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Heterogeneous Risk Preferences and the Welfare Cost of Business Cycles
1Department of Economics and Woodrow Wilson School of Public and International Affairs, Princeton University, 363 Wallace Hall, Princeton, NJ 08544.
Review of Economic Dynamics
|June 29, 2011
Summary
Business cycles have minimal welfare costs when complete insurance markets exist. Even highly risk-averse individuals experience small losses, making aggregate consumption fluctuations largely irrelevant for overall economic welfare.
Area of Science:
- Economics
- Macroeconomics
- Financial Economics
Background:
- Business cycles traditionally pose significant welfare costs.
- Previous research, like Lucas (1987), found these costs were small for the average person.
- Heterogeneity in risk aversion and the role of insurance markets were not fully explored in this context.
Purpose of the Study:
- To investigate the welfare cost of business cycles in a complete-markets economy.
- To analyze how heterogeneous risk aversion affects welfare costs.
- To determine the relevance of aggregate consumption fluctuations under different risk preferences.
Main Methods:
- Developed a complete-markets economic model.
- Incorporated varying degrees of risk aversion among individuals.
- Analyzed the impact of insurance trading against aggregate risk.
- Estimated welfare losses using empirical data.
Main Results:
- Complete insurance markets significantly reduce the welfare cost of business cycles for all individuals.
- Less risk-averse individuals can benefit from business cycles by selling insurance.
- Even infinitely risk-averse individuals face only finite and small welfare losses.
Conclusions:
- Aggregate risk per se is largely irrelevant to welfare when complete insurance markets are present.
- The welfare cost of business cycles is primarily driven by productivity shocks or uninsured idiosyncratic risks, not aggregate consumption volatility.
- Heterogeneity in risk aversion and the functioning of insurance markets are crucial for mitigating the economic impact of business cycles.
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