Income and consumption inequality: decomposingincome risk

This paper assesses the accuracy of decomposing income risk into permanent andtransitory components using income and consumption data. We develop a specificapproximation to the optimal consumption growth rule and use Monte Carlo evidence to show that this approximation can provide a robust method for decomposingincome risk. The availability of asset data enables the use of a more accurate approximation allowing for partial self-insurance against permanent shocks. We showthat the use of data on median asset holdings corrects much of the error in thesimple approximation which assumes no self-insurance against permanent shocks. This paper assesses the accuracy of decomposing income risk into permanent andtransitory components using income and consumption data. We develop a specificapproximation to the optimal consumption growth rule and use Monte Carlo evidence to show that this approximation can provide a robust method for decomposingincome risk. The availability of asset data enables the use of a more accurate approximation allowing for partial self-insurance against permanent shocks. We showthat the use of data on median asset holdings corrects much of the error in thesimple approximation which assumes no self-insurance against permanent shocks.