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Saturday, January 12, 2013

Welfare costs of business cycles and models with heterogenous agents...

Start of quasi literature review for a heterogenous agents project I am starting in the near future.  I will continue to update this post as I come across/finish reading additional papers...comments or links to important paper are welcome!


Lucas (2003): Robert Lucas' Presidential Address given at the 2003 AEA conference in which he summarizes and defends his back-of-the-envelope calculation of the welfare costs of business cycles.  Good, gentle introduction to the literature.  Includes a good reference list and brief discussion of the the Krusell and Smith (2002) working paper.

Barlevy (2004):
This article reviews the literature on the cost of U.S. post-War business cycle fluctuations. I argue that recent work has established this cost is considerably larger than initial work found. However, despite the large cost of macroeconomic volatility, it is not obvious that policymakers should have pursued a more aggressive stabilization policy than they did. Still, the fact that volatility is so costly suggests stable growth is a desirable goal that ought to be maintained to the extent possible, just as policymakers are currently required to do under the Balanced Growth and Full Employment Act of 1978. This survey was prepared for the Economic Perspectives, a publication of the Federal Reserve Bank of Chicago.
As boring an abstract as you will ever come across. Includes a nice table summarizing various estimates of the cost of business cycles.

Krusell and Smith (1998):
How do movements in the distribution of income and wealth affect the macroeconomy? We analyze this question using a calibrated version of the stochastic growth model with partially uninsurable idiosyncratic risk and movements in aggregate productivity. Our main finding is that, in the stationary stochastic equilibrium, the behavior of the macroeconomic aggregates can be almost perfectly described using only the mean of the wealth distribution. This result is robust to substantial changes in both parameter values and model specification. Our benchmark model, whose only difference from the representative-agent framework is the existence of uninsurable idiosyncratic risk, displays far less cross-sectional dispersion and skewness in wealth than U.S. data. However, an extension that relies on a small amount of heterogeneity in thrift does succeed in replicating the key features of the wealth data. Furthermore, this extension features aggregate time series that depart significantly from permanent income behavior.
Krusell and Smith (1999):
We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity arises from uninsurable and idiosyncratic uncertainty in preferences and employment, where, regarding employment, we distinguish among employment and short- and long-term unemployment. We calibrate the model to match the distribution of wealth in U.S. data and features of transitions between employment and unemployment. Unlike previous studies, we study how business cycles affect different groups of consumers. We conclude that the cost of cycles is small for almost all groups and, indeed, is negative for some.
Krebs (2004):
This paper analyzes the welfare costs of business cycles when workers face uninsurable idiosyncratic labor income risk. In accordance with the previous literature, this paper decomposes labor income risk into an aggregate and an idiosyncratic component, but in contrast to the previous literature, this paper allows for multiple sources of idiosyncratic labor income risk. Using the multi-dimensional approach to idiosyncratic risk, this paper provides a general characterization of the welfare cost of business cycles when preferences and the (marginal) process of individual labor income in the economy with business cycles are given. The general analysis shows that the introduction of multiple sources of idiosyncratic risk never decreases the welfare cost of business cycles, and strictly increases it if there are cyclical fluctuations across the different sources of risk. Finally, this paper also provides a quantitative analysis of multi-dimensional labor income risk based on a version of the model that is calibrated to match U.S. labor market data. The quantitative analysis suggests that realistic variations across two particular dimensions of idiosyncratic labor income risk increase the welfare cost of business cycles by a substantial amount.
I study the welfare cost of business cycles in a complete-markets economy where some people are more risk averse than others. Relatively more risk-averse people buy insurance against aggregate risk, and relatively less risk-averse people sell insurance. These trades reduce the welfare cost of business cycles for everyone. Indeed, the least risk-averse people benefit from business cycles. Moreover, even infinitely risk-averse people suffer only finite and, in my empirical estimates, very small welfare losses. In other words, when there are complete insurance markets, aggregate fluctuations in consumption are essentially irrelevant not just for the average person—the surprising finding of Lucas [Lucas, Jr., R.E., 1987. Models of Business Cycles. Basil Blackwell, New York] but for everyone in the economy, no matter how risk averse they are. If business cycles matter, it is because they affect productivity or interact with uninsured idiosyncratic risk, not because aggregate risk per se reduces welfare.  
Krusell et al. (2009):
We investigate the welfare effects of eliminating business cycles in a model with substantial consumer heterogeneity. The heterogeneity arises from uninsurable and idiosyncratic uncertainty in preferences and employment status. We calibrate the model to match the distribution of wealth in U.S. data and features of transitions between employment and unemployment. In comparison with much of the literature, we find rather large effects. For our benchmark model, we find welfare effects that, on average across all consumers, are of a bit more than one order of magnitude larger than those computed by Lucas [Lucas Jr., R.E., 1987. Models of Business Cycles. Basil Blackwell, New York]. When we distinguish long- from short-term unemployment, long-term unemployment being distinguished by poor (and highly procyclical) employment prospects and low unemployment compensation, the average gain from eliminating cycles is as much as 1% in consumption equivalents. In addition, in both models, there are large differences across groups: very poor consumers gain a lot when cycles are removed (the long-term unemployed as much as around 30%), as do very rich consumers, whereas the majority of consumers—the “middle class”—sees much smaller gains from removing cycles. Inequality also rises substantially upon removing cycles.
The above paper has a 2002 working paper that seems to come to different conclusions about the welfare costs of business cycles.  Technical appendices are also provided.


  1. Cool stuff, I was interested in the same topic a little while back, so I remember reading those same papers :) The survey by Barlevy has references to a few additional papers dealing with idiosyncratic risk. For computational stuff, I found Wouter den Haan's site very useful, he has lots of teaching slides, survey paper on methods for solving these types of models, and also computer codes for JEDC comparison project (see January 2010 issue). Anyway, looking forward to more posts about your project (when you'll be able to say more).

    1. Thanks for reminder about Wouter den Haan's work...had completely forgotten about his website!