A Parsimonious Model of Idiosyncratic Income

The standard permanent and transitory income model is known to be misspecified. Estimates of income volatility within this model differ depending on the specific data moments used—whether they are in levels or differences—and how these moments are weighted during estimation. We suggest a simple modification to the standard model: allowing for two transitory shocks that persist for different lengths of time. Our proposed model, which introduces only one additional parameter, consistently and accurately identifies the parameters of the income process, regardless of the estimation method used .