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On the Welfare Effects of Eliminating Business Cycles

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  • Per Krusell
  • Anthony A. Smith, Jr.

Abstract

Calibrated versions of existing representative-agent models have in common that the welfare costs of business cycles are extremely small. We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity is due to uninsurable idiosyncratic employment and preference risk. The model is calibrated to match the distribution of wealth in U.S. data; in particular, there is a large group of consumers with no, or negative, wealth. We also consider the distinction between short- and long-term unemployment, the latter of which may go up significantly during recessions. We investigate the welfare effects for each type of agent in this economy of a once-and-for-all elimination of any aggregate risk. From an initial situation typical of an economy with cyclical aggregate productivity and employment movements, we eliminate the cyclical movements by replacing these variables with their conditional means. Along the transition path, we then record the consumption outcomes across the population and are thus able to make precise welfare-based assessments of how much different agents win, or lose, in present discounted value terms. We find that the welfare gains from eliminating cycles are very small for almost all agents, and only sizeable for a very small group of poor agents.

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Paper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 243.

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Handle: RePEc:cmu:gsiawp:243

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Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890
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  1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  2. Bils, Mark J, 1985. "Real Wages over the Business Cycle: Evidence from Panel Data," Journal of Political Economy, University of Chicago Press, vol. 93(4), pages 666-89, August.
  3. 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.
  4. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
  5. Storesletten, Kjetil & Telmer, Chris & Yaron, Amir, 2002. "Asset pricing with idiosyncratic risk and overlapping generations," Seminar Papers 703, Stockholm University, Institute for International Economic Studies.
  6. Harold L. Cole & Narayana R. Kocherlakota, 1997. "A microfoundation for incomplete security markets," Working Papers 577, Federal Reserve Bank of Minneapolis.
  7. Maurice Obstfeld, 1995. "Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability," NBER Technical Working Papers 0120, National Bureau of Economic Research, Inc.
  8. John H. Cochrane, 1989. "The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives," NBER Working Papers 2730, National Bureau of Economic Research, Inc.
  9. N. Gregory Mankiw, 1987. "The Equity Premium and the Concentration of Aggregate Shocks," NBER Working Papers 1788, National Bureau of Economic Research, Inc.
  10. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  11. Krusell, Per & Smith, Anthony Jr., 1996. "Rules of thumb in macroeconomic equilibrium A quantitative analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 20(4), pages 527-558, April.
  12. Jim Dolmas, 1998. "Risk Preferences and the Welfare Cost of Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(3), pages 646-676, July.
  13. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  14. Andrew Atkeson & Christopher Phelan, 1994. "Reconsidering the Costs of Business Cycles with Incomplete Markets," NBER Working Papers 4719, National Bureau of Economic Research, Inc.
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  1. Quantitative Macroeconomics and Real Business Cycles (QM&RBC)

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