Welfare Cost Of Business Cycles Research Articles

The welfare costs of business cycles unveiled: Measuring the extent of stabilization policies

How can we measure the welfare benefit of ongoing stabilization policies? We develop a methodology to calculate the welfare cost of business cycles taking into account that observed consumption is partially smoothed. We propose a decomposition that disentangles consumption into a mix of laissez-faire and riskless components, decoupled by a parameter that captures the span of stabilization power. We estimate this parameter profiting from two distinct variance regimes measured in the historical consumption data and an identification strategy for the mapping between the span for each of these periods. In our preferred specification, we find that the welfare cost of total fluctuations is 11 percent of lifetime consumption, of which 82 percent is smoothed by the status quo policies, yielding a residual 1.8 percent of consumption to be tackled by policymakers.

On the welfare costs of business cycles: Beyond nondurable goods

This paper constitutes the first effort to measure the welfare costs of economic cycles considering that the consumer derives utility from the consumption of nondurable goods and services and the stock of durable goods. To accomplish such a task, we put forward a novel approach based on a nonseparable utility function. As a result, we take into account the complementarities among the consumption categories and the correlations of the shocks in those series. Our findings for the U.S. economy suggest that the single-good approach in the literature tends to underestimate the welfare costs of business cycles.

Model uncertainty, economic development, and welfare costs of business cycles

Some researchers argue that the welfare gains from eliminating consumption fluctuations for the United States are not small once model uncertainty is taken into account. This paper presents new evidence on the welfare gains from eliminating model uncertainty using a data set from a broad range of countries. It quantifies exactly the effect of model uncertainty on the welfare gains using an analytical formula. The results indicate that most countries derive much larger gains from the reduction of model uncertainty compared with the United States. Countries at higher stages of economic development tend to have lower welfare gains because their gains from eliminating model uncertainty become smaller. This relationship does not depend on country size or trade openness.

Climate policies, macroprudential regulation, and the welfare cost of business cycles

Climate policies, macroprudential regulation, and the welfare cost of business cycles

Learning on the Job and the Cost of Business Cycles

We show that business cycles reduce welfare through a decrease in the average level of employment in a labor market search model with learning on the job and skill loss during unemployment. Empirically, unemployment and the job-finding rate are negatively correlated. Since new jobs are the product of these two from the employment transition equation, business cycles imply fewer new jobs. Learning on the job implies that the resulting decrease in employment reduces aggregate human capital. This reduces incentives to post vacancies, further decreasing employment and human capital. We quantify this mechanism and find large output and welfare costs of business cycles. (JEL D83, E23, E24, E32, J24, J63)

On the welfare cost of business cycles: The role of labor-market heterogeneity

Are business cycles equally beneficial or harmful to consumers? Has welfare inequality increased or decreased due to rise of income/wealth inequality? By utilizing a heterogeneous agent RBC model with endogenous labor supply, this paper aims to answer these questions. We first show that while technology-driven business cycles are beneficial on average, a finding that is consistent with the recent literature, the welfare gain is not equally distributed; it is beneficial (resp. harmful) for agents who are relatively rich (resp. poor). The key to understanding the monotonic relationship between welfare gain from the business cycles and wealth level, a finding different from the previous literature that argues that there is a non-monotonic relationship between the two, is shown to be endogenous labor supply. Finally, we analyze the short run consequence of rising income/wealth inequality on welfare cost.

Welfare effects of business cycles and monetary policies in a small open emerging economy

This paper evaluates the welfare cost of business cycles and the effects of monetary policies in a DSGE model tailored to a small open emerging economy. The model generates rich business cycle fluctuations, features labor market idiosyncratic risks and accounts for imperfect financial and capital markets inclusion. In this context, households excluded from financial and capital markets experience larger costs of business cycle fluctuations due to their inability to hedge against labor market idiosyncratic risks. Different degrees of exposure to different types of risks generate divergent preferences regarding the conduct of monetary policy. While a strong response to inflation deviation from target maximizes welfare for included households, excluded households benefit the most from unemployment and wage stabilization policies.

Tax systems and public borrowing limits in a fiscal union.

