Research

This paper examines heterogeneous income risk and its impact on consumption insurance. A novel framework is proposed wherein household-specific variances of both persistent and transitory income shocks are considered. Using the Panel Study of Income Dynamics (PSID), this study empirically investigates several key aspects of het- erogeneous income risk. First, the distribution of household-fixed income volatility exhibits right-skewness with a fat tail, posing a challenge for conventional income dynamics literature. Second, a considerable portion of the heterogeneity in income risk remains unexplained by observable characteristics, highlighting latent factors. Third, households experiencing more volatile transitory risk tend to exhibit less consumption response. I estimate an income process under the assumption of reliable parametric income shocks to capture the income volatility distribution and consumption response to heterogeneous income risk. Quantitatively, I use a standard life-cycle incomplete market model to demonstrate that the model’s predictions align consistently with empirical estimates.