Decomposing changes in income risk using consumption data

This paper concerns the decomposition of income risk into permanent and transitory components using repeated cross-section data on income and consumption. Our focus is on the detection of changes in the magnitudes of variances of permanent and transitory risks. A new approximation to the optimal consumption growth rule is developed. Evidence from a dynamic stochastic simulation is used to show that this approximation can provide a robust method for decomposing income risk in a nonstationary environment. We examine robustness to unobserved heterogeneity in consumption growth and to unobserved heterogeneity in income growth. We use this approach to investigate the growth in income inequality in the UK in the 1980s.