Dynamics of the Wealth Distribution in the Presence of Higher-Order Earnings Risk

Abstract

This paper introduces higher-order earnings risk consistent with recent empirical findings into a benchmark heterogeneous-agent macro model to examine its implication for the distribution of wealth. I find that higher-order earnings dynamics induce higher earnings inequality driven primarily by persistent earnings losses at the bottom. Poor households respond by strongly cutting consumption leading to more consumption and less wealth inequality which reinforces the known issue of generating the empirically observed wealth dispersion in this class of models. In addition to lower overall consumption, the higher-order earnings moments, particularly excess kurtosis, are passed through to consumption dynamics of the poor. Both effects combined mean that those households are willing to pay up to 1.7% of permanent consumption to avoid higher-order earnings risk. Moreover, the latter effect induces consumption dynamics of the poor to be predominantly driven by idiosyncratic earnings changes which significantly reduces the correlation between their consumption and aggregate output. Since wealthier households are not affected strongly the implications for the aggregate dynamics of the economy are negligible. Methodologically, I develop a new General Polynomial Chaos Expansion approach to solve for the aggregate dynamics of this class of models, and contrast its efficiency with previous methods.