Idiosyncratic Income Risk, Precautionary Saving, and Asset Prices

76 Pages Posted: 18 Nov 2021

See all articles by Maarten Meeuwis

Maarten Meeuwis

Washington University in St. Louis - John M. Olin Business School

Date Written: September 25, 2021

Abstract

Households are subject to substantial tail risk in individual labor income, and the amount of income risk fluctuates over the business cycle. This paper proposes a New Keynesian production-based asset pricing model where idiosyncratic labor income risk is a key source of priced risk in equity markets. Uninsured income tail risk drives the aggregate demand for consumption goods through a time-varying precautionary saving motive, generating cyclicality in firm cash flows. In the cross section, firms facing more elastic demand are more exposed to fluctuations in idiosyncratic tail risk. This risk exposure is compensated by a significant and countercyclical risk premium in equity returns. Empirical findings support the predictions of the model.

JEL Classification: G12,E12,E24,E44

Suggested Citation

Meeuwis, Maarten, Idiosyncratic Income Risk, Precautionary Saving, and Asset Prices (September 25, 2021). Available at SSRN: https://ssrn.com/abstract=3930752 or http://dx.doi.org/10.2139/ssrn.3930752

Maarten Meeuwis (Contact Author)

Washington University in St. Louis - John M. Olin Business School ( email )

One Brookings Drive
Campus Box 1133
St. Louis, MO 63130-4899
United States

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