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The welfare cost of business cycles revisited: Finite lives and cyclical variation in idiosyncratic risk

  • Storesletten, Kjetil
  • Telmer, Chris I.
  • Yaron, Amir

This paper investigates the welfare costs of business cycles in a heterogeneous agent, overlapping generations economy which is distinguished by idiosyncratic labor market risk. Aggregate variation arises both in terms of aggregate productivity shocks and countercyclical variation in the volatility of idiosyncratic shocks. Based on both aggregate data and microeconomic data from the Panel Study on Income Dynamics, we find the welfare benefits of eliminating aggregate variation to be large an order of magnitude larger than those originally documented by Lucas (1987). The key difference is countercyclical variation in idiosyncratic risk, which both amplifies the welfare cost of aggregate productivity shocks and imposes a cost of its own. The magnitude of these effects increases non-linearly in risk aversion. Our results support the increasingly popular notion that distributional effects are an important aspect of understanding the welfare cost of business cycles.

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Article provided by Elsevier in its journal European Economic Review.

Volume (Year): 45 (2001)
Issue (Month): 7 ()
Pages: 1311-1339

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Handle: RePEc:eee:eecrev:v:45:y:2001:i:7:p:1311-1339
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  13. MaCurdy, Thomas E., 1982. "The use of time series processes to model the error structure of earnings in a longitudinal data analysis," Journal of Econometrics, Elsevier, vol. 18(1), pages 83-114, January.
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