating is determined endogenously by another risk-sharing arrangement. Coalitions form to insure against idiosyncratic income risk. Self-enforcing contracts for both the original coalition and any coalition formed (joined) after deviations rely on a belief in future cooperation which we term “trust”. We treat the contracting conditions of original and deviation coalitions symmetrically and show that higher trust tightens incentive constraints since it facilitates the formation of deviating coalitions. As a consequence, although trust facilitates the initial formation of coalitions, the extent of risk sharing in successfully formed coalitions is declining in the extent of trust and efficient allocations might feature resource burning or utility burning: trust is indeed a double-edged sword.

DSGE models with heterogeneous economic agents: A new notion at the characteristics of the functioning of the economy

In the article we systematize foreign experience in building dynamic stochastic general equilibrium models (DSGE) with heterogeneous economic agents. The advantages of models of this class relative to simpler specifications are analyzed while studying a few fundamental topics: starting with the reaction of aggregates in models where agents face idiosyncratic income risk, monetary and fiscal policies, and ending with models with entrepreneurship, the problem of the zero lower bound, and models of the social security system. Models with heterogeneous economic agents often give a radically different look at many well studied things in simpler models. They allow more accurate reproduction of empirical data and relationships, for example cross-sectional distributions of income and wealth. Therefore, it is very promising to study these models.

Optimal Fiscal Policy in a Model with Uninsurable Idiosyncratic Income Risk

AbstractWe study optimal fiscal policy in a standard incomplete-markets model with uninsurable idiosyncratic income risk, where a Ramsey planner chooses time-varying paths of proportional capital and labour income taxes, lump-sum transfers (or taxes), and government debt. We find that (1) short-run capital income taxes are effective in providing redistribution since the tax base is relatively unequal and inelastic; (2) an increasing pattern of labour income taxes over time mitigates intertemporal distortions from capital income taxes; (3) the optimal policy increases overall transfers, calibrated initially to the US welfare system, by roughly $50\%$; (4) two-thirds of the welfare gains come from redistribution and the remaining third come mostly from insurance; and (5) redistribution also leads to a more efficient allocation of labour via wealth effects on labour supply—lower productivity households can afford to work relatively less.

Unemployment risk, consumption dynamics, and the secondary market for durable goods

I provide a theoretical framework of optimal purchases of new and used consumer durables in an economy with heterogeneous agents, idiosyncratic income risk and incomplete financial markets. Agents choose optimally between consuming nondurable and durable goods and accumulating a risk-free asset. The price of durable goods in the secondary market is determined endogenously, through market clearing. The model generates pro-cyclical durable expenditures and (resale) prices, which is consistent with the available empirical evidence for the US economy. The mechanism behind this result is that, following increases in unemployment risk during recessions, durable goods become less attractive to households, which rebalance their portfolio towards liquid asset holdings. This decreases the demand for durable goods and exerts a downward pressure on their price. I show that the illiquidity associated to durable accumulation is key in generating the results. The benefits of extending income support to unemployed households during recessions are studied in a policy experiment.

High Marginal Tax Rates on the Top 1 Percent? Lessons from a Life-Cycle Model with Idiosyncratic Income Risk

This paper argues that high marginal labor income tax rates on top earners are an effective tool for social insurance even when households have high labor supply elasticity, households make dynamic savings decisions, and policies have general equilibrium effects. We construct a large-scale overlapping generations model with uninsurable labor productivity risk, show that it has a realistic wealth distribution, and numerically characterize the optimal top marginal rate. We find that marginal tax rates for top 1 percent earners of 79 percent are optimal as long as the model earnings and wealth distributions display a degree of concentration as observed in US data. (JEL D15, D31, H21, H24, H55, J22, J31)

