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Windfall Income Shocks with Finite Planning Horizons

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How do households respond when they receive unanticipated income, such as an inheritance or government stimulus cheque? To study these so-called windfall income shocks, I build a model of household consumption and savings that reconciles two important empirical facts:

  • households with ample wealth and liquidity spend a significant portion of their windfall
  • the larger the windfall, the smaller the portion of it that is spent

My model features two layers that correspond to broad planning horizons:

  • an outer lifecycle layer in which households plan their consumption and savings based on their anticipated lifetime income, including career progression and risk of unemployment
  • an inner windfall layer in which households respond to a windfall by making short-term consumption and savings plans

For the inner windfall layer, the length of these plans takes into account the benefits of spreading consumption over time and the question of whether to go without leisure activities in favour of making financial plans.

Using data from the model, I estimate planning costs based on payments from the Economic Stimulus Act enacted by US Congress in early 2008. This estimated model generates a realistic distribution of responses to the windfall. The model can therefore be used to design optimal fiscal stimulus programs and understand how households will spend income gains that result from changes in monetary policy.