The Welfare Costs of Business Cycles Revisited: Finite Lives and Cyclical Variation in Idiosyncratic Risk

Kjetil Storesletten, IIES, Stockholm University
Chris I. Telmer, GSIA, Carnegie Mellon University
Amir Yaron, Finance Deparment, The Wharton School, University of Pennsylvania and NBER

Abstract

This paper investigates the welfare costs of business cycles in a heterogeneous agent, overlapping generations economy which is distinguished by idiosyncratic labor market risk. Aggregate variation arises both in terms of aggregate productivity shocks and countercyclical variation in the volatility of idiosyncratic shocks. Based on both aggregate data and microeconomic data from the Panel Study on Income Dynamics, we "nd the welfare bene"ts of eliminating aggregate variation to be large } an order of magnitude larger than those originally documented by Lucas (1987). The key di!erence is countercyclical variation in idiosycratic risk, which both ampli"es the welfare cost of aggregate productivity shocks and imposes a cost of its own. The magnitude of these e!ects increases non-linearly in risk aversion. Our results, therefore, are consistent with the increasingly popular notion that distributional e!ects are an important aspect of understanding the welfare cost of business cycles.