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On the Welfare Effects of Eliminating Business Cycles

  • Per Krusell
  • Anthony A. Smith, Jr.

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.

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Paper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 243.

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Handle: RePEc:cmu:gsiawp:243
Contact details of provider: Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890
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  1. Mankiw, N. Gregory, 1986. "The equity premium and the concentration of aggregate shocks," Journal of Financial Economics, Elsevier, vol. 17(1), pages 211-219, September.
  2. Harold L. Cole & Narayana R. Kocherlakota, 1997. "A microfoundation for incomplete security markets," Working Papers 577, Federal Reserve Bank of Minneapolis.
  3. Jim Dolmas, 1998. "Risk Preferences and the Welfare Cost of Business Cycles," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(3), pages 646-676, July.
  4. Andrew Atkeson & Christopher Phelan, 1994. "Reconsidering the Costs of Business Cycles with Incomplete Markets," NBER Chapters, in: NBER Macroeconomics Annual 1994, Volume 9, pages 187-218 National Bureau of Economic Research, Inc.
  5. Aiyagari, S Rao, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, MIT Press, vol. 109(3), pages 659-84, August.
  6. Kjetil Storesletten & Chris Telmer & Amir Yaron, 1996. "Asset pricing with idiosyncratic risk and overlapping generations," Economics Working Papers 405, Department of Economics and Business, Universitat Pompeu Fabra, revised Jul 1999.
  7. Maurice Obstfeld, 1995. "Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability," NBER Technical Working Papers 0120, National Bureau of Economic Research, Inc.
  8. Per Krusell & Anthony A. Smith & Jr., 1998. "Income and Wealth Heterogeneity in the Macroeconomy," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 867-896, October.
  9. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  10. Bils, Mark J, 1985. "Real Wages over the Business Cycle: Evidence from Panel Data," Journal of Political Economy, University of Chicago Press, vol. 93(4), pages 666-89, August.
  11. Krusell, Per & Smith, Anthony Jr., 1996. "Rules of thumb in macroeconomic equilibrium A quantitative analysis," Journal of Economic Dynamics and Control, Elsevier, vol. 20(4), pages 527-558, April.
  12. Cochrane, John H, 1989. "The Sensitivity of Tests of the Intertemporal Allocation of Consumption to Near-Rational Alternatives," American Economic Review, American Economic Association, vol. 79(3), pages 319-37, June.
  13. Attanasio, Orazio & Davis, Steven J, 1996. "Relative Wage Movements and the Distribution of Consumption," Journal of Political Economy, University of Chicago Press, vol. 104(6), pages 1227-62, December.
  14. Huggett, Mark, 1993. "The risk-free rate in heterogeneous-agent incomplete-insurance economies," Journal of Economic Dynamics and Control, Elsevier, vol. 17(5-6), pages 953-969.
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  1. Quantitative Macroeconomics and Real Business Cycles (QM&RBC)

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