Wealth, Race, and Consumption Smoothing of Typical Income Shocks

Peter Ganong, Damon Jones, Pascal J. Noel, Fiona E. Greig, Diana Farrell, Chris Wheat

NBER Working Paper No. 27552
Issued in July 2020
NBER Program(s):Economic Fluctuations and Growth, Labor Studies, Monetary Economics, Public Economics

We estimate the elasticity of consumption with respect to income using an instrument based on firm-wide changes in pay. While much of the consumption-smoothing literature uses variation in unusual windfall income, this instrument captures the temporary income variation that households typically experience. Furthermore, this estimator is precise, allowing us to address an open question about how much the elasticity varies with wealth. We find a much lower consumption response for high-liquidity households, which may help discipline structural models. We then use this instrument to study how wealth shapes racial inequality. An extensive body of work documents a substantial racial wealth gap. However, less is known about how this gap translates into differences in welfare on a month-to-month basis. We find that black (Hispanic) households cut their consumption 50 (20) percent more than white households when faced with a similarly-sized income shock. Nearly all of this differential pass-through of income to consumption is explained, in a statistical sense, by differences in liquid wealth. Combining our empirical estimates with a model, we show that the welfare cost of income volatility is at least 50 percent higher for black households and 20 percent higher for Hispanic households than it is for white households.

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Document Object Identifier (DOI): 10.3386/w27552

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