A Tractable Income Process for Business Cycle Analysis

We estimate an income process that is consistent with key facts on individual income risk and its variation over the business cycle. In particular, the estimated process generates income fluctuations that display (i) flat and acyclical variance, (ii) volatile and procyclical skewness, (iii) very high kurtosis, and (iv) a moderate rise in cross-sectional inequality over the life cycle, all consistent with the US data. Furthermore, the income process captures the predictable nature of business cycle income risk: income changes during a business cycle episode are partly predicted by income levels before that episode. The estimated process features a time-varying distribution of innovations as well as a factor structure for business cycle exposure. Incorporating the estimated process into a business cycle model adds only one state variable—as in the workhorse persistent-plus-transitory income process—making it a tractable option for modelers.