Understanding Permanent and Temporary Income Shocks   Liberty Street Economics
Liberty Street Economics

« Mission Almost Impossible: Developing a Simple Measure of Pass-Through Efficiency | Main | The Low Volatility Puzzle: Are Investors Complacent? »

November 08, 2017

Understanding Permanent and Temporary Income Shocks



LSE_Understanding Permanent and Temporary Income Shocks

The earnings of 200 million U.S. workers change each year for various reasons. Some of these changes are anticipated while others are more unexpected. Although many of these changes may be due to pleasant surprises—such as receiving salary raises and promotions—others involve disappointments—such as falling into unemployment. Arguably, some of these factors have rather short-lived effects on an individual’s earnings, whereas others may have permanent effects. Many labor economists have been interested in these various shocks to earnings. How big are the more permanent shocks to earnings? How large are they relative to those that are temporary in nature? What are the sources of these shocks? In this blog post, we exploit a novel data set that enables us to explore the properties of earnings shocks: their magnitudes as well as their origins.

We answer these questions using data from the Survey of Consumer Expectations (SCE) of the New York Fed’s Center for Microeconomic Data. The SCE is a survey of a rotating panel of households that contains detailed information on expectations about household labor income and its subsequent realizations. The comparison of expectations about future earnings to realized earnings enables us to obtain a measure of shocks.

To be more precise, the SCE asks expectation questions regarding earnings twelve months ahead, which we convert to four-month-ahead expectations. We then examine the difference between four-month realizations and four-month expectations (see the chart below), giving up to two observations for every respondent in the sample. Excluding very large outliers, the average shock for a household is near zero (0.5 percent), with a majority of households experiencing an earnings shock within a range of +10 percent and -10 percent.


Understanding Permanent and Temporary Income Shocks


Although the overall size of earnings shocks is interesting in its own right, there are a number of questions that the magnitude itself cannot answer. Are negative shocks due to unexpected layoffs or demotions? Are positive surprises driven by job-to-job transitions, promotions, or something else? What about the persistence of shocks? Arguably, unexpected declines in earnings are easier to cope with when their effects are short-lived. We now go beyond the raw income shocks and look closely at these questions.

To do so, we adapt the methodology presented in Pistaferri (2001) to account for the specific setup of the SCE survey. Essentially, this approach utilizes the insight that permanent shocks have the exact same effect on earnings expectations at all time horizons.

We apply this methodology to our sample of households whose heads are between ages 19 and 83 and for whom we have consecutive data on their household-income expectations, inflation expectations, and actual realizations of household income. We convert nominal-income expectations to real-income expectations using subjective-inflation expectations. Excluding households that report extreme expectations for income growth or extreme actual income, we end up with 1,733 households over the period 2014–16 for which we can compute permanent and temporary shocks. On average, households experience a positive permanent earnings shock of +2.7 percent and a negative temporary earnings shock of -1.0 percent. Therefore, in our sample, permanent shocks are not only more persistent (by assumption), but also more than twice as large in magnitude when compared to temporary shocks.

What are the sources of permanent shocks? The SCE allows us to correlate income shocks with labor market events. For example, if a household experiences an increase in earnings, the survey asks respondents to explain the primary source of the increase—choosing among items such as a promotion, an outside offer, an employer change, or a raise. We compute the mean level of permanent shocks for people that report a particular reason.

The first row of the table below shows that households that experience a nonemployment spell (employment (E) to nonemployment (NE)) experience a 20 percent permanent decline in their earnings. The table reports the magnitude of shocks associated with different events that could cause permanent changes in earnings relative to a nonemployment spell. For example, our analysis shows that a regular raise is associated with a positive permanent effect of raising household earnings. More specifically, one regular raise undoes about 60 percent of the permanent decline associated with a nonemployment spell. In other words, in order to make up for the permanent loss in earnings that come with an unemployment spell, one needs to get about 1.5 raises. Given that raises are determined typically on an annual basis, one could infer that it takes at least two years to make up for this loss just by getting raises. The permanent increase in earnings associated with positive performance is stronger than that for a raise. Yet, getting one raise as a result of a good performance is still insufficient to compensate for a layoff, as it makes up about 70 percent of the loss in permanent income from the layoff.


