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welfare cost of business cycles when markets are incomplete

  • tom krebs

This paper analyzes the welfare effects of business cycles when workers face uninsurable idiosyncratic labor income risk that has a cyclical component. In accordance with the recent literature, this paper assumes that eliminating business cycles amounts to integrating out aggregate shocks (the integration principle) and that idiosyncratic shocks and aggregate shocks are stochastically independent (the independence assumption). This paper provides two arguments why the previous literature has underestimated the welfare costs of business cycles. First, the welfare cost of business cycles are in general indeterminate, and the previous literature has only reported the lower bound that is consistent with the data. In a simple example calibrated to match the observed cyclical variations in displacement probabilities, the lower bound is .35 percent of average consumption and the upper bound is 1.39 percent (using log-utility). Second, the previous literature has only focused on cyclical variations in job displacement (unemployment) probabilities, but neglected cyclical variations in the average income loss of displaced workers. In a simple calibrated example, the introduction of cyclical variations in the average income loss of displaced workers increases the lower bound from .35 percent of average consumption to .94 percent and the upper bound from 1.39 percent to 1.89 percent (again for log-utility)

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Paper provided by Econometric Society in its series Econometric Society 2004 North American Summer Meetings with number 283.

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Date of creation: 11 Aug 2004
Date of revision:
Handle: RePEc:ecm:nasm04:283
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  12. Kenneth L. Judd, 1998. "Numerical Methods in Economics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262100711, June.
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  18. Krebs, Tom, 2004. "Testable implications of consumption-based asset pricing models with incomplete markets," Journal of Mathematical Economics, Elsevier, vol. 40(1-2), pages 191-206, February.
  19. Kjetil Storesletten & Chris I. Telmer & Amir Yaron, 2000. "The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk," NBER Working Papers 8040, National Bureau of Economic Research, Inc.
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  22. Imrohoruglu, Ayse, 1989. "Cost of Business Cycles with Indivisibilities and Liquidity Constraints," Journal of Political Economy, University of Chicago Press, vol. 97(6), pages 1364-83, December.
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  26. Beaudry, Paul & DiNardo, John, 1991. "The Effect of Implicit Contracts on the Movement of Wages over the Business Cycle: Evidence from Micro Data," Journal of Political Economy, University of Chicago Press, vol. 99(4), pages 665-88, August.
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