Reconsidering the Costs of Business Cycles with Incomplete Markets

29 Pages Posted: 26 May 2011

See all articles by Andrew Atkeson

Andrew Atkeson

University of California, Los Angeles (UCLA) - Department of Economics; National Bureau of Economic Research (NBER)

Christopher Phelan

Federal Reserve Bank of Minneapolis

Date Written: April 1994

Abstract

In this paper, we measure the potential welfare gains from counter-cyclical policy in an economy with incomplete markets. In the course of conducting this measurement, we focus on two questions as central to the determination of those potential gains: (1) what is the likely effect of counter-cyclical policy on the nature of the income risk faced by individuals in the economy, and (2) what are the likely general equilibrium effects brought about as asset prices change due to the implementation of counter-cyclical policies? In taking up the first question, we see it as critical to distinguish whether the main effect of counter-cyclical policy is to directly reduce the income risk faced by each individual or is simply to reduce the correlation across individuals in the income risk that they face. We present a model of the wage and employment risk faced by individuals over the cycle in which the levels of those risks are chosen endogenously. On the basis of that model, we argue that the main effect of counter- cyclical policy aimed at reducing aggregate fluctuations may be simply to remove the correlation across individuals in the unemployment risk that they face. We then use asset price data to argue that in an incomplete markets framework, the potential welfare gains from counter-cyclical policy are close to zero.

Suggested Citation

Atkeson, Andrew G. and Phelan, Christopher J., Reconsidering the Costs of Business Cycles with Incomplete Markets (April 1994). NBER Working Paper No. w4719. Available at SSRN: https://ssrn.com/abstract=1853148

Andrew G. Atkeson (Contact Author)

University of California, Los Angeles (UCLA) - Department of Economics ( email )

Box 951477
Los Angeles, CA 90095-1477
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Christopher J. Phelan

Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States
612-204-5615 (Phone)

HOME PAGE: http://phelan.mpls.frb.fed.us

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