Household Debt and Income Inequality, 1963–2003

I construct an economy with heterogeneous agents that mimics the time-series behavior of the earnings distribution in the United States from 1963 to 2003. Agents face aggregate and idiosyncratic shocks and accumulate real and financial assets. I estimate the shocks that drive the model using data on income inequality, aggregate income, and measures of financial liberalization. I show how the model economy can replicate two empirical facts: the trend and cyclical behavior of household debt and the diverging patterns in consumption and wealth inequality over time. While business cycle fluctuations can account for the short-run changes in household debt, its prolonged rise of the 1980s and the 1990s can be quantitatively explained only by the concurrent increase in income inequality.     

Re-Examining the Consumption–Wealth Relationship: The Role of Model Uncertainty

This paper discusses the consumption–wealth relationship. We use data on consumption, assets, and labor income and a vector error correction framework. This framework defines a set of models that differ in the number of co-integrating vectors, the form of deterministic components and lag length. Further models can be defined through parametric restrictions and, in particular, interest centers on a weak exogeneity restriction that says that the co-integrating residuals do not affect consumption and income directly. Key results in previous work relate to the roles of permanent and transitory shocks in driving wealth and how consumption responds to these shocks. We investigate the robustness of these results to model uncertainty and argue for the use of Bayesian model averaging. We find that there is a large degree of model uncertainty. Whether this uncertainty has important empirical implications depends on the researcher's attitude toward the theory used to motivate a co-integrating relationship between consumption, assets and income. If we work with models consistent with this theory and impose the weak exogeneity restriction, we find precisely estimated results that show that permanent shocks have only a small role in driving assets and that the predominant transitory shocks have little effect on consumption. These findings are consistent with the previous literature. However, if we work with a broader set of models and let the data speak, we find that the exact magnitude of the role of permanent shocks is hard to estimate precisely. Thus, although some support exists for the view that their role is small, we cannot rule out the possibility that they have a substantive role to play.     

Does Consumption Respond More to Housing Wealth Than to Financial Market Wealth? If So,Why?

This paper uses long-run equilibrium relationship between consumption and different components of wealth to estimate the effect of changes in housing wealth and financial wealth on consumption. By exploiting this long-run property, it has been shown that a dollar increase in housing wealth increases consumption by seven cents, whereas, a corresponding dollar increase in financial wealth increases consumption by only three cents. This difference in the wealth effect arises because transitory shocks dominate variation in financial wealth, whereas permanent shocks account for most of the variation in housing wealth. This paper also shows that the relative importance of permanent component for housing wealth has witnessed an increase over the last thirty years. Therefore, housing wealth effect has also increased over time.     

Precautionary saving and the marginal propensity to consume out of permanent income

The budget constraint requires that, eventually, consumption must adjust fully to any permanent shock to income. Intuition suggests that, knowing this, optimizing agents will fully adjust their spending immediately upon experiencing a permanent shock. However, this paper shows that if consumers are impatient and are subject to transitory as well as permanent shocks, the optimal marginal propensity to consume out of permanent shocks (the MPCP) is strictly less than one, because buffer-stock savers have a target wealth-to-permanent-income ratio; a positive shock to permanent income moves the ratio below its target, temporarily boosting saving.     

Estimating exchange rate responsiveness to shocks

The goal of this paper is to examine the importance of permanent and transitory shocks using a more efficient trend-cycle decomposition of the real exchange rate series. Our main contribution is that in measuring the impact of shocks, we not only impose common trend restrictions but also common cycle restrictions. We later confirm, through a post sample forecasting exercise, the efficiency gains from imposing common cycle restrictions. Our results indicate that permanent shocks are responsible for the bulk of the real exchange rate variations for Japan, Italy, Germany, France, and the UK vis-à-vis the US dollar over short horizons. For Canada, however, transitory shocks are dominant over the short horizon. In sum, while for Japan, France, and Italy, around 15% of the variation in real exchange rate is due to transitory shocks, for Canada, Germany and the UK, over 25% of the variations over the short horizon are due to transitory shocks. Thus, we claim that the role of transitory shocks should not be ignored.     

Innocent Bystanders? Monetary policy and inequality

We study the effects of monetary policy shocks on—and their historical contribution to—consumption and income inequality in the United States since 1980 as measured by the Consumer Expenditure Survey. Contractionary monetary policy systematically increases inequality in labor earnings, total income, consumption and total expenditures. Furthermore, monetary policy shocks account for a non-trivial component of the historical cyclical variation in income and consumption inequality. Using detailed micro-level data on income and consumption, we document some of the different channels via which monetary policy shocks affect inequality, as well as how these channels depend on the nature of the change in monetary policy.     

