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Heterogeneous Risk Preferences and the Welfare Cost of Business Cycles

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  • Sam Schulhofer-Wohl

    (Princeton University)

Abstract

I study the welfare cost of business cycles in a complete-markets economy where some people are more risk averse than others. Relatively more risk-averse people buy insurance against aggregate risk, and relatively less risk-averse people sell insurance. These trades reduce the welfare cost of business cycles for everyone. Indeed, the least risk-averse people benefit from business cycles. Moreover, even infinitely risk-averse people suffer only finite and, in my empirical estimates, very small welfare losses. In other words, when there are complete insurance markets, aggregate fluctuations in consumption are essentially irrelevant not just for the average person -- the surprising finding of Lucas (1987) -- but for everyone in the economy, no matter how risk averse they are. If business cycles matter, it is because they affect productivity or interact with uninsured idiosyncratic risk, not because aggregate risk per se reduces welfare. (Copyright: Elsevier)

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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): 11 (2008)
Issue (Month): 4 (October)
Pages: 761-780

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Handle: RePEc:red:issued:07-133

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Keywords: Business cycles; Risk aversion; Risk sharing; Heterogeneity;

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References

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  1. Alvarez, Fernando & Jermann, Urban J., 2000. "Using Asset Prices to Measure the Cost of Business Cycles," Working Papers, University of Pennsylvania, Wharton School, Weiss Center 00-1, University of Pennsylvania, Wharton School, Weiss Center.
  2. Robert B. Barsky & Miles S. Kimball & F. Thomas Juster & Matthew D. Shapiro, 1995. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Survey," NBER Working Papers 5213, National Bureau of Economic Research, Inc.
  3. Krusell, P & Smith Jr, A-A, 1995. "Income and Wealth Heterogeneity in the Macroeconomic," RCER Working Papers, University of Rochester - Center for Economic Research (RCER) 399, University of Rochester - Center for Economic Research (RCER).
  4. Gadi Barlevy, 2003. "The cost of business cycles under endogenous growth," Working Paper Series, Federal Reserve Bank of Chicago WP-03-13, Federal Reserve Bank of Chicago.
  5. Maurice Obstfeld, 1995. "Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability," NBER Technical Working Papers, National Bureau of Economic Research, Inc 0120, National Bureau of Economic Research, Inc.
  6. Per Krusell & Anthony A. Smith, Jr., . "On the Welfare Effects of Eliminating Business Cycles," GSIA Working Papers, Carnegie Mellon University, Tepper School of Business 243, Carnegie Mellon University, Tepper School of Business.
  7. Barsky, Robert B, et al, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 112(2), pages 537-79, May.
  8. Garey Ramey & Valerie A. Ramey, 1991. "Technology Commitment and the Cost of Economic Fluctuations," NBER Working Papers 3755, National Bureau of Economic Research, Inc.
  9. J. Bradford DeLong & Lawrence H. Summers, 1988. "How Does Macroeconomic Policy Affect Output?," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 19(2), pages 433-494.
  10. Richard Blundell & Luigi Pistaferri & Ian Preston, 2008. "Consumption Inequality and Partial Insurance," American Economic Review, American Economic Association, American Economic Association, vol. 98(5), pages 1887-1921, December.
  11. Sam Schulhofer-Wohl, 2007. "Heterogeneity, Risk Sharing and the Welfare Costs of Risk," 2007 Meeting Papers, Society for Economic Dynamics 926, Society for Economic Dynamics.
  12. repec:fth:harver:1418 is not listed on IDEAS
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Cited by:
  1. 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.
  2. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2009. "Quantitative macroeconomics with heterogeneous households," Staff Report, Federal Reserve Bank of Minneapolis 420, Federal Reserve Bank of Minneapolis.
  3. Colleen Carey & Stephen H. Shore, 2013. "From the Peaks to the Valleys: Cross-State Evidence on Income Volatility over the Business Cycle," The Review of Economics and Statistics, MIT Press, vol. 95(2), pages 549-562, May.
  4. Lester, Robert & Pries, Michael & Sims, Eric, 2014. "Volatility and welfare," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 38(C), pages 17-36.
  5. Pierre-Andre Chiappori & Krislert Samphantharak & Sam Schulhofer-Wohl & Robert Townsend, 2013. "Heterogeneity and risk sharking in village economies," Staff Report, Federal Reserve Bank of Minneapolis 483, Federal Reserve Bank of Minneapolis.
  6. Michał Brzoza-Brzezina & Marcin Kolasa & Grzegorz Koloch & Krzysztof Makarski & Michał Rubaszek, 2013. "Monetary Policy In A Non-Representative Agent Economy: A Survey," Journal of Economic Surveys, Wiley Blackwell, Wiley Blackwell, vol. 27(4), pages 641-669, 09.

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