Inequality over the business cycle: Estimating income risk using micro data on consumption, mimeo

We use CEX repeated cross-section data on consumption and income, to evalu-ate the nature of increased income inequality in the 1980s and 90s. We decompose unexpected changes in family income into transitory and permanent, and idiosyn-cratic and aggregate components, and estimate the contribution of each component to total inequality. The model we use is a linearized incomplete markets model, enriched to incorporate risk-sharing while maintaining tractability. Our estimates suggest that taking risk sharing into account is important for the model fit; that the increase in inequality in the 1980s was mainly permanent; and that inequality is driven almost entirely by idiosyncratic income risk. In addition we find no ev-idence for cyclical behavior of consumption risk, casting doubt on Constantinides and Duffie’s (1995) explanation for the equity premium puzzle