The Cost of Business Cycles Under Endogenous Growth

Abstract

Robert E. Lucas, Jr. argued that the welfare gains from reducing aggregate consumption volatility are negligible. Subsequent work that revisited his calculation continued to find small welfare benefits, further reinforcing the perception that business cycles do not matter. This paper argues instead that fluctuations can affect welfare, by affecting the growth rate of consumption. I show that fluctuations can reduce growth starting from a given initial consumption, which can imply substantial welfare effects as Lucas himself observed. Empirical evidence suggests the welfare effects are likely to be substantial, about two orders of magnitude greater than Lucas' original estimates.

Matching frictions, unemployment dynamics and the cost of business cycles

“…This shows a clear difference from our paper: we aim at unveiling in the basic matching model the mechanisms which lead to business cycle costs, namely the stock-flow unemployment dynamics and the congestion effects due to decreasing marginal returns in the matching function. Although the implied business cycle costs are weaker than in recent studies (Krebs (2007), Reis (2009) and Barlevy (2004) for instance), the effect of aggregate fluctuations on the employment level adds to the list of factors missing from Lucas's argument, and would indicate more substantial welfare costs from business cycles.…”

“…This result is completely at odds with the neoclassical synthesis and the Keynesian legacies, but also, to a lesser extent, with a recent literature that documents far larger costs of business cycles (Beaudry and Pages (1999), Krebs (2007), Storesletten et al (2001), Barlevy (2004), De Santis (2007 and Krusell et al (2009)). …”

“…Ramey and Ramey (1993) explore this mechanism in a model where firms have to pre-commit to a specific technology before starting production. Stabilization may also increase welfare through its effect on capital accumulation (Matheron and Maury (2000), Epaulard and Pommeret (2003) and Barlevy (2004)). Finally, a very recent paper by Jung and Kuester (2008) emphasizes the non-linear relation between unemployment and the job finding rate.…”

Individual Experience of Positive and Negative Growth is Asymmetric: Global Evidence from Subjective Well-Being Data

“…A growing number of scholars, however, question the notion that the welfare cost of business cycles would be negligible and provide evidence to the contrary (see e.g. Yellen and Akerlof, 2006;Barlevy, 2004;De Santis, 2007). Wolfers (2003) actually uses subjective well-being measures to estimate the welfare cost of business cycle volatility with regards to unemployment and inflation.…”

The Credibility of Fiscal Rules Policy and Business Cycle Volatility

“…In fact, the fluctuations of the output growth crucially determine a large number of economic outcomes (Giovanni and Levchenko, 2009) and therefore also the perceived success or failure of economic policies. Higher output volatility is shown to be connected to lower private investment (Aizenman and Marion, 1999), substantial welfare effects (Barlevy, 2004), and eventually also to lower long-run economic growth (e.g., Ramey and Ramey, 1995;Imbs, 2007).…”