This paper argues that the typical household’s saving is better described by a “bufferstock” version than by the traditional version of the Life Cycle/Permanent Income Hypothesis (LC/PIH) model. Buffer-stock behavior emerges if consumers with important income uncertainty are sufficiently impatient. In the traditional model, consumption growth is determined solely by tastes; in contrast, buffer-stock consumers set average consumption growth equal to average labor income growth, regardless of tastes. The model can explain three empirical puzzles: the “consumption/income parallel ” of Carroll and Summers [1991]; the “consumption/income divergence ” first documented in the 1930's; and the temporal stability of the household age/wealth profile despite the unpredictability of idiosyncratic wealth changes.

This paper evaluates the key implication of rational expectations and the basic Life Cycle/Permanent Income Hypothesis (LCH/PIH): that predictable changes in income have no e®ect on the growth rate of consumption expenditures. 1 This implication is important for understanding the e®ectiveness and optimal timing of ¯scal policy, the causes and propagation of business cycles, and the e®ects of income °uctuations on the growth rate of the economy. Using household-level consumption data from the Consumer Expenditure Survey (CEX), this paper tests whether expenditures on nondurable goods increase contemporaneously with predictable changes in Social Security tax withholding. 2 Individuals with wage and salary income earned in the United States are subject to Social Security tax withholding of around seven percent of their gross pay up to an annual maximum income level. The structure of the Social Security tax system provide two sources of variation. First, a series of pre-announced tax rate increases occurred in the 1980's. Since the share of after-tax labor income in total income di®ers across households and since some individuals are not subject to Social Security tax withholding, these changes

We show that a life-cycle model with realistically calibrated uninsurable labor income risk and moderate risk aversion can simultaneously match stock market participation rates and asset allocation decisions conditional on participation. The key ingredients of the model are Epstein–Zin preferences, a fixed stock market entry cost, and moderate heterogeneity in risk aversion. Households with low risk aversion smooth earnings shocks with a small buffer stock of assets, and consequently most of them (optimally) never invest in equities. Therefore, the marginal stockholders are (endogenously) more risk averse, and as a result they do not invest their portfolios fully in stocks. IN THIS PAPER, WE PRESENT A LIFE-CYCLE ASSET allocation model with intermediate consumption and stochastic uninsurable labor income that provides an explanation for two very important empirical observations: low stock market participation rates in the population as a whole, and moderate equity holdings for stock market participants. Our life-cycle model integrates three main motives that have been identified

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A typical household has a home mortgage as its most significant financial contract. The form of this contract is correspondingly important. This paper studies the choice between a fixed-rate (FRM) and an adjustable-rate (ARM) mortgage. In an environment with uncertain inflation, a nominal FRM has risky real capital value whereas an ARM has a stable real capital value. However an ARM can increase the short-term variability of required real interest payments. This is a disadvantage of the ARM for a household that faces borrowing constraints and has only a small buffer stock of financial assets. The paper uses numerical methods to solve a life-cycle model with risky labor income and borrowing constraints, under alternative assumptions about available mortgage contracts. While an ARM is generally an attractive form of mortgage, a household with a large mortgage, risky labor income, high risk aversion, a high cost of default, and a low probability of moving is less likely to prefer an ARM. The paper also considers an inflation-indexed FRM, which removes the wealth risk of the nominal FRM without incurring the income risk of the ARM, and is therefore a superior vehicle for household risk management. The welfare gain from mortgage

The textbook neoclassical growth model predicts that countries with faster productivity growth should invest more and attract more foreign capital. We show that the allocation of capital flows across developing countries is the opposite of this prediction: capital does not flow more to countries that invest and grow more. We call this puzzle the “allocation puzzle. ” Using a wedge analysis, we find that the pattern of capital flows is driven by national saving: the allocation puzzle is a saving puzzle. Further disaggregation of capital flows reveals that the allocation puzzle is also related to the pattern of accumulation of international reserves. The solution to the “allocation puzzle”, thus, lies at the nexus between growth, saving and international reserve accumulation. We conclude with a discussion of some possible avenues for research. 1.

This paper explores the macroeconomic and welfare implications of the sharp rise in U.S. wage inequality (1967-1996). In the data, cross-sectional earnings variation increased substantially more than wage variation, due to a sharp rise in the wage-hours correlation. At the same time, inequality in hours worked and consumption remained roughly constant through time. Using data from the PSID, we decompose the rise in wage inequality into changes in the variance of permanent, persistent and transitory shocks. With the estimated changes in the wage process as the only primitive, we show that a standard calibrated OLG model with incomplete markets can successfully account for all these patterns in cross-sectional U.S. data. Through a set of counter-factual experiments, we assess the role of each component of the wage process for the evolution in the various dimensions of inequality. The model also allows us to investigate the welfare costs of the rise in inequality: we find that the unconditional expected welfare loss is equivalent to a 5 percent decline in lifetime income for the worst-affected cohorts, those entering the labor market in the mid 1980’s. Ex post, these costs are widely dispersed across agents, due both to differences in permanent individual attributes and to differences in labor market histories. An extensive sensitivity analysis verifies the robustness of our results to alternative preferences and borrowing limits, and to the inclusion of female labor force participation.

Intertemporal preferences are di ¢ cult to measure. We estimate time preferences using a structural bu¤er stock consumption model and the Method of Simulated Moments. The model includes stochastic labor income, liquidity constraints, child and adult dependents, liquid and illiquid assets, revolving credit, retirement, and discount functions that allow short-run and long-run discount rates to di¤er. Data on retirement wealth accumulation, credit card borrowing, and consumption-income comovement identify the model. Our benchmark estimates imply a 40% short-term annualized discount rate and a 4.3 % long-term annualized discount rate. Almost all speci…cations reject the restriction to a constant discount rate. Our quantitative results are sensitive to assumptions about the return on illiquid assets and the coe ¢ cient of relative risk aversion. When we jointly estimate the coe ¢ cient of relative risk aversion and the discount function, the short-term discount rate is 15 % and the long-term discount rate is 3.8%.

Is individual labor income more risky in recessions? This is a difficult question to answer because existing panel data sets are so short. To address this problem, we develop a generalized method of moments estimator that conditions on the macroeconomic history that each member of the panel has experienced. Variation in the cross-sectional variance between households with differing macroeconomic histories allows us to incorporate business cycle information dating back to 1930, even though our data do not begin until 1968. We implement this estimator using household-level labor earnings data from the Panel Study of Income Dynamics. We estimate that idiosyncratic risk is (i) highly persistent, with an annual autocorrelation coefficient of 0.95, and (ii) strongly countercyclical, with a conditional standard

A central prediction of the quasi-hyperbolic model of time preference is that consumers will be impatient over short-run tradeoffs. I present the first nonlaboratory test of this implication using data on the nutritional intake of food stamp recipients. Caloric intake declines by 10 to 15 percent over the 30-day period following receipt of food stamps, implying a significant preference for immediate consumption. Resulting estimates of the daily discount rate are inconsistent with any reasonable calibration of an exponential discounting model. The data support an explanation based on time preference and reject several alternative explanations, including high elasticities of intertemporal substitution, strategic interactions and food depreciation. Consider a consumer who is indifferent between enjoying one additional dollar of consumption today and 99.6 additional cents of consumption tomorrow. Such an individual has a daily discount factor of 0.996, and if she is an exponential discounter her annual discount factor will be about 0.23. She would therefore strictly prefer 24 dollars of additional consumption today to 100 dollars of additional consumption