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Multi-Dimensional Risk and the Cost of Business Cycles

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Author Info
Tom Krebs (University of Mannheim)

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Abstract

This paper analyzes the welfare costs of business cycles when workers face uninsurable idiosyncratic labor income risk. In accordance with the previous literature, this paper decomposes labor income risk into an aggregate and an idiosyncratic component, but in contrast to the previous literature, this paper allows for multiple sources of idiosyncratic labor income risk. Using the multi-dimensional approach to idiosyncratic risk, this paper provides a general characterization of the welfare cost of business cycles when preferences and the (marginal) process of individual labor income in the economy with business cycles are given. The general analysis shows that the introduction of multiple sources of idiosyncratic risk never decreases the cost of business cycles, and strictly increases it if there are cyclical fluctuations across the different sources of risk. This paper also provides a quantitative analysis based on a version of the model that is calibrated to match U.S. labor market data. The quantitative analysis suggests that realistic variations across two particular dimensions of idiosyncratic labor income risk increase the welfare cost of business cycles by a substantial amount. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2006.07.002
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Publisher Info
Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 9 (2006)
Issue (Month): 4 (October)
Pages: 640-658
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Handle: RePEc:red:issued:05-39

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Related research
Keywords: Cost of business cycles Labor market risk Incomplete markets

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Find related papers by JEL classification:
D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
E21 - Macroeconomics and Monetary Economics - - Macroeconomics: Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization

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    Other versions:
  2. Heaton, John & Lucas, Deborah J, 1996. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," Journal of Political Economy, University of Chicago Press, vol. 104(3), pages 443-87, June. [Downloadable!] (restricted)
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  4. Krebs, Tom, 2004. "Testable implications of consumption-based asset pricing models with incomplete markets," Journal of Mathematical Economics, Elsevier, vol. 40(1-2), pages 191-206, February. [Downloadable!] (restricted)
  5. Alon Brav & George M. Constantinides & Christopher C. Geczy, 2002. "Asset Pricing with Heterogeneous Consumers and Limited Participation: Empirical Evidence," NBER Working Papers 8822, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  6. David K. Levine & William R. Zame, 2002. "Does Market Incompleteness Matter?," Econometrica, Econometric Society, vol. 70(5), pages 1805-1839, September. [Downloadable!] (restricted)
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  7. Andrew Atkeson & Christopher Phelan, 1994. "Reconsidering the Costs of Business Cycles with Incomplete Markets," NBER Working Papers 4719, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  8. Tom Krebs, 2003. "Growth and Welfare Effects of Business Cycles in Economies with Idiosyncratic Human Capital Risk," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 846-868, October. [Downloadable!] (restricted)
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  10. Jacobson, Louis S & LaLonde, Robert J & Sullivan, Daniel G, 1993. "Earnings Losses of Displaced Workers," American Economic Review, American Economic Association, vol. 83(4), pages 685-709, September. [Downloadable!] (restricted)
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  11. Tom Krebs, 2003. "Human Capital Risk And Economic Growth," The Quarterly Journal of Economics, MIT Press, vol. 118(2), pages 709-744, May. [Downloadable!] (restricted)
  12. Deaton, Angus, 1991. "Saving and Liquidity Constraints," Econometrica, Econometric Society, vol. 59(5), pages 1221-48, September. [Downloadable!] (restricted)
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  13. Gadi Barlevy & Daniel Tsiddon, 2004. "Earnings inequality and the business cycle," Working Paper Series WP-04-08, Federal Reserve Bank of Chicago. [Downloadable!]
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  14. Beaudry, Paul & Pages, Carmen, 2001. "The cost of business cycles and the stabilization value of unemployment insurance," European Economic Review, Elsevier, vol. 45(8), pages 1545-1572, August. [Downloadable!] (restricted)
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  15. Carroll, Christopher D. & Samwick, Andrew A., 1997. "The nature of precautionary wealth," Journal of Monetary Economics, Elsevier, vol. 40(1), pages 41-71, September. [Downloadable!] (restricted)
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  16. Hubbard, R. Glenn & Skinner, Jonathan & Zeldes, Stephen P., 1994. "The importance of precautionary motives in explaining individual and aggregate saving," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 40(1), pages 59-125, June. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Per Krusell & Toshihiko Mukoyama & Ayseg ul Sahin, 2007. "Labor-Market Matching with Precautionary Savings and Aggregate Fluctuations," Levine's Bibliography 122247000000001783, UCLA Department of Economics. [Downloadable!]
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