The Welfare Costs of Macroeconomic Fluctuations Under Incomplete Markets: Evidence from State-Level Consumption Data

CIRPEE Working Paper No. 05-24

26 Pages Posted: 24 Aug 2005

See all articles by Kris Jacobs

Kris Jacobs

University of Houston - C.T. Bauer College of Business

Stephane Pallage

University of Quebec at Montreal - Department of Economics; Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Michel A. Robe

University of Illinois at Urbana-Champaign

Date Written: July 2005

Abstract

Existing estimates of the welfare cost of business cycles suggest that it is quite low and might well be minuscule. Many of these estimates are based on aggregate U.S. consumption data. Arguably, because markets are incomplete and risk-sharing is imperfect, the welfare costs computed with aggregate consumption data are likely underestimates. Yet, incomplete-market models have not yielded significantly greater cost figures. Previous incomplete-market studies, however, have relied on model-generated consumption series that reflect optimal decisions in models calibrated using individual income data. In this paper, we maintain the assumption incomplete markets but use observed consumption streams instead. Using state-level retail sales figures, we show that the welfare cost of macroeconomic volatility is in fact very substantial. In one half of the U.S. states, the welfare gain from the removal of business cycles can in fact exceed the gain from receiving an extra percentage point of consumption growth in perpetuity. In short, our results indicate that macroeconomic volatility has first-order welfare implications.

Keywords: Incomplete markets, consumption volatility, growth, welfare

JEL Classification: E32, E60

Suggested Citation

Jacobs, Kris and Pallage, Stephane and Robe, Michel A., The Welfare Costs of Macroeconomic Fluctuations Under Incomplete Markets: Evidence from State-Level Consumption Data (July 2005). CIRPEE Working Paper No. 05-24, Available at SSRN: https://ssrn.com/abstract=784445 or http://dx.doi.org/10.2139/ssrn.784445

Kris Jacobs

University of Houston - C.T. Bauer College of Business ( email )

Houston, TX 77204-6021
United States

Stephane Pallage

University of Quebec at Montreal - Department of Economics ( email )

P.O. Box 8888, Downtown Station
Montreal, Quebec H3C 3P8
Canada
514-987-3000 ext. 8730 (Phone)
514-987-8494 (Fax)

Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Pavillon De Sève
Ste-Foy, Quebec G1K 7P4
Canada

Michel A. Robe (Contact Author)

University of Illinois at Urbana-Champaign ( email )

601 E John St
Champaign, IL 61820
United States

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