Household Earnings and Consumption: A Nonlinear Framework

We develop a flexible framework to study the nonlinear relationship between shocks to household earnings and consumption over the life cycle. Log-earnings are the sum of a general Markovian persistent component and a transitory innovation. Consumption is modelled as an age-dependent nonlinear function of assets and the two earnings components. We establish the nonparametric identification of the earnings process and the consumption rule, and apply quantile-based methods for estimation. Exploiting the enhanced consumption and asset data in the PSID for 1999-2009, we find the impact of earnings shocks varies substantially across households’ earnings histories, and that this nonlinearity drives heterogeneous consumption responses. We also find that the insurability of earnings shocks is higher late in the life-cycle, and that assets play an important role. JEL code: C23, D31, D91.