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Using Asset Prices to Measure the Cost of Business Cycles

  • Alvarez, Fernando

    (U of Chicago)

  • Jermann, Urban J.

    (U of Pennsylvania and Federal Reserve Bank of Minneapolis)

We propose a method to measure the welfare cost of economic fluctuations that does not require full specification of consumer preferences and instead uses asset prices. The method is based on the marginal cost of consumption fluctuations, the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of consumption. We show that this measure is an upper bound for the benefit of reducing all consumption fluctuations. We also clarify the link between the cost of consumption uncertainty, the equity premium, and the slope of the real term structure. To measure the marginal cost of fluctuations, we fit a variety of pricing kernels that reproduce key asset pricing statistics. We find that consumers would be willing to pay a very high price for a reduction in overall consumption uncertainty. However, for consumption fluctuations corresponding to business cycle frequencies, we estimate the marginal cost to be about 0.55% of lifetime consumption based on the period 1889-1997 and about 0.30% based on 1954-97.

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Paper provided by University of Pennsylvania, Wharton School, Weiss Center in its series Working Papers with number 00-1.

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Date of creation: Aug 2000
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Handle: RePEc:ecl:upafin:00-1
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  1. Maurice Obstfeld, 1995. "Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability," NBER Technical Working Papers 0120, National Bureau of Economic Research, Inc.
  2. Lars Hansen & Thomas Sargent & Thomas Tallarini, . "Robust Permanent Income and Pricing," GSIA Working Papers 1997-51, Carnegie Mellon University, Tepper School of Business.
  3. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  4. Andrew B. Abel, 1998. "Risk Premia and Term Premia in General Equilibrium," NBER Working Papers 6683, National Bureau of Economic Research, Inc.
  5. Campbell, John Y, 1996. "Understanding Risk and Return," Journal of Political Economy, University of Chicago Press, vol. 104(2), pages 298-345, April.
  6. John Y. Campbell, 1987. "Bond and Stock Returns in a Simple Exchange Model," NBER Working Papers 1509, National Bureau of Economic Research, Inc.
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  8. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  9. Eric van Wincoop, 1998. "How big are potential welfare gains from international risksharing?," Staff Reports 37, Federal Reserve Bank of New York.
  10. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  11. Chris Otrok, 1999. "On Measuring the Welfare Cost of Business Cycles," Virginia Economics Online Papers 318, University of Virginia, Department of Economics.
  12. Per Krusell & Anthony A. Smith, Jr., . "On the Welfare Effects of Eliminating Business Cycles," GSIA Working Papers 243, Carnegie Mellon University, Tepper School of Business.
  13. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  14. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
  15. 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.
  16. Arthur F. Burns & Wesley C. Mitchell, 1946. "Measuring Business Cycles," NBER Books, National Bureau of Economic Research, Inc, number burn46-1, December.
  17. 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.
  18. Epstein, Larry G & Zin, Stanley E, 1991. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: An Empirical Analysis," Journal of Political Economy, University of Chicago Press, vol. 99(2), pages 263-86, April.
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