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On the Welfare Effects of Eliminating Business Cycles

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  • Per Krusell
  • Anthony A. Smith, Jr.

Abstract

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.

Suggested Citation

  • Per Krusell & Anthony A. Smith, Jr., "undated". "On the Welfare Effects of Eliminating Business Cycles," GSIA Working Papers 243, Carnegie Mellon University, Tepper School of Business.
  • Handle: RePEc:cmu:gsiawp:243
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    References listed on IDEAS

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    1. 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 1227-1262, December.
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    4. Kjetil Storesletten & Chris Telmer & Amir Yaron, 2007. "Asset Pricing with Idiosyncratic Risk and Overlapping Generations," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 10(4), pages 519-548, October.
    5. Obstfeld, Maurice, 1994. "Evaluating risky consumption paths: The role of intertemporal substitutability," European Economic Review, Elsevier, vol. 38(7), pages 1471-1486, August.
    6. 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.
    7. Harold L. Cole & Narayana R. Kocherlakota, 1997. "A microfoundation for incomplete security markets," Working Papers 577, Federal Reserve Bank of Minneapolis.
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    12. 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.
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    More about this item

    JEL classification:

    • C68 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Computable General Equilibrium Models
    • D31 - Microeconomics - - Distribution - - - Personal Income and Wealth Distribution
    • D61 - Microeconomics - - Welfare Economics - - - Allocative Efficiency; Cost-Benefit Analysis
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles

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