Permanent Versus Transitory Income Shocks Over the Business Cycle
74 Pages Posted: 11 Feb 2022
Date Written: November 23, 2021
This paper investigates how income shocks shape consumption dynamics over the business cycle. First, we break new ground and create a unique panel dataset of transitory and permanent income shocks by combining household-level income expectations with the findings of the DNB Household Survey conducted in the Netherlands in the period 2006-2018. We then use the first and second moments of the identified income shocks in a structural life-cycle framework and show that the model matches the observed consumption patterns well. Finally, using counterfactual model simulations, we assess the importance of the nature of income shocks (permanent income hypothesis), future income uncertainties (precautionary saving motive), and cohort effects, and show how they individually shaped consumption dynamics over that period in the Netherlands.
Keywords: subjective expectations, income shocks, consumption, business cycle
JEL Classification: C13, D12, D91, E21
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