Skewed Idiosyncratic Income Risk over the Business Cycle: Sources and Insurance

We provide new evidence on business cycle fluctuations in skewed labor income risk in the United States, Germany, Sweden, and France. We document four results. First, in all countries, the skewness of individual income growth is strongly procyclical, whereas its variance is flat and acyclical. Second, this result also holds for continuously employed, full-time workers, indicating that the hours margin is not the main driver; additional analyses of hours and wages confirm that both margins are important. Third, within-household smoothing does not seem effective at mitigating skewness fluctuations. Fourth, tax-and-transfer policies blunt some of the largest declines in incomes, reducing procyclical fluctuations in skewness. (JEL E23, E24, E32, H24, I38, J22, J31)

Idiosyncratic Income Risk and Aggregate Fluctuations

Idiosyncratic Income Risk and Aggregate Fluctuations

Optimal taxes on capital in the OLG model with uninsurable idiosyncratic income risk

We characterize the optimal linear tax on capital in an Overlapping Generations model with two period lived households facing uninsurable idiosyncratic labor income risk. The Ramsey government internalizes the general equilibrium effects of private precautionary saving on factor prices and taxes capital unless the weight on future generations in the social welfare function is sufficiently high. For logarithmic utility a complete analytical solution of the Ramsey problem exhibits an optimal aggregate saving rate that is independent of income risk, whereas the optimal time-invariant tax on capital implementing this saving rate is increasing in income risk. The optimal saving rate is constant along the transition and its sign depends on the magnitude of risk and on the Pareto weight of future generations. If the Ramsey tax rate that maximizes steady state utility is positive, then implementing this tax rate permanently induces a Pareto-improving transition even if the initial equilibrium capital stock is below the golden rule.

Credit Shocks and Equilibrium Dynamics in Consumer Durable Goods Markets

Abstract This article studies equilibrium dynamics in consumer durable goods markets after aggregate credit shocks. We introduce two novel features into a general-equilibrium model of durable consumption with heterogeneous households facing idiosyncratic income risk and borrowing constraints: (1) indivisible durable goods are vertically differentiated in their quality and (2) trade on secondary markets at market-clearing prices, with households endogenously choosing when to trade or scrap their durables. The model highlights a new transmission mechanism for macroeconomic shocks and successfully matches several empirical patterns that we document using data on U.S. car markets around the Great Recession. After a tightening of the borrowing limit, debt-constrained households postpone the decision to scrap and upgrade their low-quality cars, which depresses mid-quality car prices. In turn, this effect reduces wealthy households’ incentives to replace their mid-quality cars with high-quality ones, thereby decreasing new-car sales. We further use our framework to evaluate targeted fiscal stimulus policies such as the Car Allowance Rebate System in 2009 (“Cash for Clunkers”).

Idiosyncratic Income Risk, Precautionary Saving, and Asset Prices

Idiosyncratic Income Risk, Precautionary Saving, and Asset Prices

The Macroeconomic Effects of Universal Basic Income Programs

What are the consequences of a nationwide reform of a transfer system based on means-testing toward one of unconditional transfers? I answer this question with a quantitative model to assess the general equilibrium, inequality, and welfare effects of substituting the current US income security system with a universal basic income (UBI) policy. To do so, I develop an overlapping generations model with idiosyncratic income risk that incorporates intensive and extensive margins of the labor supply, on-the-job learning, and child-bearing costs. The tax-transfer system closely mimics the US design. I calibrate the model to the US economy and conduct counterfactual analyses that implement reforms toward a UBI. I find that an expenditure-neutral reform has moderate impacts on agents’ labor supply response but induces aggregate capital and output to grow due to larger precautionary savings. A UBI of $1,000 monthly requires a substantial increase in the tax rate of consumption used to clear the government budget and leads to an overall decrease in the macroeconomic aggregates, stemming from a drop in the labor supply. In both cases, the economy has more equally distributed disposable income and consumption. The UBI economy constitutes a welfare loss at the transition if it is expenditure-neutral and results in a gain in the second scenario.

