Current Research

“Understanding Wage Inequality: Ben-Porath Meets Skill-Biased Technical Change” (with Burhanettin Kuruscu)

First draft coming soon.. In the meantime, the slides of this paper from SED 2005 (slides contain a subset of the results from this paper)

Abstract

This paper introduces an analytically tractable general equilibrium, overlapping-generations model of human capital accumulation, and shows that it provides a consistent explanation of several key features of the evolution of the U.S. wage distribution from 1970 to 2000. The framework is based on the Ben-Porath (1967) model. The key feature of the model, and the only source of heterogeneity, is that individuals differ in their ability to accumulate human capital. To highlight the working of the model, we abstract from all kinds of idiosyncratic uncertainty that has been the focus of recent research. Thus, wage inequality only results from differences in human capital accumulation. In this environment, different individuals’ investments respond differently to changes in the returns to human capital, resulting in rich time-series and cross-sectional changes in the wage distribution. An important implication of this framework is that changes in between-group and within-group inequality are driven by the same underlying force, suggesting that the distinction is rather artificial. The main thought experiment is the following. We calibrate the model to be consistent with the features of the wage distribution in 1970, and then consider the effect of skill-biased technical change, modeled as an increase in the returns to human capital after 1970. The model is both qualitatively and quantitatively consistent with: (i) a large increase in wage inequality but a much smaller rise in consumption inequality, which happens at the aggregate level as well as within each cohort (Blundell and Preston, 1998), (ii) a falling college-high school premium in the 70's followed by a strong rise starting in early 80's (Katz and Murphy 1992), (iii) stagnating median wages (and a slow-down in labor productivity) from mid-70's until mid-90's, (iv) the fact that the wage growth of a worker between 1965 and 1990 was almost linearly related to his position in the wage percentile distribution in 1965 (Juhn, Murphy and Pierce 1993), (v) the evolution of the 90-50 and 50-10 percentile differentials. We also show theoretically that several of these results are robust features of this model, as long as the heterogeneity in ability is sufficiently large.

“Firm Volatility and Wage Inequality” (with Thomas Philippon), Work in progress.

The slides of this paper from SED2005 (containing a subset of the empirical and theoretical results)

“Does Market Incompleteness Matter for Asset Prices?” (with Burhanettin Kuruscu)

Forthcoming in the Journal of European Economic Association, P&P, 2006

Abstract

In this paper we argue that market incompleteness resulting from limited stock market participation is important for understanding the behavior of asset prices. We first study some new implications of the limited participation model studied in Guvenen (2005, “A Parsimonious Macroeconomic Model..”) for the time-series behavior of asset prices, and present some new empirical evidence consistent with the main mechanism of that model. Furthermore, existing asset pricing models in incomplete markets settings almost exclusively abstract away from labor-leisure choice which is a key element in macro models. We introduce this choice into our model and investigate its implications.

“Estimating Preference Parameters Using General Equilibrium Restrictions” (with Tony Smith), work in progress

“Explaining Life-Cycle Asset Allocation: The Role of Bequests and Under-diversification” (with Claudio Campanale), work in progress

Manuscripts

Learning Your Earning: Are Labor Income Shocks Really Very Persistent? (Revised: July 2005)

Abstract

The current literature offers two views on the nature of the income process. According to the first view, which we call the “Restricted Income Profiles” (RIP) model (MaCurdy, 1982), individuals are subject to large and very persistent shocks, while facing similar life-cycle income profiles (conditional on a few characteristics). According to the alternative view, which we call the “Heterogeneous Income Profiles” (HIP) model (Lillard and Weiss, 1979), individuals are subject to income shocks with modest persistence, while facing individual-specific income profiles. While labor income data arguably provides more support for the latter view, it does not seem to distinguish between the two hypotheses in a definitive way. Despite this, the RIP model is overwhelmingly used to specify the income process in economic models, because it delivers implications consistent with certain features of consumption data. In this paper we study the consumption-savings behavior under the HIP model, which so far has not been investigated. In a life-cycle model, we assume that individuals enter the labor market with a prior belief about their individual-specific profile and learn over time in a Bayesian fashion. We find that learning is slow, and thus initial uncertainty affects decisions throughout the life-cycle allowing us to estimate the prior uncertainty from consumption behavior later in life. This procedure implies that 40 percent of variation in income growth rates is forecastable by individuals at time zero. The resulting model is consistent with several features of consumption data including (i) the substantial rise in within-cohort consumption inequality (Deaton and Paxson 1994), (ii) the non-concave shape of the age-inequality profile (which the RIP model is not consistent with), and (iii) the fact that consumption profiles are steeper for higher educated individuals (Carroll and Summers 1991). These results bring new evidence from consumption data on the nature of labor income risk.

