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The Welfare Costs of Business Cycles Unveiled: Measuring the Extent of Stabilization Policies

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Abstract
How can we measure the welfare benefit of ongoing stabilization policies? We develop a methodology to calculate the welfare cost of business cycles taking into account that observed consumption is partially smoothed. We propose a decomposition that disentangles consumption in a mix of laissez-faire (absent policies) and riskless components. With a novel identification strategy, we estimate the span of stabilization power. In our preferred specification, we find that the welfare cost of total fluctuations is 11 percent of lifetime consumption, of which 82 percent is smoothed by the status quo policies, yielding a residual 1.8 percent of consumption to be tackled by policymakers.

Suggested Citation

  • Fernando Barros & Fabio Gomes & Andre Luduvice, 2021. "The Welfare Costs of Business Cycles Unveiled: Measuring the Extent of Stabilization Policies," Working Papers 21-14R2, Federal Reserve Bank of Cleveland, revised 02 Mar 2023.
    • Handle: RePEc:fip:fedcwq:92917
    DOI: 10.26509/frbc-wp-202114r2
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    1. Fernando Barros Jr & Francisco L Lima Filho & Diego M Silva, 2017. "The Welfare Cost of Business Cycles for Heterogeneous Consumers: A State-Space Decomposition," Economics Bulletin, AccessEcon, vol. 37(3), pages 1928-1941.
    2. Fernando Alvarez & Urban J. Jermann, 2004. "Using Asset Prices to Measure the Cost of Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 112(6), pages 1223-1256, December.
    3. Jushan Bai & Pierre Perron, 1998. "Estimating and Testing Linear Models with Multiple Structural Changes," Econometrica, Econometric Society, vol. 66(1), pages 47-78, January.
    4. Olivier Blanchard, 2000. "What Do We Know about Macroeconomics that Fisher and Wicksell Did Not?," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 115(4), pages 1375-1409.
    5. Rong Hai & Dirk Krueger & Andrew Postlewaite, 2020. "On the welfare cost of consumption fluctuations in the presence of memorable goods," Quantitative Economics, Econometric Society, vol. 11(4), pages 1177-1214, November.
    6. Storesletten, Kjetil & Telmer, Chris I. & Yaron, Amir, 2001. "The welfare cost of business cycles revisited: Finite lives and cyclical variation in idiosyncratic risk," European Economic Review, Elsevier, vol. 45(7), pages 1311-1339.
    7. Obstfeld, Maurice, 1994. "Evaluating risky consumption paths: The role of intertemporal substitutability," European Economic Review, Elsevier, vol. 38(7), pages 1471-1486, August.
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    More about this item

    Keywords

    business cycles; consumption; stabilization; macroeconomic history;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
    • N10 - Economic History - - Macroeconomics and Monetary Economics; Industrial Structure; Growth; Fluctuations - - - General, International, or Comparative

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