Working Paper: NBER ID: w15829
Authors: Andreas Fuster; Paul S. Willen
Abstract: Shiller (2003) and others have argued for the creation of financial instruments that allow individuals to insure risks associated with their lifetime labor income. In this paper, we argue that while the purpose of such assets is to smooth consumption across states of nature, one must also consider the assets' effects on households' ability to smooth consumption over time. We show that consumers in a realistically calibrated life-cycle model would generally prefer income-linked loans (with a rate positively correlated with income shocks) to an income-hedging instrument (a limited liability asset whose returns correlate negatively with income shocks) even though the assets offer identical opportunities to smooth consumption across states. While for some parameterizations of our model the welfare gains from the presence of income-linked assets can be substantial (above 1% of certainty-equivalent consumption), the assets we consider can only mitigate a relatively small part of the welfare costs of labor income risk over the life cycle.
Keywords: Income-linked assets; Consumption smoothing; Welfare gains; Labor income risk
JEL Codes: D91; E21; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| incomelinked loans (F34) | reduce consumption fluctuations (D15) |
| incomehedging instruments (G13) | provide insurance against income shocks (G52) |
| correlation between income shocks and asset returns (G19) | affects welfare gains from assets (D69) |
| incomelinked loans (F34) | preferred over income-hedging instrument (G19) |
| welfare gains from incomelinked assets (D69) | substantial (Y20) |
| assets mitigate welfare costs of labor income risk (J32) | limited (Y50) |
| correlation of 0.5 between income shocks and asset returns (C10) | effectiveness of the assets (G31) |
| higher correlation (C10) | greater potential welfare gains (D69) |
| lower correlations (C10) | negligible benefits (J32) |