Idiosyncratic Income 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)

Financial Literacy and Risk Protection During the Covid-19 Pandemic

AbstractThis study documents that competent access to financial markets can smooth consumption in the face of idiosyncratic income shocks. Using household-level data on financial literacy and financial resilience in Italy during the first phase of the Covid-19 pandemic, we find that financial literacy and financial asset ownership both influenced consumption changes in theoretically sensible ways. The results are robust in specifications controlling for several socio-demographic characteristics, saving choices, public transfers, and to different estimation methods.

Efficient risk sharing and separation

This paper extends the model of risk sharing with limited commitment to feature separation. Partners face idiosyncratic income and match quality shocks, share risk subject to limited commitment, and separate whenever they are better off doing so. We characterise analytically the sets of shock realisations where constrained-efficient separations occur and the dynamics of consumption while the risk-sharing partnership continues. The separation probability typically jumps as parameter values change continuously, and an additional inefficient equilibrium emerges. A key reason is complementarity between risk sharing and staying together today and in the future. Income inequality affects consumption inequality via its effect on separations, and consumption inequality can optimally exceed income inequality for any history of income realisations. Both partial risk sharing and separation are relevant for many applications, including the interaction between partners in a household and countries in an economic union.

Financial intermediation and efficient risk sharing in two-period lived OLG models

This article investigates a two-period lived overlapping-generations (OLG) model that incorporates financial intermediation. A risk-neutral bank offers loan and deposit contracts that insure risk-averse agents against idiosyncratic income shocks. Agents prefer financial intermediation to capital markets if it provides efficient risk sharing. The analysis demonstrates that in any two-period lived OLG model in which productive capital is increasing in investment levels, financial intermediation, when implemented for the purpose of efficient risk sharing, cannot instigate business cycles or complex dynamics. The resulting dynamics is monotonic and qualitatively indistinguishable from the dynamics of the classical OLG model by Diamond (Am Econ Rev 55(5):1126–1150, 1965). Business cycles may only occur if banks offer inefficient contracts. Efficient contracts will, in general, not induce dynamically efficient growth paths.

Consumption Smoothing in the Working-Class Households of Interwar Japan

I analyze factory worker households in the early 1920s in Osaka to examine idiosyncratic income shocks and consumption. Using the household-level monthly panel dataset, I find that while households could not fully cope with idiosyncratic income shocks at that time, they mitigated fluctuations in indispensable consumption during economic hardship. In terms of risk-coping mechanisms, I find suggestive evidence that savings institutions helped mitigate vulnerabilities and that both using borrowing institutions and adjusting labor supply served as risk-coping strategies among households with less savings.

Сценарная оценка макроэкономических эффектов прогрессивного налогообложения в России

The purpose of the study is to assess the impact of alternative options of progressive taxation on Russia’s macroeconomic performance. For quantitative assessments, a neoclassical general equilibrium model with heterogeneous households subject to idiosyncratic income shocks was used. Three groups of scenarios were analyzed, setting a threshold progressive tax scale with thresholds of 30, 50, and 70 thousand rubles, under which state income tax revenues (1) grow, (2) remain unchanged, and (3) decline. The maximum personal income tax rate in the analyzed scenarios was 25%. Steady states and transitions were calculated for the scenarios. According to the quantitative estimates, the first reform leads to a loss of 0.3% to 1.3% of GDP in the long run, depending on the assumed rates and threshold. Despite the increase in lump-sum transfers, aggregate household consumption decreases by 0.5–1.7% in all cases. The second reform leads to a loss of 0.2% to 0.6% of GDP in the long run. The third reform leads to insignificant fluctuations of GDP within 0.1%: GDP increases at the threshold of 30 thousand rubles and decreases at other thresholds. The scale of inequality reduction, as measured by the Gini coefficient, increases with an increase in the top tax rate. However, as the threshold increases, the depth of the Gini index reduction first increases and then decreases. In the short run, there is upward pressure on wages and prices. This is because a decrease in labor supply with unchanged capital in the short run leads to an increase in wage rates (a shift along the labor demand curve), and an increase in wage rates means an increase in marginal costs for firms, leading to higher prices.

Does financial inclusion promote consumption smoothing? Evidence from emerging and developing economies

An important issue for emerging and developing economies (EMDEs) is how to reduce the occurrence of hand-to-mouth consumption by allowing consumption smoothing. Financial inclusion increases access to the formal banking system and financial markets, and allows households to use more appropriate financial instruments, which should enable them to diversify consumption, disrupting the connection to idiosyncratic income shocks. This paper empirically investigates whether financial inclusion can smooth consumption and promote risk sharing for a large heterogenous sample of 85 EMDEs for 1995 to 2017. We find that financial inclusion decreases the volatility of consumption and reduces deviations in country consumption vs world consumption. Curiously, we find that financial inclusion does not help countries improve risk sharing by lowering their exposure to idiosyncratic output shocks. We further find that risk sharing through domestic credit markets expands with financial inclusion, although it does not appear to reduce unsmoothed consumption.

