On the Welfare Effects of Eliminating Business Cycles

Calibrated versions of existing representative-agent models have in common that the welfare costs of business cycles are extremely small. We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity is due to uninsurable idiosyncratic employment and preference risk. The model is calibrated to match the distribution of wealth in U.S. data; in particular, there is a large group of consumers with no, or negative, wealth. We also consider the distinction between short- and long-term unemployment, the latter of which may go up significantly during recessions. We investigate the welfare effects for each type of agent in this economy of a once-and-for-all elimination of any aggregate risk. From an initial situation typical of an economy with cyclical aggregate productivity and employment movements, we eliminate the cyclical movements by replacing these variables with their conditional means. Along the transition path, we then record the consumption outcomes across the population and are thus able to make precise welfare-based assessments of how much different agents win, or lose, in present discounted value terms. We find that the welfare gains from eliminating cycles are very small for almost all agents, and only sizeable for a very small group of poor agents.