HKUST IEMS Working Papers No. 2015-08
We provide a new explanation for the stronger relationship between income and subjective wellbeing (SWB) found in cross-sectional versus panel studies based on the predictions of a rational expectations model of utility maximization with permanent and transitory income shocks. The model predicts that SWB is affected by unanticipated rather than anticipated income, and is more influenced by permanent rather than transitory income shocks. We hypothesize that share of cross-sectional income variation accounted for by permanent income is greater than the share of changes in income over time accounted for by unanticipated shocks to permanent income. We test our predictions using a unique panel dataset from rural China which includes subjective expectations of future income and actual income in each wave, enabling us to separately identify the effects of unanticipated permanent and transitory income shocks. The results confirm the predictions, providing support for the importance of permanent income in explaining SWB.
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