The Macroeconomic Implications of Rising Wage Inequality in the US∗

This paper explores the macroeconomic and welfare implications of the sharp rise in US wage inequality (1967-1995). In the data, cross-sectional earnings variation increased substantially more than wage variation, due to a sharp rise in the wage-hours correlation. On the contrary, inequality in hours worked, consumption and wealth (excluding the top 1%) remained roughly constant through time. Using data from the PSID, we decompose the rise in wage inequality into permanent, persistent and transitory shocks. With the estimated changes in the wage process as the only primitive, we show that a standard calibrated OLG model with incomplete markets can successfully account for these crosssectional dynamics. The model also allows us to investigate the welfare costs of the rise in inequality: we find that on average they amount up to 3.3% of lifetime income, but there is huge heterogeneity, due to both differences in permanent individual attributes and to differences in labor market histories. JEL Classification Codes: E21, D31.