On the Welfare Costs of Consumption Uncertainty
Robert J. Barro
Harvard University - Department of Economics; National Bureau of Economic Research (NBER)
NBER Working Paper No. w12763
Satisfactory calculations of the welfare cost of aggregate consumption uncertainty require a framework that replicates major features of asset prices and returns, such as the high equity premium and low risk-free rate. A Lucas-tree model with rare but large disasters is such a framework. In a baseline simulation, the welfare cost of disaster risk is large -- society would be willing to lower real GDP by about 20% each year to eliminate all disaster risk, including wars. In contrast, the welfare cost from usual economic fluctuations is much smaller, though still important -- corresponding to lowering GDP by around 1.5% each year.
Number of Pages in PDF File: 32
Date posted: December 22, 2006