How do households respond to income shocks?∗

Commonly used consumption/saving models have radically different implications for households response to income shocks, ranging from the hands-to-mouth model, where consumption bears all the adjustment, to the complete markets model, where wealth bears all the adjustment. In this paper we use the Italian Survey of Household Income and Wealth, which is the only available micro dataset that contains a panel on income, consumption and wealth, to document how consumption and wealth co-move with short run and long run income changes and to assess which model best captures this response. We find that households who do not own real estate nor businesses change their consumption and their wealth by about 23 and 17 cents, respectively, in response to a short run 1 Euro change in after-tax labor income. For longer run income changes consumption response becomes stronger and wealth response weaker. We show this response to be quantitatively consistent with a permanent income model with quadratic utility but not with a model in which households have CRRA utility and thus an income and wealth-dependent precautionary saving motive. We finally show that for households owning real estate or businesses, consumption response is weaker and wealth response is much stronger, suggesting an important role for additional shocks, possibly correlated with income shocks. Ijel codes: d91, e21 key words: Consumption, Risk Sharing, Precautionary saving, Incomplete Markets ∗PRELIMINARY. We thank Ctirad Slavik for excellent research assistance, seminar participants at the University of Minnesota, University of Pennsylvania, Cowles Foundation, St. Louis and Philadelphia FED, Arizona State, Carnegie Mellon, Penn State, Rochester, University of Virginia, Duke, SUNY Albany, ECB, Frankfurt, SAVE Conference in Deidesheim and the 2008 SED and NBER Summer Institute for many helpful suggestions and the NSF (under grant SES-0820494) for financial support.