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An Analytical Approach to the Welfare Cost of Business Cycles and the Benefit from Activist Monetary Policy

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  • Kiley Michael T.

    ()
    (Federal Reserve Board and Organisation for Economic Cooperation and Development)

Abstract

A closed-form solution for quantity and asset-price movements in a dynamic general equilibrium model with non-state-separable preferences shows that the welfare cost of fluctuations and the equity premium can be large in such a model. But a large welfare loss from cycles does not imply a large gain from good monetary policy. Although monetary policy can implement the optimal allocation in a sticky-price version of the model, the gain from such activism is trivial because the optimal allocation continues to imply volatile consumption in response to productivity shocks. This highlights a distinction between recent models and older Keynesian-style models: In recent models, fluctuations are largely an efficient response to shocks and inefficiencies stem from price distortions associated with price rigidity, i.e., Harberger triangles. In the older literature, fluctuations were viewed as inherently inefficient with large costs, i.e., Okun's gaps.

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Bibliographic Info

Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 3 (2003)
Issue (Month): 1 (March)
Pages: 1-26

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Handle: RePEc:bpj:bejmac:v:contributions.3:y:2003:i:1:n:4

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  1. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
  2. Andrew B. Abel, 2003. "The Effects of a Baby Boom on Stock Prices and Capital Accumulation in the Presence of Social Security," Econometrica, Econometric Society, vol. 71(2), pages 551-578, March.
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  8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  9. BĂ©nassy, Jean-Pascal, 1993. "Money and wage contracts in an optimizing model of the business cycle," CEPREMAP Working Papers (Couverture Orange) 9325, CEPREMAP.
  10. 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.
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  12. Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
  13. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
  14. Basu, Parantap, 1987. "An Adjustment Cost Model of Asset Pricing," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 609-21, October.
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Cited by:
  1. Pengfei Wang & Yi Wen, 2007. "Endogenous volatility, endogenous growth, and large welfare gains from stabilization policies," Working Papers 2006-032, Federal Reserve Bank of St. Louis.
  2. Preston J. Miller & Gary H. Stern, 2004. "Avoiding significant monetary policy mistakes," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Dec, pages 2-9.
  3. Mariano M. Croce, 2006. "Welfare Costs, Long Run Consumption Risk, and a Production Economy," 2006 Meeting Papers 582, Society for Economic Dynamics.

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