Earnings Volatility Trends and the Great Moderation: A Multifactor Residual Approach

By Neveu, Andre R. | Atlantic Economic Journal, June 2015 | Go to article overview

Earnings Volatility Trends and the Great Moderation: A Multifactor Residual Approach


Neveu, Andre R., Atlantic Economic Journal


Introduction

The period of the Great Moderation that began in 1984 represented a new lower volatility macroeconomic state where U.S. recessions were milder, and expansionary periods were less volatile. Multiple factors likely contributed to this reduced macroeconomic volatility. Possible contributing factors include better monetary policy, structural economic shifts, improved inventory management, or simple good luck (Summers (2005), Stock and Watson (2002), and Davis and Kahn (2008)). Regardless of what led to the low macroeconomic volatility era of the Great Moderation, the aim of this paper is to gain a better understanding of the role played by this environment on the income growth volatility of individuals and households. (1)

Numerous studies have noted rising levels of individual and household income volatility after aggregate fluctuations became more moderate in the mid-1980s (Dynan et al. (2012), Gottschalk and Moffitt (1994), Moffitt and Gottschalk (2002, 2011), and Shin and Solon (2011)). (2) Other research on individual income volatility using different data disputes these results, showing volatility remained constant, declined, or only increased in the late 1990s (Congressional Budget Office ("CBO") (2008); Sabelhaus and Song (2009, 2010)). Many of these studies found a significant cyclical relationship even though micro and macro volatility trends appear to have diverged. This paper provides an improved understanding of this literature. Specifically, new evidence shows that income volatility has not increased at the individual level. The importance of reduced macroeconomic volatility at the micro level is also explored at the individual and family level. Income volatility for individuals and households is strongly countercyclical, where income changes become more volatile when aggregate economic conditions worsen. Taken together, it is puzzling that there are cyclical similarities between micro-level and aggregate volatility when longer-run trends appear to be divergent. This paper helps explain this puzzle by merging methods and data used by earlier researchers, and builds on previous literature by using a new approach to explicitly control for the role of macroeconomic factors in income volatility.

The presence of cyclical similarities, despite the apparent divergent trends in micro-and macro-level volatility raises important policy questions that have only recently been explored (Davis and Kahn (2008) and Sabelhaus and Song (2010)). Income fluctuations may be tightly associated with economic risk and uncertainty if an individual cannot count on keeping their source of income from one year to the next. Income volatility might also be a sign of rising opportunity where workers have the ability to shift jobs, careers, and locations more flexibly.

Several of the studies that found rising transitory income volatility used the Panel Survey of Income Dynamics (PSID). The PSID is an unbalanced panel, where respondents may periodically exit and return to the sample. Studies that found flat or declining income volatility used administrative continuous work history data from the Social Security Administration (SSA), sometimes in conjunction with other publicly available data. This paper merges the two approaches by using the PSID to create two continuous work history samples, one for individuals and another for families. Specifically, this study examines earnings volatility of the persistently employed, defined as those with 12 consecutive periods of earnings between 1971 and 2011. The resulting subsample of the original PSID has a time-series component, which is necessary to extract the role of macroeconomic factors from micro-level income data. The approach taken here is an alternative to fixed effects models commonly used in the literature, since income volatility can be decomposed into components that can be explained by either idiosyncratic or macroeconomic factors.

Similar to CBO (2008) and Sabelhaus and Song (2010), this research finds that unconditional individual income volatility fell in the mid-1980s, but remained relatively stable through the late 1990s and early 2000s. …

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