Working Paper: CEPR ID: DP14538
Authors: Christopher Busch; Alexander Ludwig
Abstract: We extend the canonical income process with persistent and transitory risk toshock distributions with left-skewness and excess kurtosis, to which we refer as higher-order risk. We estimate our extended income process by GMM for household datafrom the United States. We find countercyclical variance and procyclical skewness ofpersistent shocks. All shock distributions are highly leptokurtic. The existing tax andtransfer system reduces dispersion and left-skewness of shocks. We then show thatin a standard incomplete-markets life-cycle model, first, higher-order risk has sizablewelfare implications, which depend crucially on risk attitudes of households; second,higher-order risk matters quantitatively for the welfare costs of cyclical idiosyncraticrisk; third, higher-order risk has non-trivial implications for the degree of self-insuranceagainst both transitory and persistent shocks.
Keywords: Labor income risk; Business cycle; GMM estimation; Skewness; Persistent and transitory income shocks; Risk attitudes; Lifecycle model
JEL Codes: D31; E24; E32; H31; J31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| higher-order income risk (D80) | negative welfare implications (D62) |
| higher-order income risk (D80) | positive welfare implications (for log utility) (D11) |
| higher-order risk (D81) | welfare costs of cyclical idiosyncratic risk (D69) |
| higher-order risk (D81) | self-insurance against income shocks (G52) |
| self-insurance against income shocks (G52) | weaker consumption response to income shocks (D12) |
| precautionary savings (D14) | weaker consumption response to income shocks (D12) |