Euler Equations, Subjective Expectations and Income Shocks

Abstract

In this paper, we make three substantive contributions. First, we use elicited subjective income expectations to identify the levels of permanent and transitory income shocks in a lifecycle framework. Second, we use these shocks to assess whether households’ consumption is insulated from them. Third, we use the shock data to estimate an Euler equation for consumption. We find that households are able to smooth transitory shocks, but adjust their consumption in response to permanent shocks, albeit not fully. The estimates of the Euler equation parameters with and without expectational errors are similar, which is consistent with rational expectations. We break new ground by combining data on subjective expectations about future income from the Michigan Survey with microdata on actual income from the Consumer Expenditure Survey.

Permanent versus transitory income shocks over the business cycle

“…We exploit a unique, micro panel-dataset of Dutch households to identify the levels of transitory and permanent income shocks, following the approach developed by Pistaferri ( 2001) and later exploited by Attanasio, Kovacs, and Molnar (2017). We find large variations of the shocks both between cohorts and over time.…”

“…In order to identify the permanent and transitory components of income shock, we follow the approach developed by Pistaferri (2001) and exploited by Attanasio, Kovacs, and Molnar (2017). By using this method, we first show how expectations and different income shocks are functions of each other.…”

“…First, we identify individual-specific permanent and transitory income shocks; we reconstruct their time series over the last decade; and we illustrate their heterogeneity across cohorts and subgroups. Our methodology is closely related to Pistaferri (2001) and Attanasio, Kovacs, and Molnar (2017). The former paper uses the Italian Survey on Household Income and Wealth, which collected information on income expectations in two specific waves (1989 and 1991).…”

“…Moreover, the biannual structure of the Survey does not allow to consider changes in income expectations occurring within the two year span. The paper by Attanasio, Kovacs, and Molnar (2017) combines two data sources -one for income realization (Consumer Expenditure Survey) and one for expectations (Michigan Survey) -to build up a synthetic cohort-panel. 1 Given the structure of the data, this analysis focuses on average cohort variables, while we are able to measure individual specific expectations.…”

Permanent versus Transitory Income Shocks over the Business Cycle

“…We exploit a unique, micro panel-dataset of Dutch households to identify the levels of transitory and permanent income shocks, following the approach developed by Pistaferri (2001) and later exploited by Attanasio, Kovacs, and Molnar (2017). We find large variations of the shocks both between cohorts and over time.…”