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 estimate the elasticity of consumption with respect to income using an instrument based on firm-wide changes in monthly pay. While much of the consumption-smoothing literature uses variation in unusual windfall income, this instrument captures the income variation that households typically experience. In addition, because it can be constructed for every worker in every month, it allows for more precision than most previous estimates. We implement this approach in administrative bank account data and find an average elasticity of 0.23, with a standard error of 0.01. The increased precision also allows us to address an open question about the extent of heterogeneity by wealth in the elasticity. We find a much lower consumption response for high liquidity households, which may help discipline structural consumption models.