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Measuring the Cost of Economic Fluctuations with Preferences that Rationalize the Equity Premium

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  • Angelo Melino

Abstract

Lucas (2003) argues that the potential welfare gains from stabilizing the business cycle are small. In fact, he shows that the benefits of eliminating all economic fluctuations are small, both in an absolute sense and when compared to the potential gains from other reforms. His estimates are obtained using standard preferences. In this paper, I show that a model consistent with observed data on asset returns leads to very different conclusions. Calibrating preferences to observed asset market data raises the estimated welfare gains from completely eliminating aggregate fluctuations by approximately two orders of magnitude. Most of the gains, however, come from the elimination of low frequency contributions.

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Bibliographic Info

Paper provided by University of Toronto, Department of Economics in its series Working Papers with number tecipa-256.

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Length: 24 pages
Date of creation: 08 Oct 2006
Date of revision:
Handle: RePEc:tor:tecipa:tecipa-256

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Keywords: welfare cost; fluctuations; stabilization;

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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. 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.
  3. Larry G. Epstein & Stanley E. Zin, 1991. "The Independence Axiom and Asset Returns," NBER Technical Working Papers 0109, National Bureau of Economic Research, Inc.
  4. Lars Peter Hansen & Ravi Jagannathan, 1990. "Implications of security market data for models of dynamic economies," Discussion Paper / Institute for Empirical Macroeconomics 29, Federal Reserve Bank of Minneapolis.
  5. Larry G. Epstein & Angelo Melino, 1993. "A Revealed Preference Analysis of Asset Pricing Under Recursive Utility," NBER Working Papers 4524, National Bureau of Economic Research, Inc.
  6. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  7. TallariniJr., Thomas D., 2000. "Risk-sensitive real business cycles," Journal of Monetary Economics, Elsevier, vol. 45(3), pages 507-532, June.
  8. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
  9. Hansen, Lars Peter & Richard, Scott F, 1987. "The Role of Conditioning Information in Deducing Testable," Econometrica, Econometric Society, vol. 55(3), pages 587-613, May.
  10. Phillippe Weil, 1997. "The Equity Premium Puzzle and the Risk-Free Rate Puzzle," Levine's Working Paper Archive 1833, David K. Levine.
  11. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 806-830, October.
  12. Robert E. Lucas Jr., 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March.
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Cited by:
  1. Guillén, Osmani Teixeira de Carvalho & Issler, João Victor & Franco-Neto, Afonso Arinos de Mello, 2013. "On the Welfare Costs of Business-Cycle Fluctuations and Economic-Growth Variation in the 20th Century and Beyond," Economics Working Papers (Ensaios Economicos da EPGE) 748, FGV/EPGE Escola Brasileira de Economia e Finanças, Getulio Vargas Foundation (Brazil).

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