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Asset Bubbles and the Cost of Economic Fluctuations

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  • Mollerstrom, Johanna Britta
  • Laibson, David I.
  • Chauvin, Kyle

Abstract

Lucas (1987, 2003) estimates that the cost of economic fluctuations is low; a social planner would pay no more than 0.1% of (permanent) consumption to eliminate all future business cycle fluctuations. The current paper extends Lucas’ calculations by studying the costs of fluctuations arising from asset bubbles. We estimate two classes of costs: consumption volatility due to asset bubbles in a representative agent economy and consumption volatility that arises because households have heterogeneous exposure to the bubble assets. We show that the magnitude of welfare costs is primarily driven by the existence of heterogeneity. Our benchmark calibration implies that the asset bubbles of the last decade generated a social welfare cost equal to a permanent 3% reduction in the level of national consumption. If assets are held proportionately across the population, these welfare costs fall by an order of magnitude. Our calculations are sensitive to the details of the calibration, including the degree of balance sheet and trading heterogeneity, the coefficient of relative risk aversion, and the magnitude of the asset bubble. Our preferred specifications generate welfare costs ranging from 1% to 10% of (permanent) national consumption.

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  • Mollerstrom, Johanna Britta & Laibson, David I. & Chauvin, Kyle, 2011. "Asset Bubbles and the Cost of Economic Fluctuations," Scholarly Articles 9938146, Harvard University Department of Economics.
  • Handle: RePEc:hrv:faseco:9938146
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    6. Nina Biljanovska & Lucyna Gornicka & Alexandros Vardoulakis, 2019. "Optimal Macroprudential Policy and Asset Price Bubbles," IMF Working Papers 2019/184, International Monetary Fund.
    7. David Eil & Justin M. Rao, 2011. "The Good News-Bad News Effect: Asymmetric Processing of Objective Information about Yourself," American Economic Journal: Microeconomics, American Economic Association, vol. 3(2), pages 114-138, May.
    8. Eric Posner & E. Glen Weyl, 2013. "Benefit-Cost Analysis for Financial Regulation," American Economic Review, American Economic Association, vol. 103(3), pages 393-397, May.
    9. Narayan, Paresh Kumar & Sharma, Susan Sunila & Phan, Dinh Hoang Bach, 2016. "Asset price bubbles and economic welfare," International Review of Financial Analysis, Elsevier, vol. 44(C), pages 139-148.
    10. Merlin, Giovanni Tondin, 2018. "Entrepreneurship, financial frictions and the welfare gains of business cycles," Textos para discussão 484, FGV EESP - Escola de Economia de São Paulo, Fundação Getulio Vargas (Brazil).

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