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.

Inequality and Asset Fire Sales

It is widely acknowledged that fire sales were a critical factor in inducing and exacerbating the financial crises of 2007--2008. The leverage of financial intermediaries, which is defined as the ratio of total assets to capital, is a key factor in causing fire sales. Why do financial intermediaries expand their balance sheets despite subsequently having to sell their assets at discounted prices? To examine this question, we incorporate financial intermediaries into a three-period incomplete market economy model, in which households face countercyclical and uninsured idiosyncratic income shocks. We demonstrate that countercyclical income inequality and market incompleteness result in leveraged investment and subsequent asset fire sales by financial intermediaries in equilibrium. The first contribution of this paper is that we demonstrate that the mechanism between asset prices and leverages could successfully solve the famed asset-pricing puzzles. The second contribution is that we analyze the impact of financial regulation on the welfare of ex ante homogeneous households.

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.

A Parsimonious Model of Idiosyncratic Income

The standard model of permanent and transitory income is known to be misspecified. Estimates of income volatility in the model differ depending on the type of data moments used—levels or differences—and how these moments are weighted in the estimation. We propose two changes to the standard model. First, we account for the time-aggregated nature of observed income data. Second, we allow transitory shocks to persist for varying lengths of time. With only one additional parameter, our proposed model consistently recover the parameters of the income process irrespective of the estimation method. To the extent that researchers employ the standard model, we advise special caution with the use of first-difference moments.

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)

Efficiency Versus Insurance: Capital Income Taxation and Privatizing Social Security

We study the interactions between capital income tax and social security privatization in the context of rising longevity. In an economy with idiosyncratic income shocks, redistributive defined benefit social security provides some insurance against income uncertainty. This insurance comes at the expense of efficiency loss due to labor supply distortions. The existing view in the literature states that reducing this distortion by introducing (partially funded) defined contribution social security would reduce welfare because the loss of insurance and the transitory fiscal gap dominate the efficiency gains. However, prior research financed the transitory costs of the reform by taxing consumption. We show that in the context of longevity, capital income taxation provides a superior alternative: welfare gains are sufficient to outweigh the loss of insurance and transitory fiscal gap. We provide explanations for a mechanism behind this result and we reconcile our results with the earlier literature.

Idiosyncratic Income Risk and Aggregate Fluctuations

Idiosyncratic Income Risk and Aggregate Fluctuations

Countercyclical Labor Income Risk and Portfolio Choices over the Life Cycle

Abstract I estimate a life cycle model of portfolio choices that incorporates the relationship between market returns and the skewness of idiosyncratic income shocks. The cyclicality of skewness can explain (a) low stock market participation among young households, (b) why the equity share of participants slightly increases until retirement, and (c) why renters invest less in stocks than do homeowners. With a relative risk aversion of 6 and yearly participation cost of $250, the model matches the evolution of wealth, participation, and conditional equity shares over the life cycle. Nevertheless, cyclical skewness increases the equity premium by at most 0.5 percentage points. Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Sharing idiosyncratic risk even though prices are “wrong”

We design an infinite-horizon dynamic asset market experiment with perishable consumption and a long-lived asset where gains from trade originate from individuals experiencing idiosyncratic income shocks. Our study is based on the consumption-based general equilibrium theory (Lucas (1978)). The presence of traders having induced motive to smooth consumption is not sufficient to eliminate price bubbles. Despite the asset being consistently priced higher than the equilibrium price, traders are able to share idiosyncratic risk and attain higher welfare. The co-existence of traders with income shocks along with those having no induced motive to trade does not hinder in the former smoothing their consumption stream. Our results hold for markets with and without aggregate risk.

CO-MOVEMENT OF STEADY-STATE GOVERNMENT DEBT AND HOUSEHOLD DEBT

To understand whether and how movements of government debt and household debt are related, stationary equilibrium government debt and household debt are characterized in a politico-economic model where office-seeking policymakers decide government debt and individual voters can borrow facing uninsurable idiosyncratic income shocks. An increase in uninsurable income risk unconditionally raises stationary equilibrium government debt and aggregate household debt together, while an increase in household-loan collateral value or population aging conditionally does so, entailing positive correlations between these two debts’ movements. In contrast, an increase in interest rate conditionally causes these two debts to move in the opposite directions.