How Do Households Respond to Income Shocks?
We use the Italian Survey of Household Income and Wealth from 1987 to 2008 and the two most recent waves of the Panel Study of Income Dynamics (for the years 2004 and 2006), the only available micro datasets that contain a household panel on detailed categories of income, consumption and wealth, to document co-movements of several components of the household budget constraint with short run and long run changes in labor income. We construct a measure of labor income shocks and show that these shocks are associated with modest consumption changes (that are increasing over the horizon of the change) and larger wealth changes (that are falling over the horizon of the change). The consumption evidence suggests that labor income shocks have a modest persistence and can be insured well using simple uncontingent borrowing and saving. The wealth evidence suggests an important role for wealth shocks, possibly correlated with income shocks, in affecting consumption.
This paper was presented at the August 2011 meeting of CFSP's Savings and Financial Underpinnings of Macro Models Workshop. The corresponding presentation and discussion are also available.