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Heterogeneous Risk Preferences and the Welfare Cost of Business Cycles

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  • Sam Schulhofer-Wohl

    (Princeton University)

Abstract

I study the welfare cost of business cycles in a complete-markets economy where some people are more risk averse than others. Relatively more risk-averse people buy insurance against aggregate risk, and relatively less risk-averse people sell insurance. These trades reduce the welfare cost of business cycles for everyone. Indeed, the least risk-averse people benefit from business cycles. Moreover, even infinitely risk-averse people suffer only finite and, in my empirical estimates, very small welfare losses. In other words, when there are complete insurance markets, aggregate fluctuations in consumption are essentially irrelevant not just for the average person -- the surprising finding of Lucas (1987) -- but for everyone in the economy, no matter how risk averse they are. If business cycles matter, it is because they affect productivity or interact with uninsured idiosyncratic risk, not because aggregate risk per se reduces welfare. (Copyright: Elsevier)

Suggested Citation

  • Sam Schulhofer-Wohl, 2008. "Heterogeneous Risk Preferences and the Welfare Cost of Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(4), pages 761-780, October.
    • Handle: RePEc:red:issued:07-133
    DOI: 10.1016/j.red.2008.01.003
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    3. Colleen Carey & Stephen H. Shore, 2013. "From the Peaks to the Valleys: Cross-State Evidence on Income Volatility over the Business Cycle," The Review of Economics and Statistics, MIT Press, vol. 95(2), pages 549-562, May.
    4. Jonathan Heathcote & Kjetil Storesletten & Giovanni L. Violante, 2009. "Quantitative Macroeconomics with Heterogeneous Households," Annual Review of Economics, Annual Reviews, vol. 1(1), pages 319-354, May.
    5. Giacomo De Giorgi & Michele Pellizzari, 2014. "Understanding Social Interactions: Evidence from the Classroom," Economic Journal, Royal Economic Society, vol. 124(579), pages 917-953, September.
    6. Merlin, Giovanni Tondin, 2018. "Entrepreneurship, financial frictions and the welfare gains of business cycles," Textos para discussão 484, FGV EESP - Escola de Economia de São Paulo, Fundação Getulio Vargas (Brazil).
    7. Eunseong Ma, 2024. "The 40-Hour Work Week," Working papers 2024rwp-225, Yonsei University, Yonsei Economics Research Institute.
    8. Pierre‐André Chiappori & Krislert Samphantharak & Sam Schulhofer‐Wohl & Robert M. Townsend, 2014. "Heterogeneity and risk sharing in village economies," Quantitative Economics, Econometric Society, vol. 5, pages 1-27, March.
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    15. Per Krusell & Toshihiko Mukoyama & Aysegul Sahin & Anthony A. Smith, Jr., 2009. "Revisiting the Welfare Effects of Eliminating Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 12(3), pages 393-402, July.

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    Keywords

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    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth

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