Coalition-Proof Risk Sharing Under Frictions

We analyze efficient risk-sharing arrangements when coalitions may deviate. Coalitions form to insure against idiosyncratic income risk. Self-enforcing contracts for both the original coalition and any deviating coalition rely on a belief in future cooperation which we term capital. We treat the contracting conditions of original and deviating coalitions symmetrically and show that higher social capital tightens incentive constraints since it facilitates both the formation of the original as well as a deviating coalition. As a consequence, although social capital facilitates the initial formation of coalitions, the extent of risk sharing in successfully formed coalitions is declining in the extent of social capital and equilibrium allocations might feature resource burning or utility burning: social capital is indeed a double-edged sword. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Unsecured Credit Supply Risk and Bond Prices

Changes in credit supply induce large and frequent variations in households' access to unsecured debt. They generate a novel financial precautionary motive, which compounds the classical motive associated with idiosyncratic income risk, as borrowers accumulate risk-free bonds to hedge against them. Using a structural model, I estimate that this motive is an important driver of Treasury rates over the business cycle. It explains the historically low level of real rates in the last decade despite consumption growth, solving a post-Great Recession risk-free rate puzzle. It is also critical for the volatility and comovement of household balance sheet and macroeconomic moments.

Aggregate Demand and Sovereign Debt Crises

Sovereign debt crises coincide with deep recessions. I propose a model of sovereign debt that rationalizes large contractions in economic activity via an aggregate-demand amplification mechanism. The mechanism also sheds new light on the response of consumption to sovereign risk, which I document in the context of the Eurozone crisis. By explicitly separating the decisions of households and the government, I examine the interaction between sovereign risk and the precautionary savings motive. When a default is likely, households anticipate its negative consequences and cut consumption for self-insurance reasons. The resulting shortage in aggregate spending worsens economic conditions through nominal wage rigidities, boosting default incentives and restarting the vicious cycle of high spreads and low demand. I study the implications of this feedback mechanism in a model where the government of a small open economy borrows from foreign lenders but some of the debt is held by heterogeneous domestic savers subject to uninsurable idiosyncratic income risk. I calibrate the model to Spain in the 2000s and find that about a third of the output contraction is caused by default risk. More generally, sovereign risk exacerbates volatility in consumption over time as well as across agents, creating large and unequal welfare costs even if default does not materialize.

How do tax progressivity and household heterogeneity affect Laffer curves?

How much additional tax revenue can the government generate by increasing the level of labor income taxes? In this paper, we argue that the degree of tax progressivity is a quantitatively important determinant of the answer to this question. To make this point, we develop a large scale overlapping generations model with single and married households facing idiosyncratic income risk, extensive and intensive margins of labor supply, as well as endogenous accumulation of human capital through labor market experience. We calibrate the model to U.S. macro, micro, and tax data and characterize the labor income tax Laffer curve for various degrees of tax progressivity. We find that the peak of the U.S. Laffer curve is attained at an average labor income tax rate of 58 % . This peak (the maximal tax revenues the government can raise) increases by 7 % if the current progressive tax code is replaced with a flat labor income tax. Replacing the current U.S. tax system with one that has Denmark' s progressivity would lower the peak by 8 % . We show that modeling the extensive margin of labor supply and endogenous human capital accumulation is crucial for these findings. With joint taxation of married couples (as in the U.S.), higher tax progressivity leads to significantly lower labor force participation of married women and substantially higher labor force participation of single women, an effect that is especially pronounced when future wages of females depend positively on past labor market experience.

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Credit Shocks and Equilibrium Dynamics in Consumer Durable Goods Markets

This paper studies the equilibrium dynamics in consumer durable goods markets after aggregate credit shocks. We introduce two novel features into a general-equilibrium model of durable consumption with heterogeneous households facing idiosyncratic income risk and borrowing constraints: (1) different qualities of durable goods trade on secondary markets at market-clearing prices; and (2) households endogenously choose when to trade them or scrap them. The model successfully matches several empirical patterns that we document using data on U.S. car markets around the Great Recession. After a tightening of the borrowing limit, debt-constrained households postpone the decision to scrap and upgrade their low-quality cars, depressing mid-quality car prices. In turn, this effect reduces wealthy households' incentives to replace their mid-quality cars with high-quality ones, thereby decreasing new-car sales. We further use our framework to study the effects of collateral constraints and aggregate income shocks, and to evaluate targeted fiscal stimulus policies such as the Car Allowance Rebate System in 2009 (Cash for Clunkers).

