Income Shocks and their Transmission into Consumption

Edmund Crawley, Alexandros Theloudis

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Abstract

Measuring how household consumption responds to income shocks is important for understanding how families cope with adverse events, for designing government insurance or other income support policies, and for understanding the transmission of business cycles and monetary policy. It is also important for evaluating the effects of fiscal or labor market reforms on consumer welfare, and for how these reforms may impact the macroeconomy given that consumption is a large share of GDP. This article reviews the economics literature of, primarily, the last 20 years, that studies the link between income shocks and consumption fluctuations at the household level. We identify three broad approaches through which researchers estimate the consumption response to income shocks: 1.) structural methods in which a fully or partially specified model helps identify the consumption response to income shocks from the data; 2.) natural experiments in which the consumption response of one group who receives an income shock is compared to another group who does not; 3.) elicitation surveys in which consumers are asked how they expect to react to various hypothetical events. None of these approaches is exclusive to a single field within economics; studies that use any of these methods are ordinarily classified, depending on their specific focus, in macroeconomics, labor economics, public finance – to name only a few fields. Our aim in this short article is to survey this increasingly busy literature and provide an accessible summary of the various estimates of the consumption response to income shocks. We concentrate on the similarities and differences between the various studies, in particular with respect to the method, data, consumption notion, and type of income shock analyzed, thus also with respect to the type of consumption response each work identifies. Our focus is on responses to shocks, i.e., unanticipated income changes; Jappelli and Pistaferri (2010) review the earlier evidence on responses to anticipated income changes. The survey proceeds as follows. Section 1 introduces a brief theoretical framework that helps fix ideas for the subsequent discussion. The next sections are devoted to the different approaches to the estimation of the consumption response. Section 2 surveys the studies that employ structural methods, section 3 reviews the evidence from natural experiments, and section 4 focuses on the elicitation surveys. Section 5 concludes.
Original languageEnglish
Place of PublicationTilburg
PublisherCentER, Center for Economic Research
Number of pages22
Volume2024-012
Publication statusPublished - 23 Apr 2024

Publication series

NameCentER Discussion Paper
Volume2024-012

Keywords

  • consumption insurance
  • consumption smoothing
  • income shocks
  • pass-through
  • marginal propensity to consume
  • covariance restrictions
  • natural experiments
  • elicitation surveys

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