Finance and Economics Discussion Series

Modeling Earnings Dynamics

Joseph Altonji, Anthony Smith, and Ivan Vidangos
2009-08

Abstract: In this paper we use indirect inference to estimate a joint model of earnings, employment, job changes, wage rates, and work hours over a career. Our model incorporates duration dependence in several variables, multiple sources of unobserved heterogeneity, job-specific error components in both wages and hours, and measurement error. We use the model to address a number of important questions in labor economics, including the source of the experience profile of wages, the response of job changes to outside wage offers, and the effects of seniority on job changes. We provide estimates of the dynamic response of wage rates, hours, and earnings to various shocks and measure the relative contributions of the shocks to the variance of earnings in a given year and over a lifetime. We find that human capital accounts for most of the growth of earnings over a career although job seniority and job mobility also play significant roles. Unemployment shocks have a large impact on earnings in the short run as well a substantial long long-term effect that operates through the wage rate. Shocks associated with job changes and unemployment make a large contribution to the variance of career earnings and operate mostly through the job-specific error components in wages and hours.

Keywords: Earnings dynamics, income shocks, wage growth, job mobility, indirect inference