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An Analytical Approach to the Welfare Cost of Business Cycles and the Benefit from Activist Monetary Policy

  • Kiley Michael T.


    (Federal Reserve Board and Organisation for Economic Cooperation and Development)

A closed-form solution for quantity and asset-price movements in a dynamic general equilibrium model with non-state-separable preferences shows that the welfare cost of fluctuations and the equity premium can be large in such a model. But a large welfare loss from cycles does not imply a large gain from good monetary policy. Although monetary policy can implement the optimal allocation in a sticky-price version of the model, the gain from such activism is trivial because the optimal allocation continues to imply volatile consumption in response to productivity shocks. This highlights a distinction between recent models and older Keynesian-style models: In recent models, fluctuations are largely an efficient response to shocks and inefficiencies stem from price distortions associated with price rigidity, i.e., Harberger triangles. In the older literature, fluctuations were viewed as inherently inefficient with large costs, i.e., Okun's gaps.

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Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 3 (2003)
Issue (Month): 1 (March)
Pages: 1-26

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Handle: RePEc:bpj:bejmac:v:contributions.3:y:2003:i:1:n:4
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