Permanent and transitory components of GDP and stock prices: further analysis

Using the conventional VAR identification approach, Cochrane (Quarterly Journal of Economics 107: 241–65, 1994) finds that substantial amounts of variation in GDP growth and stock returns are due to transitory shocks. Following the common trend decomposition of King etal. (American Economic Review 81: 819–40, 1991), we show that Cochrane's results depend on the assumption of weak exogeneity of one of the variables with respect to the cointegration vector. When this assumption holds both approaches coincide. If not, the shocks Cochrane called transitory are not totally transitory. In this case, the conventional VAR approach with the assumption of the weak exogeneity may overstate the magnitude of transitory shocks and understate that of permanent shocks. We find that the permanent components of GDP and stock prices are much larger than those estimates of Cochrane, although substantial (but much smaller than in Cochrane 1994) variations in GDP growth and stock returns are attributed to transitory shocks.     

Emerging market business cycles: Learning about the trend

Emerging market business cycles feature a higher variability of consumption relative to output and a strongly countercyclical trade balance. An equilibrium business cycle model in which agents learn to distinguish between the permanent and transitory components of total factor productivity shocks using the Kalman filter accounts for these features. Calibrated to Mexico, the model accounts for the behavior of consumption and the trade balance for a wide range of variability and persistence of permanent shocks relative to transitory shocks. Estimation for Mexico and Canada suggests more severe informational frictions in emerging markets than in developed economies.     

Consumption, the persistence of shocks, and asset price volatility

In a general equilibrium setting, a temporary component in consumption introduces a wedge between the volatility of equity returns and the volatility of consumption growth. This paper explores the asset pricing consequences of this property in a model in which consumption is the sum of a permanent and a transitory component. Permanent shocks are assumed to be rare events, while transitory shocks follow a diffusion process. When calibrated to US annual data, the model matches first and second moments of equity and bond returns for preference parameters within acceptable bounds. Permanent and transitory shocks together explain the equity premium, while transitory shocks alone explain the excess volatility of returns.     

Permanent sales increase and investment

When firms experience increases in sales that they consider to be permanent, the present value of expected profits also increases, leading to increases in the firms' investments. Our study investigates the permanent sales hypothesis (PSH) of firms' investment; it examines whether investment decisions are influenced by changes in the permanent, in contrast to transitory, component of sales income increases. Using the co-integration test and the structural vector auto-regression (SVAR) framework, our paper finds strong support for the hypothesis that investment behavior is primarily explained by permanent changes in sales income. Empirical multiple time series regression results also confirm that investments are a function of a number of past yearly sales changes. Our results show that larger, more liquid, and lower debt ratio firms follow PSH more closely than smaller, less liquid, higher debt ratio firms. Recent studies on corporate investment (i.e., Fazzari, Hubbard, and Petersen, 1988) have argued that the higher the dependence on the internal source of funding of the investment, the stronger the severity of financing constraints. Our study shows that the more dependent on the permanent cumulative increase of internal source of funding a firm's funding on investment, the less financially constrained firms.     

The Slow Adjustment of Aggregate Consumption to Permanent Income

This paper investigates the relationship between aggregate consumption and permanent income using a new approach to the estimation of cointegrated systems that builds on Stock and Watson's common stochastic trends representation. The permanent and transitory movements in aggregate income and consumption are estimated directly using the Kalman filter and are allowed to be correlated. This approach avoids any implicit restriction that permanent income be as smooth as consumption. Instead, permanent income appears to be relatively volatile, with consumption adjusting toward it only slowly over time. These results provide a clear rejection of the standard version of the permanent income hypothesis and are suggestive of alternative theories of consumption behavior such as habit formation or precautionary savings.     

Income Risk and Portfolio Choice: An Empirical Study

This paper investigates the relationship between portfolio choice and labor income risk in the National Longitudinal Survey of Youth 1979 Cohort. Permanent income risk (variability of shocks to income that have permanent effect) significantly reduces the share of risky assets in the household's portfolio, while transitory income risk (variability of shocks with no lasting effect) does not. This result provides strong evidence that households' portfolio choices respond to labor income risks in a manner consistent with economic theory.     

Common and country-specific components in national stock prices

Previous studies on cointegration among national stock markets show conflicting results. This paper designs a general state space model to investigate the importance of a common world-wide component and the existence of country-specific components in national stock market indices. For G7 countries, there exist country-specific permanent and transitory components. Based on a variance decomposition analysis, Germany, Italy, and Japan's country-specific permanent shocks account for about half of their total permanent shocks. Most of France, Germany, and the United Kingdom's transitory shocks are country-specific. G7 countries do not seem to cointegrate around one common stochastic trend, and potential long-run international diversification benefits still exist.     

Credit Card Debt and Default over the Life Cycle

This paper solves an empirically parameterized model of life cycle consumption, which allows for uncollaterized borrowing and the possibility of default. The simulation results show that: (i) "social stigma " and credit limit have a very large impact on default rates; (ii) education level also has a significant effect on the probability of default, namely, through differences in the shape of lifetime labor income profiles; and (iii) the response of simulated default rates to labor income shocks is determined by the nature of labor income uncertainty (temporary versus permanent). Additionally, the model generates simultaneous consumer holdings of credit card debt and liquid assets.     

