Welfare cost of business cycles
In macroeconomics, the cost of business cycles is the decrease in social welfare, if any, caused by business cycle fluctuations.
Nobel economist Robert Lucas proposed measuring the cost of business cycles as the percentage increase in consumption that would be necessary to make a representative consumer indifferent between a smooth, non-fluctuating, consumption trend and one that is subject to business cycles.
Under the assumptions that business cycles represent random shocks around a trend growth path, Robert Lucas argued that the cost of business cycles is extremely small,[1][2] and as a result the focus of both academic economists and policy makers on economic stabilization policy rather than on long term growth has been misplaced.[3][4] Lucas himself, after calculating this cost back in 1987, reoriented his own macroeconomic research program away from the study of short run fluctuations.
However, Lucas' conclusion is controversial. In particular, Keynesian economists typically argue that business cycles should not be understood as fluctuations above and below a trend. Instead, they argue that booms are times when the economy is near its potential output trend, and that recessions are times when the economy is substantially below trend, so that there is a large output gap.[4][5] Under this viewpoint, the welfare cost of business cycles is larger, because an economy with cycles not only suffers more variable consumption, but also lower consumption on average.
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However, a major problem related to the above way of estimating (hence ) and in fact, possibly to Lucas' entire approach is the so-called equity premium puzzle, first observed by Mehra and Prescott in 1985.[8] The analysis above implies that since macroeconomic risk is unimportant, the premium associated with systematic risk, that is, risk in returns to an asset that is correlated with aggregate consumption should be small (less than 0.5 percentage points for the values of risk aversion considered above). In fact the premium has averaged around six percentage points.
In a survey of the implications of the equity premium, Simon Grant and John Quiggin note that 'A high cost of risk means that
recessions are extremely destructive'.[9]
Evidence from effects on subjective wellbeing[edit]
Justin Wolfers has shown that macroeconomic volatility reduces subjective wellbeing; the effects are somewhat larger than expected under the Lucas approach. According to Wolfers, 'eliminating unemployment volatility would raise well-being by an amount roughly equal to that from lowering the average level of unemployment by a quarter of a percentage point'.[10]