Using Asset Prices to Measure the Cost of Business Cycles

68 Pages Posted: 22 Oct 2000 Last revised: 11 Apr 2010

See all articles by Fernando Alvarez

Fernando Alvarez

University of Chicago - Department of Economics; National Bureau of Economic Research (NBER)

Urban J. Jermann

University of Pennsylvania - Finance Department; National Bureau of Economic Research (NBER)

Multiple version iconThere are 2 versions of this paper

Date Written: October 2000

Abstract

We propose a method to measure the welfare cost of economic fluctuations that does not require full specification of consumer preferences and instead uses asset prices. The method is based on the marginal cost of consumption fluctuations, the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of consumption. We show that this measure is an upper bound for the benefit of reducing all consumption fluctuations. We also clarify the link between the cost of consumption uncertainty, the equity premium, and the slope of the real term structure. To measure the marginal cost of fluctuations, we fit a variety of pricing kernels that reproduce key asset pricing statistics. We find that consumers would be willing to pay a very high price for a reduction in overall consumption uncertainty. However, for consumption fluctuations corresponding to business cycle frequencies, we estimate the marginal cost to be about 0.55% of lifetime consumption based on the period 1889-1997 and about 0.30% based on 1954-97.

Suggested Citation

Alvarez, Fernando and Jermann, Urban J., Using Asset Prices to Measure the Cost of Business Cycles (October 2000). NBER Working Paper No. w7978. Available at SSRN: https://ssrn.com/abstract=246880

Fernando Alvarez (Contact Author)

University of Chicago - Department of Economics ( email )

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Urban J. Jermann

University of Pennsylvania - Finance Department ( email )

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National Bureau of Economic Research (NBER)

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