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An analytical approach to the welfare cost of business cycles and the benefit from activist monetary policy

  • Michael T. Kiley

Typical dynamic general-equilibrium (DGE) models with stochastic productivity, consumers with state-separable (expected utility) preferences, and capital accumulation imply a small welfare cost of business cycles and a small market price of risk (i.e., equity premium). I present an analytical solution to quantity and asset-price movements in a DGE model with preferences that are either state-separable or non-state-separable; non-state-separable preferences leave the response of quantities to productivity shocks unaltered from the solutions under expected utility, but can raise substantially the welfare cost of fluctuations or the equity premium implied by the model. I then show that a large welfare loss to business cycles does not imply a large gain from an activist monetary policy. In particular, monetary policy can implement the optimal allocation in a sticky-price version of the model, but the welfare gain from such a policy is trivial because the optimal allocation continues to imply a volatile consumption stream in response to productivity shocks. These results highlight an important distinction between recent new-Keynesian or neo-Monetarist models of business cycles and older Keynesian-style models: In the recent literature, economic fluctuations are largely an efficient response to shocks to the economy (and the deviations from efficiency stem primarily from relative price distortions associated with price rigidity--i.e., Harberger triangles). In the older literature, fluctuations were viewed as inherently inefficient (with larger inefficiencies--i.e., Okun's gaps). In both literatures, this distinction is largely assumed rather than discovered, and the proper view of this distinction is the key determinant of the potential benefit of stabilization policy.

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Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 2001-41.

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Date of creation: 2001
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Handle: RePEc:fip:fedgfe:2001-41
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  1. L. Epstein & S. Zin, 2010. "First order risk aversion and the equity premium puzzle," Levine's Working Paper Archive 1400, David K. Levine.
  2. Storesletten, Kjetil & Telmer, Chris I. & Yaron, Amir, 2001. "The welfare cost of business cycles revisited: Finite lives and cyclical variation in idiosyncratic risk," European Economic Review, Elsevier, vol. 45(7), pages 1311-1339.
  3. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  4. Basu, Parantap, 1987. "An Adjustment Cost Model of Asset Pricing," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 609-21, October.
  5. Gilboa, Itzhak & Schmeidler, David, 1989. "Maxmin expected utility with non-unique prior," Journal of Mathematical Economics, Elsevier, vol. 18(2), pages 141-153, April.
  6. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, June.
  7. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1, December.
  8. Hercovitz, Z. & Sampson, M., 1989. "Output Growth, The Real Wage, And Employment Fluctuations," RCER Working Papers 179, University of Rochester - Center for Economic Research (RCER).
  9. BĂ©nassy, Jean-Pascal, 1993. "Money and wage contracts in an optimizing model of the business cycle," CEPREMAP Working Papers (Couverture Orange) 9325, CEPREMAP.
  10. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  11. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
  12. Andrew B. Abel, 2002. "The Effects of a Baby Boom on Stock Prices and Capital Accumulation in the Presence of Social Security," NBER Working Papers 9210, National Bureau of Economic Research, Inc.
  13. Weil, Philippe, 1990. "Nonexpected Utility in Macroeconomics," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 29-42, February.
  14. Long, John B, Jr & Plosser, Charles I, 1983. "Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
  15. William Poole, 1999. "Monetary policy rules?," Review, Federal Reserve Bank of St. Louis, issue Mar, pages 3-12.
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