Endogenous Volatility, Endogenous Growth, and Large Welfare Gains from Stabilization Policies

Abstract

This paper constructs an endogenous growth model driven by self-ful…lling expectation shocks to explain the stylized fact that the average growth rate of GDP is related negatively to volatility and positively to capacity utilization. The implied welfare gain from further stabilizing the U.S. economy is about a quarter of annual consumption, which is consistent in order of magnitude with estimates based on the empirical studies of Ramey and Ramey (1995) and Alvarez and Jermann (2004). Hence, policies designed to reduce ‡uctuations can generate large welfare gains because smaller ‡uctuations are associated with permanently higher rates of growth.