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Multi-Dimensional Risk and the Cost of Business Cycles

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  • Tom Krebs

    (University of Mannheim)

Abstract

This paper analyzes the welfare costs of business cycles when workers face uninsurable idiosyncratic labor income risk. In accordance with the previous literature, this paper decomposes labor income risk into an aggregate and an idiosyncratic component, but in contrast to the previous literature, this paper allows for multiple sources of idiosyncratic labor income risk. Using the multi-dimensional approach to idiosyncratic risk, this paper provides a general characterization of the welfare cost of business cycles when preferences and the (marginal) process of individual labor income in the economy with business cycles are given. The general analysis shows that the introduction of multiple sources of idiosyncratic risk never decreases the cost of business cycles, and strictly increases it if there are cyclical fluctuations across the different sources of risk. This paper also provides a quantitative analysis based on a version of the model that is calibrated to match U.S. labor market data. The quantitative analysis suggests that realistic variations across two particular dimensions of idiosyncratic labor income risk increase the welfare cost of business cycles by a substantial amount. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2006.07.002
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Bibliographic Info

Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 9 (2006)
Issue (Month): 4 (October)
Pages: 640-658

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Handle: RePEc:red:issued:05-39

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Related research

Keywords: Cost of business cycles; Labor market risk; Incomplete markets;

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References

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  1. Beaudry, Paul & Pages, Carmen, 2001. "The cost of business cycles and the stabilization value of unemployment insurance," European Economic Review, Elsevier, Elsevier, vol. 45(8), pages 1545-1572, August.
  2. Fernando Alvarez & Urban J. Jermann, 2004. "Using Asset Prices to Measure the Cost of Business Cycles," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 112(6), pages 1223-1256, December.
  3. Deaton, Angus, 1991. "Saving and Liquidity Constraints," Econometrica, Econometric Society, Econometric Society, vol. 59(5), pages 1221-48, September.
  4. 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.
  5. R. Glenn Hubbard & Jonathan Skinner & Stephen P. Zeldes, 1993. "The Importance of Precautionary Motives in Explaining Individual and Aggregate Saving," NBER Working Papers 4516, National Bureau of Economic Research, Inc.
  6. Pierre-Olivier Gourinchas & Jonathan A. Parker, 1999. "Consumption Over the Life Cycle," NBER Working Papers 7271, National Bureau of Economic Research, Inc.
  7. Alon Brav & George M. Constantinides & Christopher C. Geczy, 2002. "Asset Pricing with Heterogeneous Consumers and Limited Participation: Empirical Evidence," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 110(4), pages 793-824, August.
  8. David K. Levine & William R. Zame, 2002. "Does Market Incompleteness Matter?," Econometrica, Econometric Society, Econometric Society, vol. 70(5), pages 1805-1839, September.
  9. Gadi Barlevy & Daniel Tsiddon, 2004. "Earnings inequality and the business cycle," Working Paper Series, Federal Reserve Bank of Chicago WP-04-08, Federal Reserve Bank of Chicago.
  10. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A, University of Bonn, Germany 381, University of Bonn, Germany.
  11. Joao Gomes & Jeremy Greenwood & Sergio Rebelo, 1997. "Equilibrium Unemployment," NBER Working Papers 5922, National Bureau of Economic Research, Inc.
  12. Andrew Atkeson & Christopher Phelan, 1994. "Reconsidering the Costs of Business Cycles with Incomplete Markets," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 1994, Volume 9, pages 187-218 National Bureau of Economic Research, Inc.
  13. Christopher D. Carroll, 1996. "Buffer-Stock Saving and the Life Cycle/Permanent Income Hypothesis," NBER Working Papers 5788, National Bureau of Economic Research, Inc.
  14. Louis S. Jacobson & Robert J. LaLonde & Daniel Sullivan, 1992. "Earnings Losses of Displaced Workers," Upjohn Working Papers and Journal Articles, W.E. Upjohn Institute for Employment Research 92-11, W.E. Upjohn Institute for Employment Research.
  15. Carroll, Christopher D. & Samwick, Andrew A., 1997. "The nature of precautionary wealth," Journal of Monetary Economics, Elsevier, Elsevier, vol. 40(1), pages 41-71, September.
  16. Costas Meghir & Luigi Pistaferri, 2001. "Income variance dynamics and heterogenity," IFS Working Papers, Institute for Fiscal Studies W01/07, Institute for Fiscal Studies.
  17. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 104(3), pages 443-87, June.
  18. Tom Krebs, 2003. "Human Capital Risk And Economic Growth," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 118(2), pages 709-744, May.
  19. 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, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 846-868, October.
  20. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers, Federal Reserve Bank of Minneapolis 502, Federal Reserve Bank of Minneapolis.
  21. Krebs, Tom, 2004. "Testable implications of consumption-based asset pricing models with incomplete markets," Journal of Mathematical Economics, Elsevier, vol. 40(1-2), pages 191-206, February.
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Cited by:
  1. Per Krusell & Toshihiko Mukoyama & Ayseg ul Sahin, 2007. "Labor-Market Matching with Precautionary Savings and Aggregate Fluctuations," Levine's Bibliography 122247000000001783, UCLA Department of Economics.
  2. Per Krusell & Toshihiko Mukoyama & Aysegul Sahin & Anthony A. Smith, Jr., 2008. "Appendices for "Revisiting the Welfare Effects of Eliminating Business Cycles"," Technical Appendices, Review of Economic Dynamics 08-211, Review of Economic Dynamics.

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