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Reconsidering the Costs of Business Cycles with Incomplete Markets

In: NBER Macroeconomics Annual 1994, Volume 9

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  • Andrew Atkeson
  • Christopher Phelan

Abstract

In this paper, we measure the potential welfare gains from counter-cyclical policy in an economy with incomplete markets. In the course of conducting this measurement, we focus on two questions as central to the determination of those potential gains: (1) what is the likely effect of counter-cyclical policy on the nature of the income risk faced by individuals in the economy, and (2) what are the likely general equilibrium effects brought about as asset prices change due to the implementation of counter-cyclical policies? In taking up the first question, we see it as critical to distinguish whether the main effect of counter-cyclical policy is to directly reduce the income risk faced by each individual or is simply to reduce the correlation across individuals in the income risk that they face. We present a model of the wage and employment risk faced by individuals over the cycle in which the levels of those risks are chosen endogenously. On the basis of that model, we argue that the main effect of counter- cyclical policy aimed at reducing aggregate fluctuations may be simply to remove the correlation across individuals in the unemployment risk that they face. We then use asset price data to argue that in an incomplete markets framework, the potential welfare gains from counter-cyclical policy are close to zero.

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This chapter was published in:

  • Stanley Fischer & Julio J. Rotemberg, 1994. "NBER Macroeconomics Annual 1994, Volume 9," NBER Books, National Bureau of Economic Research, Inc, number fisc94-1, May.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 11010.

    Handle: RePEc:nbr:nberch:11010

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    1. Constantinides,George & Duffie,Darrel, 1992. "Asset pricing with heterogeneous consumers," Discussion Paper Serie A 381, University of Bonn, Germany.
    2. Attanasio, Orazio & Davis, Steven J, 1996. "Relative Wage Movements and the Distribution of Consumption," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1227-62, December.
    3. repec:fth:harver:1418 is not listed on IDEAS
    4. Deaton, Angus & Paxson, Christina, 1994. "Intertemporal Choice and Inequality," Journal of Political Economy, University of Chicago Press, vol. 102(3), pages 437-67, June.
    5. John H. Cochrane & Lars Peter Hansen, 1993. "Asset Pricing Explorations for Macroeconomics," NBER Working Papers 4088, National Bureau of Economic Research, Inc.
    6. 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, vol. 104(3), pages 443-87, June.
    7. J. Bradford De Long & Lawrence H. Summers, . "How Does Macroeconomic Policy Matter?," J. Bradford De Long's Working Papers _130, University of California at Berkeley, Economics Department.
    8. 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.
    9. Brainard, William & Dolbear, F T, 1971. "Social Risk and Financial Markets," American Economic Review, American Economic Association, vol. 61(2), pages 360-70, May.
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