An Empirical Investigation of Labor Income Processes (NEW: August 2005)

Abstract

The current literature offers two views on the nature of the income process. According to the first view, which we call the “Restricted Income Profiles” (RIP) model (MaCurdy, 1982), individuals are subject to large and very persistent shocks, while facing similar life-cycle income profiles (conditional on a few characteristics). According to the alternative view, which we call the “Heterogeneous Income Profiles” (HIP) model (Lillard and Weiss, 1979), individuals are subject to income shocks with modest persistence, while facing individual-specific income profiles. In this paper, we first show that ignoring profile heterogeneity, when in fact it is present, introduces an upward bias into the estimates of persistence. Second, we estimate a parsimonious parameterization of the HIP model that is suitable for calibrating economic models. The estimated persistence is about 0.8 in the HIP model compared to about 0.99 in the RIP model. Moreover, the heterogeneity in income profiles is estimated to be substantial, explaining between 65 to 80 percent of income inequality at the time of retirement. We also analyze the differences in the income process by education and find that profile heterogeneity is significantly larger among higher educated individuals. Finally we show that the main evidence against profile heterogeneity in the existing literature–that the autocorrelations of income changes are small and negative–is also replicated by the HIP model, casting doubt on the previous interpretation of this evidence.

A Parsimonious Macroeconomic Model for Asset Pricing: Habit Formation or Cross-Sectional Heterogeneity? (Revised: February 2005)

Abstract

In this paper we study asset prices in a parsimonious two-agent macroeconomic model with two key features: limited participation in the stock market and heterogeneity in the elasticity of intertemporal substitution in consumption. The parameter values for the model are taken from the business cycle literature, and in particular, are not calibrated to match financial statistics. The model generates a number of asset pricing phenomena that have been documented in the literature, including a high equity premium and a low risk-free rate; pro-cyclical variation in the price-dividend ratio; counter-cyclical variation in the equity premium, in its volatility, and in the Sharpe ratio; and long-horizon predictability of returns with high R² values. We also show that the similarity of our results to those from an external habit model is not a coincidence: the model has a reduced form representation that is similar to Campbell and Cochrane’s (1999) framework for asset pricing. However, the implications of the two models for macroeconomic questions and policy analyses are different.

Ø Additional Appendix (contains the counterparts of various tables in the paper for the parameterizations described in Section 8 of the paper. Also contains the computational algorithm for solving the model)

Ø FORTRAN 90 Codes that solve the Limited Participation Model in the “Parsimonious Macroeconomic Model for Asset Pricing”

Reconciling Conflicting Evidence on the Elasticity of Intertemporal Substitution: A Macroeconomic Perspective (forthcoming, Journal of Monetary Economics)

Abstract

In this paper, we reconcile two opposing views about the elasticity of intertemporal substitution (EIS), a parameter that plays a key role in macroeconomic analysis. On the one hand, empirical studies using aggregate consumption data typically find that the EIS is close to zero (Hall 1988). On the other hand, calibrated macroeconomic models designed to match growth and business cycle facts typically require that the EIS be close to one (Weil, 1989, Lucas, 1990). We show that this apparent contradiction arises from ignoring two kinds of heterogeneity across individuals. First, a large fraction of households in the U.S. do not participate in stock markets. Second, a variety of microeconomic studies using individual-level data conclude that an individual's EIS increases with his wealth. We study a dynamic macro model featuring these two realistic sources of heterogeneity which have been largely assumed away in macroeconomics to date. We find that limited participation creates substantial wealth inequality matching that in U.S. data. Consequently, the dynamic behavior of output and investment is almost entirely determined by the preferences of the wealthy minority of households. At the same time, since consumption is much more evenly distributed across households than is wealth, estimation using aggregate consumption uncovers the low EIS of the majority of households (i.e., the poor).

Ø Additional Appendix (contains a computational appendix, a data appendix, and an estimation appendix)

Do Stockholders Share Risk More Effectively than Non-stockholders? (Revised: July 2005)

Abstract

This paper analyzes the extent of risk-sharing among stockholders and among non-stockholders. Wealthy households play a crucial role in many economic problems due to the substantial concentration of asset holdings in the U.S. data. Hence, to evaluate the empirical importance of market incompleteness, it is essential to determine if idiosyncratic shocks are important for the wealthy, who have access to better insurance opportunities, but also face different risks, than the average household. We study a model where each period households decide whether to participate in the stock market by paying a fixed cost. Due to this endogenous entry decision, the testable implications of perfect risk-sharing take the form of a sample selection model, which we estimate and test using a semi-parametric GMM estimator proposed by Kyriazidou (2001). Using data from PSID we strongly reject perfect risk-sharing among stockholders, but perhaps surprisingly, do not find evidence against it among non-stockholders. These results appear to be robust to several extensions we considered. These findings indicate that market incompleteness may be more important for the wealthy, and suggest further focus on risk factors that primarily affect this group, such as entrepreneurial income risk.