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Markov-Switching Model of Family Income Quintile Shares

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Abstract

This paper examines the impact of unemployment and inflation on family income shares. Unemployment and inflation are decomposed into their structural (long-term), cyclical (short-term), anticipated and unanticipated components, respectively. I propose a new framework to analyze family income quintile shares by using a two-state Markov-switching model, also known as Hamilton’s regime-switching model. The benefit of using a Markov-switching model is that it permits capturing complex dynamic behavior of non-linear time series macroeconomic variables. The switching mechanism follows a first-order Markov chain of unobservable state variables and subsequent estimated conditional transition probabilities. This paper applies a two-state regime-switching process to capture the asymmetrical effects of unemployment and inflation on family income shares. The two states of family income quintile shares are state 1 (lower income) and state 2 (upper income). This approach differs from previous studies because it examines income inequality within each quintile rather than between quintiles. It is well documented in the literature that there is income inequality between lower and higher income quintiles. Therefore, the analysis of income inequality within the quintile allows for greater insight into changes in family income share corresponding to changes in the state variables. The general findings are that unemployment has adverse effects on lower income shares while inflation acts like a progressive tax on higher income shares.

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Notes

  1. Stagflation led to the emergence of the misery index. This index, which is the simple sum of the inflation rate and unemployment rate, served as a tool to show just how badly people were feeling when stagflation hit the economy.

  2. The unemployment rate represents the number of unemployed as a percentage of the labor force. Labor force data are restricted to people 16 years of age and older, who currently reside in 1 of the 50 states or the District of Columbia, who do not reside in institutions (e.g., penal and mental facilities, homes for the aged), and who are not on active duty in the Armed Forces).

  3. The GDP implicit price deflator, or GDP deflator, measures changes in the prices of goods and services produced in the United States, including those exported to other countries. Prices of imports are excluded.

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  1. Department of Economics and Business, Lehman College, 250 Bedford Park Boulevard West, Bronx, NY, 10468, USA

    Nikolaos Papanikolaou

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Papanikolaou, N. Markov-Switching Model of Family Income Quintile Shares. Atl Econ J 48, 207–222 (2020). https://doi.org/10.1007/s11293-020-09664-4

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