Welfare Cost of Business Cycles under Liquidity Constraints and Worker Heterogeneity

This paper studies the welfare cost of business cycles under incomplete markets and heterogeneous labour skills for male and female workers. The main goals are to estimate welfare gains and/or losses of economic agents if they could live in an economy without aggregate uncertainty, and to analyse the magnitudes of gains and/or losses among subgroups of agents. These tasks can be realised by calibrating a stochastic general equilibrium model with aggregate productivity shocks, individual skill uncertainty and unemployment risks, and compare the results to a similar model only without aggregate fluctuations. It is found that when business cycles are removed the overall welfare could increase up to almost 6% which is 700 times larger than the famous result in Lucas (1987). However, from a disaggregated perspective, the results are contrary to conventional expectation that subgroups with lower income should gain more benefit from the removal of business cycles due to the more adverse labour market conditions which hinder the ability to smooth consumption particularly under liquidity constraints and aggregate uncertainty. Instead, females gain less benefit than males, low-skilled workers are less better off than high-skilled workers, and unemployed workers gain slightly less than employed workers. Wealth inequality is found to remain fairly unchanged when business cycles are present in the economy although there is a noticeable shift in wealth distribution.