Income uncertainty shocks and precautionary savings

This thesis is aimed at studying how income uncertainty shocks can affect household consumption and saving. By using an extended life cycle model combined with proxies of uncertainty the paper attempts to describe the pattern of increased saving in Norway after the Great Recession in the period from 2008 to 2013. Next, by comparing the developments of realized volatility in the income process and developments in proxies of uncertainty, the paper studies how current income uncertainty from the COVID-19 pandemic might affect future consumption and saving. The model is calibrated on Norwegian household data. Based on the calibrated model, a simulation of 100 000 households is performed. The results from the model shows that by accounting for the observed increased income uncertainty the model predicts a 0.666 percent increase in precautionary savings in the first year after the Great Recession. Assuming that the shock is perceived as permanent and lasts for five years the model yields an increase in financial wealth of 5.6 percent, compared to the baseline estimate without the income uncertainty shock. Further by comparing the developments in proxies uncertainty during the Great Recession with the COVID-19 pandemic, the income shock is of either equal or of a larger proportion depending on two different scenarios of recovery. In the worst case scenario income uncertainty yields an increase in savings of 1 percent in 2020 and a increase in financial wealth of 8.4 percent from 2020 to 2025 compared to the baseline estimate without the income shock