How do households respond to income shocks?

We use panel data from the Italian Survey of Household Income and Wealth from 1991 to 2016 to document what components of the household budget constraint change in response to shocks to household labor income, both over shorter and over longer horizons. Consumption and wealth responses are informative about the household consumption (or savings) function and thus about what class of consumption-savings model best describes the data. Empirically, we first show that shocks to labor income are associated with negligible changes in transfers and non-labor income components, modest changes in consumption expenditures, and large changes in wealth. To understand the wealth response we then split households into a sample that does not own business or real estate wealth, and a sample that does. For the first group, we find that consumption responses are more substantial (and increasing with the horizon of the income shock) and wealth responses are much smaller (and mildly increasing with the income shock horizon). Turning to theory, we argue that for this group, a simple extension of the standard permanent income hypothesis (PIH) consumption function that allows for partial insurance against even permanent income shocks explains the consumption and wealth responses well, both at short and long horizons. For the second group with business wealth or real estate wealth the standard framework cannot explain the large changes in wealth associated with income shocks. We conclude that models which include shocks to the value of household wealth are necessary to fully evaluate the sources and consequences of household resource risk.