An analytical approach to the welfare cost of business cycles and the benefit from activist monetary policy
AbstractTypical dynamic general-equilibrium (DGE) models with stochastic productivity, consumers with state-separable (expected utility) preferences, and capital accumulation imply a small welfare cost of business cycles and a small market price of risk (i.e., equity premium). I present an analytical solution to quantity and asset-price movements in a DGE model with preferences that are either state-separable or non-state-separable; non-state-separable preferences leave the response of quantities to productivity shocks unaltered from the solutions under expected utility, but can raise substantially the welfare cost of fluctuations or the equity premium implied by the model. I then show that a large welfare loss to business cycles does not imply a large gain from an activist monetary policy. In particular, monetary policy can implement the optimal allocation in a sticky-price version of the model, but the welfare gain from such a policy is trivial because the optimal allocation continues to imply a volatile consumption stream in response to productivity shocks. These results highlight an important distinction between recent new-Keynesian or neo-Monetarist models of business cycles and older Keynesian-style models: In the recent literature, economic fluctuations are largely an efficient response to shocks to the economy (and the deviations from efficiency stem primarily from relative price distortions associated with price rigidity--i.e., Harberger triangles). In the older literature, fluctuations were viewed as inherently inefficient (with larger inefficiencies--i.e., Okun's gaps). In both literatures, this distinction is largely assumed rather than discovered, and the proper view of this distinction is the key determinant of the potential benefit of stabilization policy.
Download InfoIf you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.
Bibliographic InfoPaper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2001-41.
Date of creation: 2001
Date of revision:
Other versions of this item:
- Kiley Michael T., 2003. "An Analytical Approach to the Welfare Cost of Business Cycles and the Benefit from Activist Monetary Policy," The B.E. Journal of Macroeconomics, De Gruyter, vol. 3(1), pages 1-26, March.
- E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
- G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
This paper has been announced in the following NEP Reports:
- NEP-ALL-2004-02-10 (All new papers)
- NEP-DGE-2002-02-15 (Dynamic General Equilibrium)
- NEP-MON-2002-02-15 (Monetary Economics)
- NEP-PKE-2002-02-15 (Post Keynesian Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Basu, Parantap, 1987. "An Adjustment Cost Model of Asset Pricing," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 609-21, October.
- Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2000.
"The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk,"
NBER Working Papers
8040, National Bureau of Economic Research, Inc.
- Storesletten, Kjetil & Telmer, Chris I. & Yaron, Amir, 2001. "The welfare cost of business cycles revisited: Finite lives and cyclical variation in idiosyncratic risk," European Economic Review, Elsevier, vol. 45(7), pages 1311-1339.
- Hercowitz, Zvi & Sampson, Michael, 1991.
"Output Growth, the Real Wage, and Employment Fluctuations,"
American Economic Review,
American Economic Association, vol. 81(5), pages 1215-37, December.
- Hercovitz, Z. & Sampson, M., 1989. "Output Growth, The Real Wage, And Employment Fluctuations," RCER Working Papers 179, University of Rochester - Center for Economic Research (RCER).
- Thomas Tallarini, .
"Risk-Sensitive Real Business Cycles,"
GSIA Working Papers
1997-35, Carnegie Mellon University, Tepper School of Business.
- Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
- Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, December.
- R. Mehra & E. Prescott, 2010.
"The equity premium: a puzzle,"
Levine's Working Paper Archive
1401, David K. Levine.
- Bénassy, Jean-Pascal, 1993.
"Money and wage contracts in an optimizing model of the business cycle,"
CEPREMAP Working Papers (Couverture Orange)
- Benassy, Jean-Pascal, 1995. "Money and wage contracts in an optimizing model of the business cycle," Journal of Monetary Economics, Elsevier, vol. 35(2), pages 303-315, April.
- Andrew B. Abel, 2002.
"The Effects of a Baby Boom on Stock Prices and Capital Accumulation in the Presence of Social Security,"
NBER Working Papers
9210, National Bureau of Economic Research, Inc.
- Andrew B. Abel, 2003. "The Effects of a Baby Boom on Stock Prices and Capital Accumulation in the Presence of Social Security," Econometrica, Econometric Society, vol. 71(2), pages 551-578, March.
- Andrew B. Abel, 2002. "The effects of a baby boom on stock prices and capital accumulation in the presence of Social Security," Working Papers 03-2, Federal Reserve Bank of Philadelphia.
- L. Epstein & S. Zin, 2010.
"First order risk aversion and the equity premium puzzle,"
Levine's Working Paper Archive
1400, David K. Levine.
- Epstein, Larry G. & Zin, Stanley E., 1990. "'First-order' risk aversion and the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 387-407, December.
- William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
- Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
- John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, October.
- Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February.
- Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
- Preston J. Miller & Gary H. Stern, 2004. "Avoiding significant monetary policy mistakes," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Dec, pages 2-9.
- Mariano M. Croce, 2006. "Welfare Costs, Long Run Consumption Risk, and a Production Economy," 2006 Meeting Papers 582, Society for Economic Dynamics.
- Pengfei Wang & Yi Wen, 2007. "Endogenous volatility, endogenous growth, and large welfare gains from stabilization policies," Working Papers 2006-032, Federal Reserve Bank of St. Louis.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Kris Vajs).
If references are entirely missing, you can add them using this form.