[...]... contributors to this area of research A theme of interest for both labor economics and macroeconomics is to understand how much risk households face, to what extent risk affects basic household choices such as consumption, labor supply and human capital investments, and what types of risks matter in explaining behavior.1 These are questions that have a long history in economics A fruitful distinction is between... revision of consumption as a result of a negative income shock (see Hall and Mishkin, 1982; Heathcote et al., 2007) More broadly, ex-ante responses to risk may include:3 (a) precautionary labor supply, i.e., cutting the consumption of leisure rather than the consumption of goods (Low, 2005) (b) delaying the adjustment to the optimal stock of durable goods in models with fixed adjustment costs of the (S,s)... insurance against “initial conditions”, such as the risk of being born to bad parents or that of growing up in bad neighborhoods Finally, the impact of shocks on behavior also matters for the purposes of understanding the likely effectiveness of stabilization or “stimulus” policies, another classical question in economics As we shall see, the modern theory of intertemporal consumption draws a sharp distinction... large changes Given the importance of the nature of income changes for predicting consumption behavior, we then move in Section 3 to a review of the literature that has tried to come up with measures of wage or earnings risk using univariate data on wages, earnings or income The objective of these papers has been that of identifying the most appropriate characterization of the income process in a parsimonious... would affect the level of consumption but not its change (unless consumers were learning about pi , see Guvenen, 2007) In the classical version of the LC-PIH the size of income changes does not matter One reason why the size of income changes may matter is because of adjustment costs: 12 See Friedman (1957) Meghir (2004) provides an analysis of how the PIH has influenced modern theory of consumption 13 However,... find evidence of this using PSID data 18 Blundell et al (2008a) contains a lengthier derivation of such an expression, including discussion of the order of magnitude of the approximation error involved 19 Results from a simulation of a stochastic economy presented in Blundell et al (2008a) show that the approximation (12) can be used to accurately detect changes in the time series pattern of permanent... changes in the forecast of the amount of uncertainty one expects in the future) Earnings, Consumption and Life Cycle Choices The interpretation of the impact of income shocks on consumption growth in the PIH model with CRRA preferences is straightforward For individuals a long time from the end of their life with the value of current financial assets small relative to remaining future labor income, i,a,t... shall see, BPP find an estimate of the MPC with respect to permanent shocks of 0.64 (s.e 0.09) and an estimate of the MPC with respect to transitory shocks of 0.05 (s.e 0.04) Clearly, the “theoretical” MPCs found by KV lie well in the confidence interval of BPP’s estimates One thing that seems not to be borne out in the data is that theoretically the degree of smoothing of permanent shocks should be strictly... liquidity constrained Assistant Professor will not change her (rent) consumption at the time of the announcement of a promotion, but only at the time of the actual salary increase With perfect credit markets, however, the model predicts that anticipated changes do affect consumption when they are announced In terms of stabilization policies, this means that two types of income changes will affect consumption... 776 Costas Meghir and Luigi Pistaferri markets and the nature of the income process, including the persistence and the volatility of shocks as well as the sources of risk, underlie both the ex-ante and the ex-post responses Understanding how much risk and what types of risks people face is important for a number of reasons First, the list of possible behavioral responses given above suggests that fluctuations . alt="" Handbook of LABOR ECONOMICS VOLUME 4B INTRODUCTION TO THE SERIES The aim of the Handbooks in Economics series is to produce Handbooks for various branches of economics, each of which. teaching supplement for use by professional researchers and advanced graduate students. Each Handbook provides self-contained surveys of the current state of a branch of economics in the form of chapters prepared. Black Department of Economics, University of Texas at Austin, IZA and NBER Paul J. Devereux School of Economics and Geary Institute, University College Dublin, CEPR and IZA Marianne Bertrand Booth School of