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Using Asset Prices to Measure the Cost of Business Cycles

  • Fernando Alvarez
  • Urban J. Jermann

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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number 7978.

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Date of creation: Oct 2000
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Publication status: published as Alvarez, Fernando and Urban J. Jermann. "Using Asset Prices To Measure The Persistence Of The Marginal Utility Of Wealth," Econometrica, 2005, v73(6,Nov), 1977-2016. Also Fernando Alvarez & Urban J. Jermann. "Using Asset Prices to Measure the Cost of Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 112(6), pages 1223-1256, December 2004.
Handle: RePEc:nbr:nberwo:7978
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  1. Campbell, John, 1986. "Bond and Stock Returns in a Simple Exchange Model," Scholarly Articles 3122544, Harvard University Department of Economics.
  2. 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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  10. Rietz, Thomas A., 1988. "The equity risk premium a solution," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 117-131, July.
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  12. 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.
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  14. Arthur F. Burns & Wesley C. Mitchell, 1946. "Measuring Business Cycles," NBER Books, National Bureau of Economic Research, Inc, number burn46-1.
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  16. Eric van Wincoop, 1998. "How big are potential welfare gains from international risksharing?," Staff Reports 37, Federal Reserve Bank of New York.
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  18. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
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