Inferring Labor Income Risk from Economic Choices: An Indirect Inference Approach

62 Pages Posted: 7 Sep 2010

See all articles by Fatih Guvenen

Fatih Guvenen

University of Minnesota - Department of Economics; National Bureau of Economic Research (NBER)

Anthony A. Smith

Yale University - Cowles Foundation

Date Written: September 2010

Abstract

This paper uses the information contained in the joint dynamics of households' labor earnings and consumption-choice decisions to quantify the nature and amount of income risk that households face. We accomplish this task by estimating a structural consumption-savings model using data from the Panel Study of Income Dynamics and the Consumer Expenditure Survey. Specifically, we estimate the persistence of labor income shocks, the extent of systematic differences in income growth rates, the fraction of these systematic differences that households know when they begin their working lives, and the amount of measurement error in the data. Although data on labor earnings alone can shed light on some of these dimensions, to assess what households know about their income processes requires using the information contained in their economic choices (here, consumption-savings decisions). To estimate the consumption-savings model, we use indirect inference, a simulation method that puts virtually no restrictions on the structural model and allows the estimation of income processes from economic decisions with general specifications of utility, frequently binding borrowing constraints, and missing observations. The main substantive findings are that income shocks are not very persistent, systematic differences in income growth rates are large, and individuals have substantial amounts of information about their future income prospects. Consequently, the amount of uninsurable lifetime income risk that households perceive is substantially smaller than what is typically assumed in calibrated macroeconomic models with incomplete markets.

Suggested Citation

Guvenen, Fatih and Smith, Anthony A., Inferring Labor Income Risk from Economic Choices: An Indirect Inference Approach (September 2010). NBER Working Paper No. w16327. Available at SSRN: https://ssrn.com/abstract=1672560

Fatih Guvenen (Contact Author)

University of Minnesota - Department of Economics ( email )

Minneapolis, MN 55455
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Anthony A. Smith

Yale University - Cowles Foundation ( email )

Box 208281
New Haven, CT 06520-8281
United States

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