How do the macroeconomic fluctuations of the business cycle and the individual microeconomic experiences of households interact to shape income dynamics? In research that I have co-authored with Martín Almuzara, Manuel Arellano and Stéphane Bonhomme, we present a novel econometric framework designed to study this question (Almuzara et al, 2025).
While traditional economic models often treat aggregate and idiosyncratic risks as separate, additive components, we show that they are deeply intertwined through complex, nonlinear mechanisms. By integrating macroeconomic time-series data with a time-series of short panels from the Panel Study of Income Dynamics (PSID) spanning the period from 1970 to 2019, we develop a strategy that maintains a representative sample of the US population across seven distinct recessions.
The methodology builds on some of our previous work (Arellano et al, 2017) by modelling income as a combination of persistent and transitory components that are allowed to vary flexibly over time. The persistent component is governed by what’s known as a Markovian process where the impact of a shock today depends on the household’s current income level, its specific history and the aggregate state of the economy.
To capture the broader economic environment, we use a business-cycle factor inferred from aggregate variables such as GDP and unemployment rates. This integration allows the model to capture how macroeconomic states ‘modulate’ the microeconomic experience.
How the state of the economy affects household safety nets and career ladders
One of our most striking empirical findings is the documentation of ‘asymmetric persistence’ across the business cycle. We find that economic fluctuations fundamentally alter how ‘sticky’ an income level is.
During recessions, it becomes significantly harder for low-income households to improve their economic status – a phenomenon that we describe as increased persistence. Conversely, high-income earners find it more difficult to maintain their position during downturns. This suggests that the safety nets or career ladders available to households are not constant, but fluctuate in effectiveness depending on the macroeconomic environment.
Negative shocks hit harder, especially for households in difficulty
Our study also highlights that household exposure to the macroeconomy is countercyclical and highly heterogeneous. Negative aggregate shocks are ‘self-amplifying’, hitting harder during recessions and exerting the most severe impact on households already experiencing idiosyncratic ‘bad luck’, such as simultaneous health issues or job instability.
This leads to a ‘tale of two skewnesses’, where the tendency for income risk to be more negatively skewed at higher income levels becomes more heavily tilted towards the downside across all income groups during recessions. This risk of large downward drops is a defining feature of the business cycle that linear models fail to take into account.
Our analysis also distinguishes between the lifespans of different economic shocks. We find that while macroeconomic shocks have a large immediate impact on income, their effects are generally short-lived, typically returning to trend within two years. In contrast, idiosyncratic microeconomic shocks disperse much more slowly, suggesting that personal setbacks have a more permanent effect on a household’s lifetime earnings than a general economic downturn. But the macroeconomic shocks are still critical because they set the stage on which microeconomic shocks play out.
The high price of economic instability
Finally, we quantify the welfare costs of these risks, offering a sobering perspective on the price of economic instability. Because macroeconomic shocks amplify individual hardships in a nonlinear fashion, we estimate that the annual cost of macroeconomic risk can reach as high as 5% of income for certain vulnerable groups.
This figure is significantly higher than previous estimates from linear models, which often suggest that the welfare costs of business cycles are negligible. For young and low-income households, the intersection of aggregate and idiosyncratic risk represents a major threat to long-term economic security, reinforcing the need for policy interventions that account for these nonlinearities.
