Working Paper: NBER ID: w7978
Authors: Fernando Alvarez; Urban J. Jermann
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.
Keywords: Welfare cost; Business cycles; Asset prices; Consumption fluctuations
JEL Codes: E32; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Asset prices (G19) | Marginal cost of consumption fluctuations (D11) |
| Consumption fluctuations (E21) | Welfare costs associated with business cycles (J32) |
| Marginal cost of consumption fluctuations (D11) | Consumers' willingness to pay for reduction in consumption uncertainty (D11) |
| Marginal cost of consumption uncertainty (D11) | Equity premium (G19) |
| Marginal cost of consumption fluctuations (D11) | Long-term real yields (E43) |
| Marginal cost of consumption fluctuations (D11) | Aggregate dividend-price ratios (G35) |