The impact of financial innovations on hedging consumption against the risk of income change and their importance for assessing inequality

SONATA 16, dr Piotr Denderski
The aim of this project is to examine the cross-sectional and temporal effects of financial innovations on consumption hedging (income risk sharing) by building a macroeconomic model, inspired by the results of micro-estimations, taking into account asset market distortions. The significant increase in income inequality has led to a flourishing of literature examining how it affected disparities in consumption levels and aggregate wealth. The degree to which changes in income affect consumption depends in particular on the ability of households to save and borrow. However, financial products vary in complexity and active involvement in the asset market entails costs. Thus, it seems reasonable to conclude that individual differences in financial literacy affect households' ability to shield their consumption from income fluctuations. Therefore, we should study the impact of current developments in IT and finance on inequality. The question I ask is whether financial innovation works like the proverbial tide that raises all boats, making those active in the financial markets more accessible, steadily improving consumer protection against risk. On the one hand, the above statement seems to be justified, because nowadays everyone can use mobile applications offering, for example, financial advice, access to information, and even active asset management. On the other hand, financial innovation has also led to the creation of more sophisticated, complex financial instruments. Therefore, it may also be the case that only the better educated could benefit from financial innovations, better securing their consumption against the risk of income changes. It should also be added that there are many factors disturbing the identification of the mechanism described above, due to other aspects of the benefits of education. For example, education may correlate with lower income risk (e.g., due to sorting into less precarious occupations or due to positive matching in the marriage market), or with a better ability to anticipate changes in income and plan accordingly. In order to take into account the above For factors, I'm going to use data from the Survey on Household Income and Wealth, an Italian panel study that dates back to the 1960s. The unique feature of this survey is the rich resource of information about the socio-economic characteristics of the respondents, their consumption, income, wealth and expectations. The depth of data on the composition of the portfolio of assets and liabilities will allow me to identify the degree of complexity of financial instruments and their use over time, as well as differences between respondents in this respect (e.g. in terms of differences in education). Based on the above The data will be used to estimate a panel regression model, explaining the change in household consumption by socio-economic characteristics as well as expected and unexpected changes in income, decomposing income shocks into permanent and temporary components. This is quite a standard task, which I want to extend, allowing for the diversification of the degree of protection of consumption against income risk due to individual and time characteristics in terms of expected, unexpected, temporary and permanent changes in income. Then, it will build an economy model to quantify the impact of the above. factors/effects of financial innovations to hedge consumption against risk. This model will be an extension of the Aiyagari-Bewley-Huggett model of incomplete markets with demographic characteristics of agents (age). In addition, I will extend this standard model to include ex-ante differences in stochastic characteristics of income, how subjective expectations are formed and the cost of participation in the asset market, which cost may be a function of individual characteristics and time (e.g. the emergence of financial innovations). To solve it, I will use the latest computational methods based on the concept of viscous solutions of the Hamilton-Jacobie-Bellman equations in continuous time. I will use the above model for quantifying the impact of improving education (taking into account the three effects I described above) and financial innovation on heterogeneity in the response of consumption to changes in income. I will estimate the parameters of the model using methods of indirect reasoning, using the estimation results obtained in the empirical part.