The Welfare Cost of Business Cycles at the States’ Levels

ucas (1987, 2003) calculates the potential welfare gains to stabilization of business cycles to be surprisingly small. Welfare gain is measured by a compensation parameter which makes a household indifferent between a deterministic lifetime stream and a compensated, risky lifetime stream of consumption. Using a constant relative risk aversion utility function and a coefficient of risk aversion of one, Lucas calculates that the welfare gain in real per capita consumption is in the order of one-twentieth of 1 percent. This is equivalent to an increase of about $18.33 in real per capita consumption per year for 1947 – 2001, stated in 2016 dollars. The main focus of this paper is to examine the welfare cost of business cycles for the 50 states using the same preference function as Lucas (1987, 2003). To our knowledge, this is the first paper that examines the welfare cost of business cycles at the state level. Our results support the findings of Lucas (1987, 2003) and Otrok (2001) that further welfare gain from stabilization of business cycles are very small, ranging from one-eighth of 1 percent for Wyoming to one-forty-fifth of 1 percent for Iowa. Further results from additional analysis also suggest that welfare cost of business cycles varies considerably across regions of the country.