The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk

32 Pages Posted: 11 Dec 2000 Last revised: 2 Apr 2001

See all articles by Kjetil Storesletten

Kjetil Storesletten

University of Oslo - Department of Economics; Centre for Economic Policy Research (CEPR)

Chris Telmer

Carnegie Mellon University - David A. Tepper School of Business

Amir Yaron

University of Pennsylvania -- Wharton School of Business; National Bureau of Economic Research (NBER)

Date Written: December 2000

Abstract

This paper investigates the welfare costs of business cycles in a heterogeneous agent, overlapping generations economy which is distinguished by idiosyncratic labor market risk. Aggregate variation arises both in terms of aggregate productivity shocks and countercyclical variation in the volatility of idiosyncratic shocks. Based on both aggregate data and microeconomic data from the Panel Study on Income Dynamics, we find the welfare benefits of eliminating aggregate variation to be large an order of magnitude larger than those originally documented by Lucas (1987). The key difference is countercyclical variation in idiosyncratic risk, which both amplifies the welfare cost of aggregate productivity shocks and imposes a cost of its own. The magnitude of these effects increases non-linearly in risk aversion. Our results support the increasingly popular notion that distributional effects are an important aspect of understanding the welfare cost of business cycles.

Suggested Citation

Storesletten, Kjetil and Telmer, Christopher I. and Yaron, Amir, The Welfare Cost of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk (December 2000). NBER Working Paper No. w8040. Available at SSRN: https://ssrn.com/abstract=253148

Kjetil Storesletten (Contact Author)

University of Oslo - Department of Economics ( email )

P.O. Box 1095 Blindern
N-0317 Oslo
Norway
+47 2284 4009 (Phone)
+47 2285 5035 (Fax)

HOME PAGE: http://folk.uio.no/kjstore/

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Christopher I. Telmer

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States
(412) 268-8838 (Phone)
(412) 268-6837 (Fax)

Amir Yaron

University of Pennsylvania -- Wharton School of Business ( email )

The Wharton School
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Philadelphia, PA 19104
United States
215-898-1241 (Phone)
215-898-6200 (Fax)

National Bureau of Economic Research (NBER) ( email )

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Cambridge, MA 02138
United States

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