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Welfare Costs, Long Run Consumption Risk, and a Production Economy

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  • Mariano M. Croce

    ()
    (economics nyu)

Abstract

The main goal of this paper is to measure the welfare costs of business cycles in a production economy in which the representative agent has low risk aversion and - at the same time - the equity premium and the co-movements of aggregate quantities and market returns are comparable to what observed in historical data. In order to do so, I consider a production economy in which the representative agent has Epstein-Zin-Weil(1989) preferences, productivity has a Long Run Risk component and there are capital adjustment costs. In this way, I try to bridge the gap between the current Long Run Risk asset pricing literature, in which quantities are taken as exogenous, and the standard macroeconomic business cycle models. Preliminary results from a benchmark exchange economy suggest that when there is a Long Run Consumption Risk and the representative agent prefers early resolution of uncertainty, the implied total welfare costs of the consumption uncertainty range from 12\% to 20\%. (JEL classification: E20, E32, G12, D81)

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File URL: http://repec.org/sed2006/up.5463.1140016340.pdf
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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 582.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:582

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Keywords: Production Economy; Long-Run Risk; Asset Pricing;

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References

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  1. Alvarez, F. & Jermann, U.J., 2000. "Using Asset Prices to Measure the Cost of Business Cycles," Weiss Center Working Papers 00-1, Wharton School - Weiss Center for International Financial Research.
  2. Michele Boldrin & Lawrence J. Christiano & Jonas D.M. Fisher, 1999. "Habit persistence, asset returns and the business cycles," Working Paper Series WP-99-14, Federal Reserve Bank of Chicago.
  3. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
  4. Philippe Weil, 1989. "The Equity Premium Puzzle and the Riskfree Rate Puzzle," NBER Working Papers 2829, National Bureau of Economic Research, Inc.
  5. Lettau, M. & Uhlig, H., 1995. "Can Habit Formation be Reconciled with Business Cycle Facts?," Discussion Paper 1995-54, Tilburg University, Center for Economic Research.
  6. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  7. Riccardo Colacito & Mariano M. Croce, 2011. "Risks for the Long Run and the Real Exchange Rate," Journal of Political Economy, University of Chicago Press, vol. 119(1), pages 153 - 181.
  8. Mariano M. Croce & Martin Lettau & Sydney C. Ludvigson, 2007. "Investor Information, Long-Run Risk, and the Duration of Risky Cash-Flows," NBER Working Papers 12912, National Bureau of Economic Research, Inc.
  9. Lars Peter Hansen & John Heaton & Nan Li, 2005. "Consumption Strikes Back?: Measuring Long-Run Risk," NBER Working Papers 11476, National Bureau of Economic Research, Inc.
  10. Jonathan A. Parker & Christian Julliard, 2004. "Consumption Risk and the Cross-Section of Expected Returns," Working Papers 138, Princeton University, Woodrow Wilson School of Public and International Affairs, Discussion Papers in Economics..
  11. 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.
  12. Ravi Bansal & Amir Yaron, 2000. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," NBER Working Papers 8059, National Bureau of Economic Research, Inc.
  13. Maurice Obstfeld, 1995. "Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability," NBER Technical Working Papers 0120, National Bureau of Economic Research, Inc.
  14. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
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Cited by:
  1. Dario Caldara & Jesús Fernández-Villaverde & Juan F. Rubio-Ramírez & Wen Yao, 2009. "Computing DSGE Models with Recursive Preferences," NBER Working Papers 15026, National Bureau of Economic Research, Inc.
  2. Guglielmo Maria Caporale & Michael Donadelli & Alessia Varani, 2014. "International Capital Markets Structure, Preferences and Puzzles: The US-China Case," Discussion Papers of DIW Berlin 1362, DIW Berlin, German Institute for Economic Research.
  3. Fernández-Villaverde, Jesús & Koijen, Ralph & Rubio-Ramírez, Juan Francisco & van Binsbergen, Jules H., 2010. "The Term Structure of Interest Rates in a DSGE Model with Recursive Preferences," CEPR Discussion Papers 7781, C.E.P.R. Discussion Papers.
  4. Sydney Ludvigson, 2008. "The Research Agenda: Sydney Ludvigson on Empirical Evaluation of Economic Theories of Risk Premia," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 9(2), April.
  5. Claudio Campanale & Gian Luca Clementi & Rui Castro, 2008. "Asset Pricing in a General Equilibrium Production Economy with Chew-Dekel Risk Preferences," Working Papers. Serie AD 2008-14, Instituto Valenciano de Investigaciones Económicas, S.A. (Ivie).
  6. Richard Dennis, 2013. "Asset Prices, Business Cycles, and Markov-Perfect Fiscal Policy when Agents are Risk-Sensitive," Working Papers 2013_15, Business School - Economics, University of Glasgow.
  7. Ralph S.J. Koijen & Jules H. van Binsbergen & Juan F. Rubio-Ramírez & Jesus Fernandez-Villaverde, 2008. "Likelihood Estimation of DSGE Models with Epstein-Zin Preferences," 2008 Meeting Papers 1099, Society for Economic Dynamics.
  8. Pancrazi, Roberto, 2013. "How Beneficial was the Great Moderation After All?," The Warwick Economics Research Paper Series (TWERPS) 1016, University of Warwick, Department of Economics.
  9. Chang, Yanqin, 2007. "high level of international risk sharing when the productivity growth contains long run risk," MPRA Paper 4476, University Library of Munich, Germany.
  10. Xiaohong Chen & Jack Favilukis & Sydney C. Ludvigson, 2007. "An estimation of economic models with recursive preferences," LSE Research Online Documents on Economics 24502, London School of Economics and Political Science, LSE Library.

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