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Welfare Costs, Long Run Consumption Risk, and a Production Economy

  • Mariano M. Croce


    (economics nyu)

The main goal of this paper is to measure the welfare costs of business cycles in a production economy in which the representative agent has low risk aversion and - at the same time - the equity premium and the co-movements of aggregate quantities and market returns are comparable to what observed in historical data. In order to do so, I consider a production economy in which the representative agent has Epstein-Zin-Weil(1989) preferences, productivity has a Long Run Risk component and there are capital adjustment costs. In this way, I try to bridge the gap between the current Long Run Risk asset pricing literature, in which quantities are taken as exogenous, and the standard macroeconomic business cycle models. Preliminary results from a benchmark exchange economy suggest that when there is a Long Run Consumption Risk and the representative agent prefers early resolution of uncertainty, the implied total welfare costs of the consumption uncertainty range from 12\% to 20\%. (JEL classification: E20, E32, G12, D81)

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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 582.

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Date of creation: 03 Dec 2006
Date of revision:
Handle: RePEc:red:sed006:582
Contact details of provider: Postal: Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA
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  1. Lars Peter Hansen & John C. Heaton & Nan Li, 2008. "Consumption Strikes Back? Measuring Long-Run Risk," Journal of Political Economy, University of Chicago Press, vol. 116(2), pages 260-302, 04.
  2. Ravi Bansal & Amir Yaron, 2004. "Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles," Journal of Finance, American Finance Association, vol. 59(4), pages 1481-1509, 08.
  3. Lawrence J. Christiano & Michele Boldrin & Jonas D. M. Fisher, 2001. "Habit Persistence, Asset Returns, and the Business Cycle," American Economic Review, American Economic Association, vol. 91(1), pages 149-166, March.
  4. Alvarez, Fernando & Jermann, Urban J., 2000. "Using Asset Prices to Measure the Cost of Business Cycles," Working Papers 00-1, University of Pennsylvania, Wharton School, Weiss Center.
  5. Mariano M. Croce & Martin Lettau & Sydney C. Ludvigson, 2007. "Investor Information, Long-Run Risk, and the Term Structure of Equity," NBER Working Papers 12912, National Bureau of Economic Research, Inc.
  6. Michael T. Kiley, 2001. "An analytical approach to the welfare cost of business cycles and the benefit from activist monetary policy," Finance and Economics Discussion Series 2001-41, Board of Governors of the Federal Reserve System (U.S.).
  7. Riccardo Colacito & Mariano Croce, 2005. "Risks For The Long Run And The Real Exchange Rate," 2005 Meeting Papers 794, Society for Economic Dynamics.
  8. Jonathan A. Parker & Christian Julliard, 2005. "Consumption Risk and the Cross Section of Expected Returns," Journal of Political Economy, University of Chicago Press, vol. 113(1), pages 185-222, February.
  9. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
  10. Maurice Obstfeld, 1995. "Evaluating Risky Consumption Paths: The Role of Intertemporal Substitutability," NBER Technical Working Papers 0120, National Bureau of Economic Research, Inc.
  11. Jermann, Urban J., 1998. "Asset pricing in production economies," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 257-275, April.
  12. repec:dgr:kubcen:199554 is not listed on IDEAS
  13. Martin Lettau & Harald Uhlig, 2000. "Can Habit Formation be Reconciled with Business Cycle Facts?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 3(1), pages 79-99, January.
  14. Thomas Tallarini, . "Risk-Sensitive Real Business Cycles," GSIA Working Papers 1997-35, Carnegie Mellon University, Tepper School of Business.
  15. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
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