welfare cost of business cycles when markets are incomplete

Tom Krebs

No 283, Econometric Society 2004 North American Summer Meetings from Econometric Society

Abstract: This paper analyzes the welfare effects of business cycles when workers face uninsurable idiosyncratic labor income risk that has a cyclical component. In accordance with the recent literature, this paper assumes that eliminating business cycles amounts to integrating out aggregate shocks (the integration principle) and that idiosyncratic shocks and aggregate shocks are stochastically independent (the independence assumption). This paper provides two arguments why the previous literature has underestimated the welfare costs of business cycles. First, the welfare cost of business cycles are in general indeterminate, and the previous literature has only reported the lower bound that is consistent with the data. In a simple example calibrated to match the observed cyclical variations in displacement probabilities, the lower bound is .35 percent of average consumption and the upper bound is 1.39 percent (using log-utility). Second, the previous literature has only focused on cyclical variations in job displacement (unemployment) probabilities, but neglected cyclical variations in the average income loss of displaced workers. In a simple calibrated example, the introduction of cyclical variations in the average income loss of displaced workers increases the lower bound from .35 percent of average consumption to .94 percent and the upper bound from 1.39 percent to 1.89 percent (again for log-utility)

Keywords: welfare cost of business cycles; incomplete markets (search for similar items in EconPapers)
JEL-codes: D52 (search for similar items in EconPapers)
Date: 2004-08-11
New Economics Papers: this item is included in nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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http://repec.org/esNASM04/up.17614.1075407777.pdf (application/pdf)

Related works:
Journal Article: Job Displacement Risk and the Cost of Business Cycles (2007)
Working Paper: Welfare Cost of Business Cycles When Markets Are Incomplete (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:ecm:nasm04:283

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