The Macroeconomic Implications of Rising Wage Inequality in the United States

This paper explores the macroeconomic and welfare implications of the sharp rise in U.S. wage inequality (1967-1996). In the data, cross-sectional earnings variation increased substantially more than wage variation, due to a sharp rise in the wage-hour correlation. At the same time, inequality in hours worked, consumption and wealth (excluding the top 1%) remained roughly constant through time. The correlation between consumption and hours declined substantially. Using data from the PSID, we decompose the rise in wage inequality into changes in the variance of permanent, persistent and transitory shocks. With the estimated changes in the wage process as the only primitive, we show that a standard calibrated OLG model with incomplete markets can successfully account for all these patterns in cross-sectional U.S. data. The model also allows us to investigate the welfare costs of the rise in inequality: we ?nd that the unconditional expected welfare loss is equivalent to a 5 percent decline in lifetime income for the worst-a?ected cohorts, those entering the labor market in the late 1980's. Ex post, these costs are widely dispersed across agents, due both to di?erences in permanent individual attributes and to differences in labor market histories. An extensive sensitivity analysis veri?es the robustness of our conclusions.