Income Inequality: A Tale of Two Cycles?

Building on previous work, this paper documents the changes in income inequality that have occurred over the past 20 years, right up until the late 1990s. In particular, we are interested in whether or not the path of inequality in the most recent economic cycle differed from that observed in the 1980s. The robustness of the results is investigated using innovative statistical techniques, in an attempt to identify whether or not the observed changes represent real increases or decreases in inequality or whether they can be attributed simply to sampling variation between years. Finally, some preliminary results are presented which attempt to identify some of the reasons underlying the observed trends in income inequality, with a particular focus on the role of the labour market.     

Does operating risk affect portfolio risk? Evidence from insurers' securities holding

This study empirically examines, in the setting of insurance companies, the hypothesis that investors facing more operating risk may behave as if they were more risk averse in investment decisions. Specifically, we study how operating risk from underwriting insurance policies affects insurers' risk taking behavior in their portfolio investments. We find that insurers with higher volatilities in underwriting incomes and cash flows are more conservative in their financial investment risk taking – they have lower credit risk exposure in their bond investments, as well as lower portfolio weights on risky bonds and equities. Further, insurers' portfolio risk exposure is sensitive to the risk of permanent underwriting income shocks but insensitive to the risk of transitory shocks. Transitory operating risk, however, is significantly related to portfolio risk when insurers face tight financing constraints. Our findings suggest a substitutive effect of operating risk on investment decisions by financial institutions.     

Heterogeneous Consumers and Fiscal Policy Shocks

This paper studies empirical facts regarding the effects of unexpected changes in aggregate macroeconomic fiscal policies on consumers that differ depending on individual characteristics. We use data from the Consumption Expenditure Survey to estimate individual‐level responses and multipliers for government spending. We find that unexpected fiscal shocks have substantially different effects on consumers depending on their income and age levels: the wealthiest individuals tend to behave according to predictions of standard Real Business Cycle (RBC) models, whereas the poorest ones behave according to standard IS–LM (non‐Ricardian) models, most likely due to credit constraints. Furthermore, government spending policy shocks tend to decrease consumption inequality.     

Currency Returns, Intrinsic Value, and Institutional-Investor Flows

We decompose currency returns into (permanent) intrinsic‐value shocks and (transitory) expected‐return shocks. We explore interactions between these shocks, currency returns, and institutional‐investor currency flows. Intrinsic‐value shocks are: dwarfed by expected‐return shocks (yet currency returns overreact to them); unrelated to flows (although expected‐return shocks correlate with flows); and related positively to forecasted cumulated‐interest differentials. These results suggest flows are related to short‐term currency returns, while fundamentals better explain long‐term returns and values. They also rationalize the long‐observed poor performance of exchange‐rate models: by ignoring the distinction between permanent and transitory exchange‐rate changes, prior tests obscure the connection between currencies and fundamentals.     

Consumption and risk sharing over the life cycle

A striking feature of U.S. data on income and consumption is that inequality increases with age. This paper asks if individual-specific earnings risk can provide a coherent explanation. We find that it can. We construct an overlapping generations general equilibrium model in which households face uninsurable earnings shocks over the course of their lifetimes. Earnings inequality is exogenous and is calibrated to match data from the U.S. Panel Study on Income Dynamics. Consumption inequality is endogenous and matches well data from the U.S. Consumer Expenditure Survey. The total risk households face is decomposed into that realized before entering the labor market and that realized throughout the working years. In welfare terms, the latter is found to be more important than the former.     

Consumption and Hedging in Oil‐Importing Developing Countries

We study the consumption and hedging strategy of an oil‐importing developing country that faces multiple crude oil shocks. In our model, developing countries have two particular characteristics: their economies are mainly driven by natural resources and their technologies are less efficient in energy usage. The natural resource exports can be correlated with the crude oil shocks. The country can hedge against the crude oil uncertainty by taking long/short positions in existing crude oil futures contracts. We find that both inefficiencies in energy usage and shocks to the crude oil price lower the productivity of capital. This generates a negative income effect and a positive substitution effect, because today’s consumption is relatively cheaper than tomorrow’s consumption. Optimal consumption of the country depends on the magnitudes of these effects and on its risk‐aversion degree. Shocks to other crude oil factors, such as the convenience yield, are also studied. We find that the persistence of the shocks magnifies the income and substitution effects on consumption, thus also affecting the hedging strategy of the country. The demand for futures contracts is decomposed in a myopic demand, a pure hedging term and productive hedging demands. These hedging demands arise to hedge against changes in the productivity of capital due to changes in crude oil spot prices. We calibrate the model for Chile and study to what extent the country’s copper exports can be used to hedge the crude oil risk.