Seminars

Abstract: The impact of earnings shocks on workers' earnings expectations is a key determinant of subsequent consumption changes. Using a unique combination of an expectations panel survey and administrative data from Denmark, we identify earnings shocks, expectation changes, and consumption changes that are often challenging to observe. Simultaneously, standard assumptions in the income process literature, including perfect differentiation of permanent and transitory shocks, have limitations in explaining the empirical expectation changes upon earnings shocks. We introduce a new income process model in which workers have partial information about the nature of earnings shocks. Our estimates show that workers distinguish only half of permanent and transitory shocks. We further investigate the implications of partial information on consumption changes both empirically and through the lens of a model. We find that workers' partial information about the earnings shocks is important to explain the degree of consumption response upon earnings shocks. Moreover, we show that partial information predicts the consumption insurance level observed in empirical literature better than conventional assumptions.