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Using Asset Prices to Measure the Cost of Business Cycles

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  • Fernando Alvarez
  • Urban J. Jermann

Abstract

We propose a method to measure the welfare cost of economic fluctuations that does not require full specification of consumer preferences and instead uses asset prices. The method is based on the marginal cost of consumption fluctuations, the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of consumption. We show that this measure is an upper bound for the benefit of reducing all consumption fluctuations. We also clarify the link between the cost of consumption uncertainty, the equity premium, and the slope of the real term structure. To measure the marginal cost of fluctuations, we fit a variety of pricing kernels that reproduce key asset pricing statistics. We find that consumers would be willing to pay a very high price for a reduction in overall consumption uncertainty. However, for consumption fluctuations corresponding to business cycle frequencies, we estimate the marginal cost to be about 0.55% of lifetime consumption based on the period 1889-1997 and about 0.30% based on 1954-97.

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Bibliographic Info

Article provided by University of Chicago Press in its journal Journal of Political Economy.

Volume (Year): 112 (2004)
Issue (Month): 6 (December)
Pages: 1223-1256

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Handle: RePEc:ucp:jpolec:v:112:y:2004:i:6:p:1223-1256

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  1. Eric van Wincoop, 1998. "How big are potential welfare gains from international risksharing?," Staff Reports 37, Federal Reserve Bank of New York.
  2. Christopher Otrok, 2000. "On Measuring the Welfare Cost of Business Cycles," Econometric Society World Congress 2000 Contributed Papers 1094, Econometric Society.
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  14. John Y. Campbell & John H. Cochrane, 1995. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," NBER Working Papers 4995, National Bureau of Economic Research, Inc.
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  18. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
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