Wealth, Race, and Consumption Smoothing of Typical Income Shocks

Abstract

We study the consumption response to typical labor income shocks and investigate how these vary by wealth and race. First, we develop an instrument based on firm-wide changes in labor income. Household income volatility stems mostly from fluctuations in labor income and this research design therefore studies the sort of income fluctuations that households typically experience from month to month. Using administrative banking data, we find an average elasticity of 0.21, with a much higher elasticity for low-liquidity households and close to zero elasticity for high-liquidity households. In a stylized model calibrated to our estimates, this degree of sensitivity implies that temporary income volatility has a large welfare cost for the average household, and especially large costs for low-liquidity households. Second, we use this instrument to study how wealth shapes racial inequality. Although an extensive body of work documents the long-term persistence of the racial wealth gap, less is known about its consequences on households’ lives from month to month. We find that Black and Hispanic households are twice as sensitive to typical income shocks as White households. Nearly all of this difference is explained in a statistical sense by racial wealth inequality. Because of racial disparities in consumption smoothing, the welfare cost of temporary income volatility is twice as high for Black and Hispanic households than for White households.