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Using Asset Prices to Measure the Cost of Business Cycles

Fernando Alvarez and Urban Jermann ()

Working Papers from University of Pennsylvania, Wharton School, Weiss Center

Abstract: We propose a method to measure the welfare cost of economic fluctuations that does not require full specification of consumer preferences and instead uses asset prices. The method is based on the marginal cost of consumption fluctuations, the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of consumption. We show that this measure is an upper bound for the benefit of reducing all consumption fluctuations. We also clarify the link between the cost of consumption uncertainty, the equity premium, and the slope of the real term structure. To measure the marginal cost of fluctuations, we fit a variety of pricing kernels that reproduce key asset pricing statistics. We find that consumers would be willing to pay a very high price for a reduction in overall consumption uncertainty. However, for consumption fluctuations corresponding to business cycle frequencies, we estimate the marginal cost to be about 0.55% of lifetime consumption based on the period 1889-1997 and about 0.30% based on 1954-97.

Date: 2000-08
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http://finance.wharton.upenn.edu/~jermann/cbcjuly03.pdf

Related works:
Journal Article: Using Asset Prices to Measure the Cost of Business Cycles (2004) Downloads
Working Paper: Using Asset Prices to Measure the Cost of Business Cycles (2000)
Working Paper: Using Asset Prices to Measure the Cost of Business Cycles (2000) Downloads
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Persistent link: https://EconPapers.repec.org/RePEc:ecl:upafin:00-1

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