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Stabilization versus Insurance

  • James Costain and Michael Reiter

Fluctuations of representative agent economies are not very costly. So if business cycles matter, it must be because agents face uninsured idiosyncratic risk which is somehow worsened by aggregate fluctuation. Idiosyncratic risk could be counteracted either through aggregate stabilization or public insurance provision. Our framework allows us to ask which of these mechanisms is optimal. We study a real business cycle model with a job matching function which, under non-distortionary full insurance, would decentralize the optimum. However, we assume public insurance can only be financed by distorting labor taxes, and that there is moral hazard in job search behavior. Without insurance, workers save to smooth their consumption. Our dynamic general equilibrium simulation characterizes the asset distribution in terms of a few moments. We interpolate the value function and check accuracy by new methods. We find that aggregate fluctuations have little average effect on unemployment, but they are costly because recessions greatly increase the probability of remaining unemployed long enough to deplete asset buffer stocks. Both public insurance provision and aggregate stabilization by increasing the procyclicality of tax collection imply nontrivial benefits.

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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 161.

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Date of creation: 01 Apr 2001
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Handle: RePEc:sce:scecf1:161
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  1. James Costain & Michael Reiter, 2005. "Business Cycles, Unemployment Insurance and the Calibration of Matching Models," Working Papers 215, Barcelona Graduate School of Economics.
  2. Barro, Robert J., 1979. "On the Determination of the Public Debt," Scholarly Articles 3451400, Harvard University Department of Economics.
  3. Joao Gomes & Jeremy Greenwood & Sergio T. Rebelo, 2001. "Equilibrium Unemployment," RCER Working Papers 479, University of Rochester - Center for Economic Research (RCER).
  4. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy under Imperfect Competition," Departmental Working Papers 200101, Rutgers University, Department of Economics.
  5. 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.
  6. Tom Krebs, 2004. "Welfare Cost of Business Cycles When Markets Are Incomplete," Working Papers 2004-08, Brown University, Department of Economics.
  7. Greenwood, J. & Huffman, G., 1991. "Tax Analysis in A Real Business Cycle Model: On Measuring Harberger Triangles and Okun Gaps," UWO Department of Economics Working Papers 9103, University of Western Ontario, Department of Economics.
  8. 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.
  9. Robert Shimer, 2005. "The Cyclical Behavior of Equilibrium Unemployment and Vacancies," American Economic Review, American Economic Association, vol. 95(1), pages 25-49, March.
  10. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
  11. Tom Krebs, 2003. "Growth and Welfare Effects of Business Cycles in Economies with Idiosyncratic Human Capital Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 846-868, October.
  12. Tom Krebs, 2007. "Job Displacement Risk and the Cost of Business Cycles," American Economic Review, American Economic Association, vol. 97(3), pages 664-686, June.
  13. Robert Shimer, 2004. "The Consequences of Rigid Wages in Search Models," Journal of the European Economic Association, MIT Press, vol. 2(2-3), pages 469-479, 04/05.
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