Markups, Gaps, and the Welfare Costs of Business Fluctuations

Abstract

In this paper we present a simple, theory-based measure of the variations in aggregate economic efficiency associated with business fluctuations.We decompose this indicator, which we refer to as "the gap", into two constituent parts: a price markup and a wage markup, and show that the latter accounts for the bulk of the fluctuations in our gap measure.Finally, we derive a measure of the welfare costs of business cycles that is directly related to our gap variable, and which takes into account explicitly the existence of a varying aggregate inefficiency.When applied to postwar U.S. data, for plausible parametrizations, our measure suggests welfare losses of fluctuations that are of a higher order of magnitude than those derived by Lucas (1987).It also suggests that the major postwar recessions involved substantial efficiency costs.

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