Measuring the Cost of Economic Fluctuations with Preferences that Rationalize the Equity Premium

Working Papers from University of Toronto, Department of Economics

Abstract: Lucas (2003) argues that the potential welfare gains from stabilizing the business cycle are small. In fact, he shows that the benefits of eliminating all economic fluctuations are small, both in an absolute sense and when compared to the potential gains from other reforms. His estimates are obtained using standard preferences. In this paper, I show that a model consistent with observed data on asset returns leads to very different conclusions. Calibrating preferences to observed asset market data raises the estimated welfare gains from completely eliminating aggregate fluctuations by approximately two orders of magnitude. Most of the gains, however, come from the elimination of low frequency contributions.

Keywords: welfare cost; fluctuations; stabilization (search for similar items in EconPapers)
JEL-codes: E32 E61 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-dge, nep-mac and nep-upt
Date: Written 2006-10-08
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