Research Discussion Papers, Bank of Finland
No 25/2012:
Welfare cost of business cycles in economies with individual consumption risk
Martin Ellison ()
and Thomas J. Sargent ()
Abstract: The welfare cost of random consumption fluctuations is
known from De Santis (2007) to be increasing in the level of individual
consumption risk in the economy. It is also known from Barillas et al.
(2009) to increase if agents in the economy care about robustness to model
misspecification. In this paper, we combine these two effects and calculate
the cost of business cycles in an economy with consumers who face
individual consumption risk and who fear model misspecification. We find
that individual risk has a greater impact on the cost of business cycles if
agents already have a preference for robustness. Correspondingly, we find
that endowing agents with concerns about a preference for robustness is
more costly if there is already individual risk in the economy. The
combined effect exceeds the sum of the individual effects.
Keywords: cost of business cycles; idiosyncratic risk; model uncertainty; robustness; (follow links to similar papers)
JEL-Codes: D81; E32; E63; (follow links to similar papers)
19 pages, July 30, 2012
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