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The Term Structure of the Welfare Cost of Uncertainty

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  • P. Lopez

Abstract

The marginal cost of aggregate fluctuations has a term structure that is a simple transformation of the term structures of equity and interest rates. I extract evidence from index option markets to infer a downward-sloping, volatile and procyclical term structure of welfare costs. On average, the gains from greater macroeconomic stability are large, especially in the short run. I estimate that at the margin the elimination of one-year ahead consumption risk is worth around 12 percentage points of additional growth; this number compares to a marginal cost of lifetime uncertainty of 2-3 percentage points. Over time, the term structure of welfare costs varies substantially, predictably and with a volatility that decreases with maturity. These empirical properties of the term structure of welfare costs cannot be easily captured by today's leading dynamic equilibrium models and therefore represent a puzzling piece of evidence with potentially important welfare implications.

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  • P. Lopez, 2014. "The Term Structure of the Welfare Cost of Uncertainty," Working papers 521, Banque de France.
    • Handle: RePEc:bfr:banfra:521
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    Cited by:

    1. Roberto Marfè, 2017. "Income Insurance and the Equilibrium Term Structure of Equity," Journal of Finance, American Finance Association, vol. 72(5), pages 2073-2130, October.
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    3. Pier dup Lopez & J. David López-Salido & Francisco Vazquez-Grande, 2015. "Nominal Rigidities and the Term Structures of Equity and Bond Returns," Finance and Economics Discussion Series 2015-64, Board of Governors of the Federal Reserve System (U.S.).
    4. Pierlauro Lopez & David Lopez-Salido & Francisco Vazquez-Grande, 2018. "Risk-Adjusted Linearizations of Dynamic Equilibrium Models," Working papers 702, Banque de France.

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    More about this item

    Keywords

    Welfare cost of business cycles; Macroeconomic priorities; Dividend strips; Return forecastability.;
    All these keywords.

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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