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Markups, Gaps, and the Welfare Costs of Business Fluctuations

  • Jordi Galí

    (CREI and Universitat Pompeu Fabra)

  • Mark Gertler

    (New York University)

  • J. David López-Salido

    (Federal Reserve Board and CEPR)

We present a simple theory-based measure of the variations in aggregate economic efficiency: the gap between the marginal product of labor and the household's consumption leisure tradeoff. We show that this indicator corresponds to the reciprocal of the markup of price over social marginal cost, and give some evidence in support of this interpretation. We then show that, with some auxiliary assumptions, our gap variable may be used to measure the efficiency costs of business fluctuations. We find that the latter costs are modest on average. However, to the extent that the flexible price equilibrium is distorted, the gross efficiency losses from recessions and gains from booms may be large. Indeed, we find that the major recessions involved large efficiency losses. These results hold for reasonable parameterizations of the Frisch elasticity of labor supply, the relative risk aversion, and steady-state distortions. Copyright by the President and Fellows of Harvard College and the Massachusetts Institute of Technology.

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Article provided by MIT Press in its journal The Review of Economics and Statistics.

Volume (Year): 89 (2007)
Issue (Month): 1 (November)
Pages: 44-59

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Handle: RePEc:tpr:restat:v:89:y:2007:i:1:p:44-59
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