Income Variance Dynamics and Heterogeneity

Abstract

Recent theoretical work has shown the importance of measuring microeconomic uncertainty for models of both general and partial equilibrium under imperfect insurance. In this paper the assumption of i.i.d. income innovations used in previous empirical studies is removed and the focus of the analysis is placed on models for the conditional variance of income shocks, which is related to the measure of risk emphasized by the theory. We first discriminate amongst various models of earnings determination that separate income shocks into idiosyncratic transitory and permanent components. We allow for education- and time-specific differences in the stochastic process for earnings and for measurement error. The conditional variance of the income shocks is modelled as a parsimonious ARCH process with both observable and unobserved heterogeneity. The empirical analysis is conducted on data drawn from the 1967-1992 Panel Study of Income Dynamics. We find strong evidence of sizeable ARCH effects as well as evidence of unobserved heterogeneity in the variances. Copyright Econometric Society 2004.

Asset returns in an endogenous growth model with incomplete markets

“…Although our incomplete-markets model with production generates values for the equity premium and the volatility of stock returns that are substantially higher than the ones found by Mehra and Prescott (1985), these values are still far below the observed values for the U.S. stock market. In our production economy, the main reason for the model's inability to generate realistic variations in stock returns is the assumption that there are no market frictions in addition to market incompleteness (no capital adjustment costs).…”

“…8 We also find that introducing aggregate depreciation shocks increases the volatility of stock returns significantly. In particular, our model implies a stock return volatility that is much higher than the stock return volatility in the simple exchange economy analyzed by Mehra and Prescott (1985) . 9 This volatility increase provides a second reason for our model's ability to generate a nonnegligible equity premium: higher (unpredictable) volatility of stock returns means stock market investment is riskier, which in turn increases the equity premium demanded by risk-averse investors.…”

“…In other words, our results are based on 8 Heaton and Lucas (1996) use an econometric specification that does not allow for income shocks of different degrees of persistence, and estimate an overall autocorrelation coefficient around .50. 9 Notice that in the simple exchange model studied by Mehra and Prescott (1985) one important reason for the low stock return volatility is the low volatility of dividends, which in turn is a consequence of the assumption that dividends are equal to output. This problem has been noticed by several authors.…”

“…In our model, as in the work by Constantinides and Duffie (1996) and Storesletten, Telmer, and Yaron (2001), this result is driven by two features of the income process: idiosyncratic income shocks are permanent and the amount of idiosyncratic risk is increasing during economic downturns. Recent empirical work has shown (Meghir andPistaferri, 2001, andStoresletten et al, 2001) that individual income data are well-described by an income process that exhibits a large and counter-cyclical permanent component, and we use the estimates of this empirical literature to calibrate the model economy. In other words, our results are based on 8 Heaton and Lucas (1996) use an econometric specification that does not allow for income shocks of different degrees of persistence, and estimate an overall autocorrelation coefficient around .50.…”

Consumption inequality and partial insurance

“…Using estimates contained in Meghir and Pistaferri [2004], a back-of-the-envelope calculation shows that the variance of measurement error in earnings accounts for approximately 30% of the variance of the overall transitory component of earnings. Given that our estimate of ψ is close to zero in most cases, an adjustment using this inflation factor would make little difference empirically.…”