Scandinavian Working Papers in Economics
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Bank of Finland 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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