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Individual Consumption Risk and the Welfare Cost of Business Cycles

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  • Massimiliano De Santis
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    Abstract

    We measure the welfare gain from removing aggregate consumption fluctuations in a model where each individual faces incomplete consumption insurance. We show that, because this welfare gain is a convex function of the overall consumption risk—aggregate plus idiosyncratic—each individual faces, to gauge the magnitude of the gain, it is important to match individuals' overall risk prior to any policy. In an economy calibrated to match individuals' overall risk, even removing 10 percent of aggregate fluctuations can result in a large welfare gain. Further, large gains do not necessarily depend on the countercyclical nature of idiosyncratic risk. (JEL E21, E32)

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    File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.97.4.1488
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    Bibliographic Info

    Article provided by American Economic Association in its journal American Economic Review.

    Volume (Year): 97 (2007)
    Issue (Month): 4 (September)
    Pages: 1488-1506

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    Handle: RePEc:aea:aecrev:v:97:y:2007:i:4:p:1488-1506

    Note: DOI: 10.1257/aer.97.4.1488
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    1. Jonathan A. Parker & Christian Julliard, 2004. "Consumption Risk and the Cross-Section of Expected Returns," Working Papers 138, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
    2. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
    3. Beaudry, Paul & DiNardo, John, 1995. "Is the Behavior of Hours Worked Consistent with Implicit Contract Theory?," The Quarterly Journal of Economics, MIT Press, vol. 110(3), pages 743-68, August.
    4. tom krebs, 2004. "welfare cost of business cycles when markets are incomplete," Econometric Society 2004 North American Summer Meetings 283, Econometric Society.
    5. Constantinides, George M & Duffie, Darrell, 1996. "Asset Pricing with Heterogeneous Consumers," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 219-40, April.
    6. Ricardo Reis, 2005. "The time-series properties of aggregate consumption: implications for the costs of fluctuations," Working Papers 134, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
    7. Fernando Alvarez & Urban J. Jermann, 2000. "Using Asset Prices to Measure the Cost of Business Cycles," NBER Working Papers 7978, National Bureau of Economic Research, Inc.
    8. Beaudry, Paul & DiNardo, John, 1991. "The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 665-88, August.
    9. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of Security Market Data for Models of Dynamic Economies," NBER Technical Working Papers 0089, National Bureau of Economic Research, Inc.
    10. Bils, Mark J, 1985. "Real Wages over the Business Cycle: Evidence from Panel Data," Journal of Political Economy, University of Chicago Press, vol. 93(4), pages 666-89, August.
    11. Tom Krebs, 2005. "Job Displacement Risk and the Cost of Business Cycles," 2005 Meeting Papers 188, Society for Economic Dynamics.
    12. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2000. "The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk," NBER Working Papers 8040, National Bureau of Economic Research, Inc.
    13. Tom Krebs, 2003. "Growth and Welfare Effects of Business Cycles in Economies with Idiosyncratic Human Capital Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 846-868, October.
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    Cited by:
    1. Dmytro Hryshko, 2012. "Labor income profiles are not heterogeneous: Evidence from income growth rates," Quantitative Economics, Econometric Society, vol. 3(2), pages 177-209, 07.
    2. Richard Anton Braun & Tomoyuki Nakajima, 2009. "Optimal monetary policy when asset markets are incomplete," CIRJE F-Series CIRJE-F-679, CIRJE, Faculty of Economics, University of Tokyo.
    3. Ellison, Martin & Sargent, Thomas J., 2012. "Welfare cost of business cycles in economies with individual consumption risk," Research Discussion Papers 25/2012, Bank of Finland.
    4. R. Anton Braun & Tomoyuki Nakajima, 2011. "Uninsured countercyclical risk: an aggregation result and application to optimal monetary policy," Working Paper 2011-04, Federal Reserve Bank of Atlanta.
    5. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2009. "Quantitative Macroeconomics with Heterogeneous Households," NBER Working Papers 14768, National Bureau of Economic Research, Inc.
    6. Basu, Parantap & Semenov, Andrei & Wada, Kenji, 2011. "Uninsurable risk and financial market puzzles," Journal of International Money and Finance, Elsevier, vol. 30(6), pages 1055-1089, October.
    7. Alisdair McKay & Tamas Papp, 2011. "Accounting for Idiosyncratic Wage Risk Over the Business Cycle," Boston University - Department of Economics - Working Papers Series WP2011-028, Boston University - Department of Economics.
    8. Guido Ascari & Tiziano Ropele, 2009. "Disinflation in a DSGE Perspective: Sacrifice Ratio or Welfare Gain Ratio?," Kiel Working Papers 1499, Kiel Institute for the World Economy.
    9. Pashchenko, Svetlana & Porapakkarm, Ponpoje, 2011. "Welfare costs of reclassification risk in the health insurance market," MPRA Paper 34189, University Library of Munich, Germany.
    10. Daniel Harenberg & Alexander Ludwig, . "Social Security and the Interactions Between Aggregate and Idiosyncratic Risk," Working Papers ETH-RC-14-002, ETH Zurich, Chair of Systems Design.
    11. De Santis Massimiliano, 2010. "Demystifying the Equity Premium," The B.E. Journal of Macroeconomics, De Gruyter, vol. 10(1), pages 1-33, May.

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