Working Paper: CEPR ID: DP9035
Authors: Enzo Cerletti; Josep Pijoan-Mas
Abstract: In this paper we study the transmission of income shocks into nondurable consumption in the presence of durable goods. We use a standard a life-cycle model with two goods to characterize the interaction of durability of goods, durability of shocks, and borrowing constraints as determinants of shock transmission. We show that borrowing constraints lead to a substitution between durable and non-durable goods upon arrival of an unexpected income change. This substitution biases the conventional measures of insurance based on the response of non-durable consumption to income changes. The sign of this bias depends critically on the persistence of the shock. We show that households have less insurance against transitory shocks and more insurance against permanent shocks than commonly measured. We calibrate the model economy to the US in order to measure the size of this bias.
Keywords: borrowing constraints; consumption insurance; durable goods; incomplete markets; persistence of income shocks
JEL Codes: D12; D91; E21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| borrowing constraints (F34) | substitution between durable and nondurable goods (D10) |
| unexpected income changes (E25) | substitution between durable and nondurable goods (D10) |
| transitory income shocks (J69) | weak response of nondurable consumption (D12) |
| permanent income shocks (G59) | strong response of nondurable consumption (D12) |
| transitory income shocks (J69) | average increase in nondurable consumption (E20) |
| durable goods (L68) | bias in conventional measures of insurance (G52) |
| permanent shocks (E32) | bias in conventional measures of insurance (G52) |
| persistence of shock (C41) | sign of the bias in conventional measures of insurance (G52) |