This paper compares the implications of tax system and public borrowing limit asymmetries for the welfare cost of business cycles and interregional consumption risk sharing in a two-region fiscal union. We identify the welfare-improving and risk-sharing-improving designs of the regional tax systems and borrowing limits. We find that the choice of public borrowing limits is more consequential than is the choice of a tax regime for union welfare. It also serves as an argument for the harmonization of fiscal policies adopted in the fiscal union, as it would internalize fiscal externalities and improve consumption risk-sharing across the union regions. The key parameter determining the merits of alternative regional tax systems and possible limits to public borrowing in the fiscal union is the productivity of public good. Other aspects of the economy, such as the type of technology process, or the nature of the productivity shock do not affect the union public finance system design significantly. Extensive simulations suggest that if the productivity of public capital lies within the range of plausible empirical estimates, allowing both regions to have flexible borrowing limits and to choose whatever tax system they prefer will reduce the overall welfare costs of business fluctuations. However, for very low productivity of public capital, the welfare-improving regional public finance reforms that would prohibit public borrowing and tax labor income can produce limited benefits.

The Welfare Costs of Business Cycles Unveiled: Measuring the Extent of Stabilization Policies

The Welfare Costs of Business Cycles Unveiled: Measuring the Extent of Stabilization Policies

The Welfare Costs of Business Cycles: Beyond Nondurable Goods

The Welfare Costs of Business Cycles: Beyond Nondurable Goods

Climate Policies, Macroprudential Regulation, and the Welfare Cost of Business Cycles

Climate Policies, Macroprudential Regulation, and the Welfare Cost of Business Cycles

Searching for the equity premium

A dynamic stochastic general equilibrium model with recursive utility, search frictions, and capital accumulation is a good start to forming a unified theory of asset prices and business cycles. The model reproduces an equity premium of 4.27% per annum, a stock market volatility of 12.42%, and an average interest rate of 1.97%, while retaining plausible business cycle dynamics. The equity premium and stock market volatility are strongly countercyclical, whereas the interest rate and consumption growth are largely unpredictable. Because of wage inertia, dividends are procyclical despite consumption smoothing via investment. The welfare cost of business cycles is huge, 33.6%.

Cyclical net entry and exit

This paper examines how the interplay between cyclical net entry and exit of firms and search and matching frictions affect business cycle dynamics. We show cyclical net entry and exit reallocates inputs across firms and destroys jobs in recessions, which amplifies and skews business cycle dynamics. The model matches the volatility and skewness of real activity, the fast rise and slow decline in unemployment that occurs in recessions, and the counter-cyclical variation in macroeconomic uncertainty. Cyclical net entry and exit generates a 20% increase in volatility, 40% increase in skewness, and 55% increase in the welfare cost of business cycles.

The Ways the Cookie Crumbles: Education and the Margins of Cyclical Adjustment in the Labor Market

I document that less educated workers experience higher and more cyclically sensitive job separation rates. Meanwhile, workers with a bachelor's degree or more exhibit pro-cyclical wages while workers without a high school degree exhibit no statistically discernible cyclical pattern. Differences in the sensitivity are most stark when measurement of labor costs accounts for the value of the persistent effects of current macroeconomic conditions on future remitted wages. These findings suggest optimally differential implementation of self-enforcing implicit wage contracts in which educated workers and their employers leverage relative employment stability to smooth the effects of cyclical fluctuations over longer horizons. This margin of adjustment is less available to the less well educated, who have shorter expected employment durations. Furthermore, failure to account for the heterogeneities documented here leads to substantial underestimation of the welfare costs of business cycles.

Hysteresis and the welfare costs of recessions

This article explores the implications of hysteresis for the welfare costs of recessions by extending the textbook New Keynesian model to include hysteresis. Hysteresis implies that recessions reduce the level of potential output. Famously Lucas (1987, 2003) argued that the welfare costs of business cycles are negligible without hysteresis. This article demonstrates that the welfare costs of recessions are huge (negligible) in the New Keynesian model with (without) hysteresis. The main finding is that an empirically observed degree of hysteresis increases the welfare costs of a recession by a factor of 121. The results are in contrast with Lucas (1987, 2003), who concluded that only changes in the long-term growth rate of consumption have a significant welfare effect. The welfare costs of recessions can be huge without a change in the long-term growth rate of consumption. Hysteresis therefore implies that stabilization policy should respond forcefully to recessions.

