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Journal Article

A test of the household income process using consumption and wealth data

Authors

Publication date

Aug 2015

Summary

The evolution of household income can be explained almost equally well by rival models. However, rival models have very different implications for other household behaviours, such as consumption. I therefore test between two prominent models in the UK using panel data on consumption and wealth, as well as income, over 1991–2006. To operate the test, I show that long-lived income shocks transmit far less than one-for-one through to consumption, and particularly so for younger households. I then compare these estimates of transmission with estimates of households’ ability to smooth shocks, captured by the data on wealth. Conditional on the suitability of the consumption model, my estimates provide evidence against the restricted income process (RIP) and in favour of an alternative heterogeneous income process (HIP). This finding also explains why cross-sectional consumption inequality grew slowly over the period even though the variance of long-lived shocks was high. Finally, I conclude that it is important to consider mean reversion of shocks when constructing life-cycle consumption models.

Published in

European Economic Review

Volume and page numbers

78 , 129 -157

DOI

https://doi.org/10.1016/j.euroecorev.2015.05.003

Subjects

Households, Economics, and Income Dynamics

Links

University of Essex, Albert Sloman Library Periodicals *restricted to University of Essex registered users* - http://serlib0.essex.ac.uk/record=b1628528~S5; University of Essex Research Repository - http://repository.essex.ac.uk/13906/

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