Wealth moves dramatically with income shocks, with implications for policy and theory

When people experience a boost or a hit to their income, how do they adjust their spending and saving? The marginal propensity to consume (MPC)—or, conversely, to save and invest—is a crucial mechanism in microeconomic and macroeconomic models. In the policy realm, MPC is at the heart of assessing the impact of government social insurance policies like unemployment insurance and low-income tax credits.

Minneapolis Fed Monetary Advisor Fabrizio Perri leverages 25 years of data from Italy’s Survey of Household Income and Wealth (SHIW) for a many-layered look at how household consumption and wealth vary when income changes (Staff Report 655, “How Do Households Respond to Income Shocks?” with Dirk Krueger and Egor Malkov). The long-panel survey of around 8,000 representative Italian households is especially useful in two respects. First, it has sufficient information to allow the economists to distinguish temporary from permanent income shocks. Second, the SHIW also has sufficient detail to analyze changes in wealth and to decompose the effects for different wealth types. Compared to consumption, the relationship of income shocks to wealth has been little studied because of scarce data.

The data show that big shocks happen: 10 percent of households at some point experienced an income shock larger than 20 percent of their annualized labor income. (Shocks can be positive or negative.) Looking across the full sample, the response of household consumption to income shocks is modest: Households adjust their consumption between 10 and 20 cents for every euro of income change, mostly by altering what they spend on nondurable goods and services.

The movement of wealth, by comparison, is dramatic. Across the full sample, household wealth changes more than 1-for-1 with a shock to income. The survey data allow the economists to break down the sample according to the type of wealth held by households (see table). Doing so reveals enormous variation in the response of wealth to income shocks.

For the researchers, the most notable finding is that households with business wealth and, especially, real estate wealth experience very strong co-movement of their wealth with income shocks. For those holding both forms, wealth co-moves with income at a ratio of more than 300 percent.

Clearly such large changes in wealth cannot be driven by wealth accumulation, as the income changes are not enough to justify these changes. The economists hypothesize that the large response of business and real estate wealth to income shocks is a correlation of income shocks with the value of wealth. For example, households living in booming areas might experience both growing labor income and growing value of their real estate. Households who own successful businesses experience simultaneously rising income and business wealth. By the same token, negative economic conditions could push income and wealth down together.

The finding suggests that economists and policymakers need to keep wealth front-of-mind when considering how income shocks affect families. “The very strong wealth responses for housing and business owners suggest that shocks to the value of these assets are important in shaping household economic decisions,” they write. “The dominant set-up used to study heterogeneous agents economies … in which households only face idiosyncratic income shocks might be missing some important sources of risk.”

A test of the permanent income hypothesis

Fifteen percent of respondents do not hold any business or real estate wealth. The wealth response for them—in this case, an effect purely on accumulated financial wealth—is much smaller than the full sample. Their consumption response to an income shock is stronger.

For this subgroup, whose consumption appears most directly connected to changes in income, the economists consider how well Milton Friedman’s workhorse “permanent income hypothesis” (PIH) fits the data. Although it is a common tool in economics, the PIH makes strong assumptions about households. In its simplest form, the PIH assumes that households live forever, can distinguish permanent from temporary changes in income, and adjust consumption at any given moment to match their lifetime expectations of income, without precautionary saving or other insurance.

The economists find the PIH can reasonably explain the short-run response of consumption to persistent income shocks. However, the hypothesis becomes less accurate over longer horizons.

If income shocks are quite persistent, the PIH suggests that changes in income over a long period of time should drive strong consumption responses but only weak wealth responses. The economists' model—informed by the Italian SHIW data—suggests instead that wealth comes very much into play. The consumption response is smaller and the wealth response is larger than what is predicted by the theory. Households appear to operate with a substantial degree of self-insurance, in which only 64 percent of a permanent shock to income translates into current consumption and the rest is absorbed by growing or shrinking wealth.

One possibility for this discrepancy is the presence of a long retirement period, when households no longer receive income but still must pay for living expenses. Such a period would induce households to mute their consumption response during the working years to keep a more stable consumption during retirement.

Read the Minneapolis Fed staff report: How Do Households Respond to Income Shocks?