Permanent versus transitory income shocks over the business cycle

Abstract

This paper investigates how income shocks shape consumption dynamics over the business cycle. First, we break new ground and create a unique panel dataset of transitory and permanent income shocks by combining household-level income expectations with realizations from the DNB Household Survey for the Netherlands in 2006–2018. We then use the first and second moments of the identified income shocks in a structural life-cycle framework and show that the model matches the observed consumption patterns well. Finally, using counterfactual model simulations, we assess the importance of the nature of income shocks (permanent income hypothesis), future income uncertainties (precautionary saving motive), and cohort effects, and show how they have individually shaped consumption dynamics over that period in the Netherlands.