A Continuous-Time Model of Income Dynamics

Abstract

Most models of income dynamics are set in a discrete-time framework with an arbitrarily chosen accounting period. This article introduces a continuous-time stochastic model of income flows, without the need to define an accounting period. Our model can be estimated using unbalanced panel data with arbitrarily spaced observations. Although our model describes the stochastic properties of income flows, estimation is based on observed incomes accruing during time intervals of possibly varying length. Our model of income dynamics is close in spirit to the discrete-time two-stage models prevalent in the literature. We impose a parsimoniously parameterized continuous-time stochastic process (possibly containing a unit root) to model the deviation from a traditional earnings function. We illustrate our approach by estimating a simplified model using microeconomic data from the German social security agency from 1975 to 1995.