Rising Earnings Instability , Portfolio Choice , and Housing Prices ∗

This paper studies the effects of the U.S. rising earnings inequality between the late 1960s and the mid 1990s on the portfolio allocation and prices of assets. In order to investigate the link, a life-cycle general equilibrium model is constructed where distinct characteristics of the housing asset is explicitly modeled and asset prices are determined in equilibrium. It is shown that the model can produce a 9% rise in the housing price, which is about 40% of the changes in the U.S. data (24%). An increased demand for precautionary savings and the general equilibrium effect play a crucial role here. A higher earnings volatility induces a higher demand for financial assets. As the return of financial assets declines due to the general equilibrium effect, the demand for housing assets increases as well. The paper also examines the effects of the rising earnings inequality on the aggregate amount of debt. Interestingly, contrary to the U.S. data, the model predicts a decline in the total amount of secured debt. A higher earnings volatility induces a higher amount of debt in complete markets models, but an increased demand for savings for precautionary motive dominates the positive effect to the amount of debt. The model also shows that incorporating housing assets into the model does not make a significant difference in the effect of the rising earnings inequality on the consumption inequality. ∗This paper is a spin-off from the paper titled ”Rising Prices of Housing and Non-Housing Capital and Rising Earnings Instability: The Role of Illiquidity of Housing”. The original paper is a chapter of my Ph.D. Dissertation at University of Pennsylvania. I am deeply indebted to José-Vı́ctor Rı́os-Rull for his passionate guidance and encouragement. I also would like to thank Dirk Krueger, Jesús Fernández-Villaverde, and Iourii Manovskii for their numerous helpful comments and suggestions. I also thank participants of SED Annual Meetings in Budapest, in particular, Christopher Carroll, for helpful comments and suggestions. †Department of Economics, University of Illinois, Urbana-Champaign. 1206 South 6th Street, Champaign, IL 61820. E-mail: [email protected].