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, therefore, are consistent with the increasingly popular notion that distributional effects are an important aspect of understanding the welfare cost of business cycles.
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For helpful discussions we thank Marianne Baxter, Michael Brandt, Chris Geczy, Joao Gomes, Per Krusell, José Victor Rı́os-Rull, Tony Smith, Stan Zin and especially Rao Aiyagari who originally suggested using our framework to assess the welfare costs of business cycles. This work has benefited from the support of NSF grant SES-9987602 and the Rodney White Center at Wharton.
- Business cycles
- Idiosyncratic risk