Lifecycle Dynamics of Income Uncertainty and Consumption

Abstract

Uninsurable income risk is often cited as an explanation for empirical deviations from the Lifecycle/Permanent-Income Hypothesis such as the hump-shaped lifecycle profile of mean consumption. In this paper, we solve a lifecycle consumption model using a calibrated income process that matches the results in Feigenbaum and Li (2008). In that paper they measure income uncertainty as the variance of income forecasting errors at different ages and over different time horizons. Here we show that, with plausible preference parameters, the precautionary saving implied by their refined measure of income uncertainty can generate a consumption hump similar to what is observed in the data with a peak around age 55. We also notice that the variation in the volatility of income shocks with respect to both age and forecast horizon has a significant impact on the size and peak age of the consumption hump.

Keywords: consumption hump, income uncertainty, time-inconsistent

JEL Classification: E21, E24, E91