Asset Pricing in OLG Economies With Borrowing Constraints and Idiosyncratic Income Risk

This paper analyzes how the combination of borrowing constraints and idiosyncratic risk affects the equity premium in an overlapping generations economy. I find that introducing a zero-borrowing constraint in an economy without idiosyncratic risk increases the equity premium by 70 percent, which means that the mechanism described in Constantinides, Donaldson, and Mehra (2002) is dampened because of the large number of generations and production. With social security the effect of the zero-borrowing constraint is a lot weaker. More surprisingly, when I introduce idiosyncratic labor income risk in an economy without a zero-borrowing constraint, the equity premium increases by 50 percent, even though the income shocks are independent of aggregate risk and are not permanent. The reason is that idiosyncratic risk makes the endogenous natural borrowing limits much tighter, so that they have a similar effect to an exogenously imposed zero-borrowing constraint. This intuition is confirmed when I add idiosyncratic risk in an economy with a zero-borrowing constraint: neither the equity premium nor the Sharpe ratio change, because the zero-borrowing constraint is already tighter than the natural borrowing limits that result when idiosyncratic risk is added.

Financial Market Integration and Income Inequality

Benefits of financial market integration include cheaper and alternative options of saving and borrowing for households and entrepreneurs. In the global financial market, asset choices for households widen so that individuals can manage their idiosyncratic income risk more effectively. On the other hand, financial market integration makes investors who hold foreign assets more vulnerable to global financial shocks. In the recent financial crisis, financial market distress which initially arose in the U.S. had an enormous impact on the peripheral countries. This example shows that the strong shock propagation occurs via integrated financial markets. The existing literature shows that financial market integration has a sizable impact not only on business cycles in the short run, but also on economic growth in the long run. However, there has been little attention to income distribution, specifically in related to the financial market integration. In this paper, we fill the void in the literature by focusing on the following two stylized facts: income inequality has been exacerbated in most countries over the past two decades, and the financial market has been integrated across countries during the same period. In particular, we answer three research questions to investigate the relationship between the two facts. First, how does financial market integration affect income inequality? Second, how do financial market integration and financial market development interact to change income inequality? Third, what components do theoretical model need to explain the interaction effect of financial market development and integration on income inequality? We test hypotheses that the effect of financial market openness on inequality is conditional on the level of domestic financial market development when the financial market opens. An empirical study with panel data comprised of 174 countries for the period 1995-2017 finds that the overall effect of financial integration on income inequality is nonlinear. Financial market integration creates the intensive and extensive margins of credit supply which may depend on the development level of financial market disproportionally. This paper uncovers a novel empirical evidence that financial market integration and financial market development interact to change income inequality. When other things are controlled, the effect of financial market integration on in-come inequality depends on financial market development. In a country with underdeveloped financial market, income inequality gets worse as financial market opens. On the other hand, when financial market is highly developed, the effect of financial market openness on income inequality is mostly insignificant in a statistical sense. The results are still valid with different measures of financial market development, integration, and income inequality. We check that the results are robust as an endogeneity issue among financial market development and integration is controlled. We also suggest some important structures for the conventional economic model to account for our empirical finding as theoretical implications. Based on these implications, extensions of the conventional small open economy model with financial constraints having suggested components such as heterogeneous holdings of foreign assets across income and asset levels and entrepreneurial shocks will be necessary to understand an interaction of financial market openness and domestic market development on the distribution of income in a country. Our finding also echoes that studying an economic mechanism in which economic growth, financial market outcomes, and inequality are endogenously determined.