On the Persistence of Income Shocks Over the Life Cycle: Evidence, Theory, and Implications Second Version

65 Pages Posted: 21 Sep 2011

See all articles by Fatih Karahan

Fatih Karahan

Federal Reserve Bank of New York

Serdar Ozkan

University of Toronto

Date Written: September 2, 2011

Abstract

How does the persistence of earnings change over the life cycle? Do workers at different ages face the same variance of idiosyncratic shocks? This paper proposes a novel specification for residual earnings that allows for an age profile in the persistence and variance of labor income shocks. We show that the statistical model is identified and estimate it using PSID data. We find that shocks to earnings are only moderately persistent (around 0:75) for young workers. Persistence rises with age up to unity until midway in life. The variance of persistent shocks exhibits a U-shaped profile over the life cycle (with a minimum of 0:01 and a maximum of 0:05). These results suggest that the standard specification in the literature (with constant persistence and variances) cannot capture the earnings dynamics of young workers. We also argue that a calibrated job turnover model can account for these non-at profiles. The key idea is that workers sort into better jobs and settle down as they age; in turn, magnitudes of wage growth rates decline, thereby decreasing variance of shocks. Furthermore the decline in job mobility results in higher persistence. Finally, we investigate the implications of age profiles for consumption-savings behavior. The welfare cost of idiosyncratic risk implied by the age-dependent income process is 34 percent lower compared with its age-invariant counterpart. This difference is mostly due to a higher degree of consumption insurance for young workers, for whom persistence is moderate. These results suggest that age profilles of persistence and variances should be taken into account when calibrating life-cycle models.

Keywords: Idiosyncratic income risk, Incomplete markets models, Earnings persistence, Consumption insurance

JEL Classification: C33, D31, D91, E21, J31

Suggested Citation

Karahan, Fatih and Ozkan, Serdar, On the Persistence of Income Shocks Over the Life Cycle: Evidence, Theory, and Implications Second Version (September 2, 2011). PIER Working Paper No. 11-030. Available at SSRN: https://ssrn.com/abstract=1931691 or http://dx.doi.org/10.2139/ssrn.1931691

Fatih Karahan (Contact Author)

Federal Reserve Bank of New York ( email )

33 Liberty Street
New York, NY 10045
United States

Serdar Ozkan

University of Toronto ( email )

Toronto, Ontario M5S 3G8
Canada

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