nancial support from the Spanish Ministry of Education and Sciences (grant SEJ2005-01124) and the

Was the increase in income inequality in the US due to permanent shocks or merely to an increase in the variance of transitory shocks? The implications for consumption and welfare depend crucially on the answer to this question. We use CEX repeated cross-section data on consumption and income to decompose idiosyncratic changes in income into predictable life-cycle changes, transitory and permanent shocks and estimate the contribution of each to total inequality. Our model ts the joint evolution of consumption and income inequality well and delivers two main results. First, we \u85nd that permanent changes in income explain all of the increase in inequality in the 1980s and 90s. Second, we reconcile this \u85nding with the fact that consumption inequality did not increase much over this period. Our results support the view that many permanent changes in income are predictable for consumers, even if they look unpredictable to the econometrician, consistent with models of heterogeneous income pro\u85les