Income variance dynamics and heterogenity

Recent theoretical work has shown the importance of measuring microeconomic uncertaintyfor models of both general and partial equilibrium under imperfect insurance.In this paper the assumption of i.i.d. income innovations used in previous empiricalstudies is removed and the focus of the analysis placed on models for the conditionalvariance of income shocks, which is related to the measure of risk emphasized by thetheory. We first discriminate amongst various models of earnings determination thatseparate income shocks into idiosyncratic transitory and permanent components. Weallow for education- and time-specific differences in the stochastic process for earningsand for measurement error. The conditional variance of the income shocks is modelledas a parsimonious ARCH process with both observable and unobserved heterogeneity.The empirical analysis is conducted on data drawn from the 1967-1992 Panel Studyof Income Dynamics. We find strong evidence of sizeable ARCH effects as well asevidence of unobserved heterogeneity in the variances.