Understanding Permanent and Temporary Income Shocks


In contrast, there are other ways that workers might catch up with their permanent earnings prior to nonemployment. For example, a single promotion generates a 17 percent larger increase in permanent earnings than the decline induced by nonemployment. One feature that is very important quantitatively for individual wage growth is job-to-job transitions. For example, economists have estimated that in the early 1990s wage gains from job changes account for at least a third of early-career wage growth. Our results corroborate this finding: The strongest effect on permanent earnings comes from employer changes, with making one job switch erasing the negative scars of two nonemployment spells.


Disclaimer
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.





Fatih Karahan Fatih Karahan is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

Sean Mihaljevich Sean Mihaljevich is a senior research analyst in the Bank’s Research and Statistics Group.

Laura Pilossoph Laura Pilossoph is an economist in the Bank’s Research and Statistics Group.



How to cite this blog post:
Fatih Karahan, Sean Mihaljevich, and Laura Pilossoph, “Understanding Permanent and Temporary Income Shocks,” Federal Reserve Bank of New York Liberty Street Economics (blog), November 8, 2017, http://libertystreeteconomics.newyorkfed.org/2017/11/understanding-permanent-and-temporary-income-shocks.html.
Posted by Blog Author at 07:00:00 AM in Expectations, Household Finance
Comments

Feed You can follow this conversation by subscribing to the comment feed for this post.

Verify your Comment

Previewing your Comment

This is only a preview. Your comment has not yet been posted.

Working...
Your comment could not be posted. Error type:
Your comment has been saved. Comments are moderated and will not appear until approved by the author. Post another comment

The letters and numbers you entered did not match the image. Please try again.

As a final step before posting your comment, enter the letters and numbers you see in the image below. This prevents automated programs from posting comments.

Having trouble reading this image? View an alternate.

Working...

Post a comment

About the Blog
Liberty Street Economics features insight and analysis from New York Fed economists working at the intersection of research and policy. Launched in 2011, the blog takes its name from the Bank’s headquarters at 33 Liberty Street in Manhattan’s Financial District.

The editors are Michael Fleming, Andrew Haughwout, Thomas Klitgaard, and Donald Morgan, all economists in the Bank’s Research Group.

The views expressed are those of the authors, and do not necessarily reflect the position of the New York Fed or the Federal Reserve System.


Economic Research Tracker

Liberty Street Economics is now available on the iPhone® and iPad® and can be customized by economic research topic or economist.


Useful Links
Comment Guidelines
We encourage your comments and queries on our posts and will publish them (below the post) subject to the following guidelines:
Please be brief: Comments are limited to 1500 characters.
Please be quick: Comments submitted after COB on Friday will not be published until Monday morning.
Please be aware: Comments submitted shortly before or during the FOMC blackout may not be published until after the blackout.
Please be on-topic and patient: Comments are moderated and will not appear until they have been reviewed to ensure that they are substantive and clearly related to the topic of the post. We reserve the right not to post any comment, and will not post comments that are abusive, harassing, obscene, or commercial in nature. No notice will be given regarding whether a submission will or will not be posted.‎
Disclosure Policy
The LSE editors ask authors submitting a post to the blog to confirm that they have no conflicts of interest as defined by the American Economic Association in its Disclosure Policy. If an author has sources of financial support or other interests that could be perceived as influencing the research presented in the post, we disclose that fact in a statement prepared by the author and appended to the author information at the end of the post. If the author has no such interests to disclose, no statement is provided. Note, however, that we do indicate in all cases if a data vendor or other party has a right to review a post.
Archives