Income Dynamics and Consumption Insurance

An accurate quantitative analysis using lifecycle incomplete markets models requires
that they match both the total amount of insurance available to households in the data
and the empirical importance of the sources of insurance such as, e.g., household saving
and borrowing or the tax and transfer system. The prominent empirical benchmark
estimates of the extent and sources of insurance provided in Blundell, Pistaferri and
Preston (American Economic Review, 2008) imply that the currently used models poorly
fit these data. We show that this is because the income process used as an input in the
incomplete markets models and when constructing the empirical benchmark estimates of
insurance abstracts from the irregular nature of income observations at the start and end
of family income spells. When ignored, this feature of the income data induces a large
bias in the empirical measures of the degree and sources of insurance and results in a
misleading assessment of the models’ performance. The empirical measures of insurance
accounting for the bias imply a limited role of assets and taxes and transfers in insuring
permanent shocks to household budgets.