Individual Consumption Risk and the Welfare Cost of Business Cycles

Abstract

This paper measures the welfare gain from removing aggregate consumption fluctuations starting from an economy in which each individual faces both aggregate and idiosyncratic income shocks, and incomplete consumption insurance. We show that, because this welfare gain is a convex function of the overall consumption risk - aggregate plus idiosyncratic - that each individual faces, to gauge the magnitude of the gain, it is important to match individuals' overall risk prior to any policy. We also show that the convexity of the welfare gain function increases substantially if individual consumption risk contains a realistic random walk component. While being agnostic about how much consumption risk countercyclical policy can remove, we show that in an economy calibrated to match individuals' overall risk, even removing ten percent of aggregate fluctuations results in a large welfare gain. In fact, a sizable welfare gain arises even in the simple model used by Lucas (1987). We also review the previous literature that has found a low gain and argue that their estimates are low because they unrealistically assume that the idiosyncratic shocks to income are transitory. With transitory shocks, individuals can come close to perfect consumption insurance, thus undercutting the need for countercyclical policy.

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