Searching for the Equity Premium

Labor market frictions are crucial for the equity premium in production economies. A dynamic stochastic general equilibrium model with recursive utility, search frictions, and capital accumulation yields a high equity premium of 4.26% per annum, a stock market volatility of 11.8%, and a low average interest rate of 1.59%, while simultaneously retaining plausible business cycle dynamics. The equity premium and stock market volatility are strongly countercyclical, while the interest rate and consumption growth are largely unpredictable. Because of wage inertia, dividends are procyclical despite consumption smoothing via capital investment. The welfare cost of business cycles is huge, 29%. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

Variable Effort, Business Cycles, and Economic Welfare

Recent literature has shown that productivity-driven business cycles are beneficial to consumers in the context of market clearing real business cycle model. In this paper, we argue that this notion of welfare-improving business cycles does not jointly satisfy (1) the balanced growth path property and (2) micro evidence on the Frisch labor supply elasticity. We then show that once “variable effort,” a channel that plays an important role in the business cycle frequency but has been ignored by the previous literature on the welfare cost of business cycles, is introduced into the model, welfare-improving business cycles can be achieved in relatively plausible parameter regions.

Perturbation solution and welfare costs of business cycles in DSGE models

Lucas (1987) argues that the removal of cyclical fluctuations would barely improve economic welfare. He considers a risk-averse consumer valuing exogenously given streams of consumption Ct=Cegte−σ2/2+σϵt driven by an iid sequence of draws ϵt from a standard normal distribution. This allows him to change the size σ2 of the fluctuations without changing the mean of the process. In production economies, too, uncertainty is typically introduced in form of multiplicative, log-normally distributed shocks so that mean-preserving spreads can be analyzed in an analogous way. However, only few stochastic dynamic general equilibrium (DSGE) models admit an analytic solution. The most prevalent method to solve these models, perturbation methods, obtain an approximation to the stochastic model by perturbing the solution of the model’s deterministic counterpart with respect to the uncertainty parameter σ. Yet, widely available formulae to compute perturbation solutions are based only on the perturbation of σϵt and do not adequately capture the additional deviation −σ2/2 in the mean between the stochastic model and its deterministic version. We show within a model admitting an analytical solution that a second-order approximation of the welfare criterion also requires to perturb the mean. Thus, welfare measures based on the standard procedures for second-order solutions are (seriously) biased by a purely exogenous mean effect. We develop a general procedure of computing second-order accurate approximations of welfare gains or losses in the canonical DSGE model by extending the computation of second-order solutions pioneered by Schmitt-Grohé and Uribe (2004) to allow for mean preserving increases in the size of shocks. We apply our method to the model considered by Cho et al. (2015) and show that different from the results reported by these authors removing the cycle is always welfare improving. Welfare measures computed from weighted residuals methods confirm the logic behind our perturbation approach and verify the accuracy of our estimates.

The Macroeconomic Impact of Microeconomic Shocks: Beyond Hulten's Theorem

We provide a nonlinear characterization of the macroeconomic impact of microeconomic productivity shocks in terms of reduced‐form nonparametric elasticities for efficient economies. We also show how microeconomic parameters are mapped to these reduced‐form general equilibrium elasticities. In this sense, we extend the foundational theorem of Hulten (1978) beyond the first order to capture nonlinearities. Key features ignored by first‐order approximations that play a crucial role are: structural microeconomic elasticities of substitution, network linkages, structural microeconomic returns to scale, and the extent of factor reallocation. In a business‐cycle calibration with sectoral shocks, nonlinearities magnify negative shocks and attenuate positive shocks, resulting in an aggregate output distribution that is asymmetric (negative skewness), fat‐tailed (excess kurtosis), and has a negative mean, even when shocks are symmetric and thin‐tailed. Average output losses due to short‐run sectoral shocks are an order of magnitude larger than the welfare cost of business cycles calculated by Lucas (1987). Nonlinearities can also cause shocks to critical sectors to have disproportionate macroeconomic effects, almost tripling the estimated impact of the 1970s oil shocks on world aggregate output. Finally, in a long‐run growth context, nonlinearities, which underpin Baumol's cost disease via the increase over time in the sales shares of low‐growth bottleneck sectors, account for a 20 percentage point reduction in aggregate TFP growth over the period 1948–2014 in the United States.

Welfare Cost of Fluctuations When Labor Market Search Interacts with Financial Frictions

AbstractWe study the welfare costs of business cycles in a search and matching model with financial frictions. The model replicates the volatility on labor and financial markets. Business cycle costs are sizable. Indeed, the interactions between labor market and financial frictions magnify the impact of shocks via (i) a credit multiplier effect and (ii) an endogenous wage rigidity inherent to financial frictions. In addition, in a nonlinear framework, large welfare costs of fluctuations are explained by the high average unemployment and the low job finding rates with respect to their deterministic steady‐state values.