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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. 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.
    2. Alvarez, Fernando & Jermann, Urban J., 2000. "Using Asset Prices to Measure the Cost of Business Cycles," Working Papers 00-1, University of Pennsylvania, Wharton School, Weiss Center.
    3. 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.
    4. 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.
    5. 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..
    6. 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.
    7. Ricardo Reis, 2005. "The Time-Series Properties of Aggregate Consumption: Implications for the Costs of Fluctuation," NBER Working Papers 11297, National Bureau of Economic Research, Inc.
    8. Tom Krebs, 2004. "Welfare Cost of Business Cycles When Markets Are Incomplete," Working Papers 2004-08, Brown University, Department of Economics.
    9. 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.
    10. Tom Krebs, 2007. "Job Displacement Risk and the Cost of Business Cycles," American Economic Review, American Economic Association, vol. 97(3), pages 664-686, June.
    11. 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.
    12. 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.
    13. 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.
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    Cited by:
    1. Harenberg, Daniel & Ludwig, Alexander, 2014. "Social Security and the Interactions Between Aggregate and Idiosyncratic Risk," MEA discussion paper series 14280, Munich Center for the Economics of Aging (MEA) at the Max Planck Institute for Social Law and Social Policy.
    2. 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.
    3. Tamas Papp & Alisdair McKay, 2012. "Accounting for idiosyncratic wage risk over the business cycle," 2012 Meeting Papers 820, Society for Economic Dynamics.
    4. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2009. "Quantitative macroeconomics with heterogeneous households," Staff Report 420, Federal Reserve Bank of Minneapolis.
    5. 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.
    6. Ascari, Guido & Ropele, Tiziano, 2012. "Disinflation in a DSGE perspective: Sacrifice ratio or welfare gain ratio?," Journal of Economic Dynamics and Control, Elsevier, vol. 36(2), pages 169-182.
    7. 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.
    8. Pashchenko, Svetlana & Porapakkarm, Ponpoje, 2011. "Welfare costs of reclassification risk in the health insurance market," Working Paper Series, Center for Fiscal Studies 2011:13, Uppsala University, Department of Economics.
    9. De Santis Massimiliano, 2010. "Demystifying the Equity Premium," The B.E. Journal of Macroeconomics, De Gruyter, vol. 10(1), pages 1-33, May.
    10. Jang-Ok Cho & Thomas Cooley & Hyung Seok Kim, . "Business Cycle Uncertainty and Economic Welfare," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
    11. Harenberg, Daniel & Ludwig, Alexander, 2014. "Social security and the interactions between aggregate and idiosyncratic risk," SAFE Working Paper Series 59, Research Center SAFE - Sustainable Architecture for Finance in Europe, Goethe University Frankfurt.
    12. 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.
    13. 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.

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