Consumption Smoothing, Equivalence Scales, and Idiosyncratic Shocks : Evidence from a Quasi-Natural Experiment in Nicaragua

Rural households in developing countries are faced with a variety of risks to both income processes and consumption streams. Additionally, due to the lack of formal financial markets and credit institutions, and in general any formal insurance mechanisms, households are less equipped to respond to idiosyncratic income shocks. The empirical analysis presented here finds that under a systemic adverse shock, households are unable to fully insure themselves against idiosyncratic income shocks as the systemic shock reduces the effectiveness of informal consumption smoothing mechanisms. Additionally, I find that the ability of households to insure their consumption against fluctuations in income depends upon the equivalence scales used in the measurement of household consumption. Moreover, allowing for economies of scale in household consumption provides evidence that households are able to fully insure themselves within villages