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Recursive Utility, Endogenous Growth, and the Welfare Cost of Volatility

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Author Info
Anne Epaulard (IMF Institute)
Aude Pommeret (Universite de Lausanne)

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Abstract

This paper proposes a measure of the welfare cost of volatility derived from a stochastic endogenous growth model extended to the case of a recursive utility function which disentangles risk aversion from intertemporal elasticity of substitution. The measure of the welfare cost of volatility takes into account not only the direct effect of volatility on expected utility but also the link between volatility and growth. It thus encompasses a direct welfare cost of fluctuations and a welfare cost due to the endogeneity of the consumption. We obtain a closed form solution for these two costs and show that the total welfare cost of volatility increases with both the risk aversion and the intertemporal elasticity of substitution. For plausible values of the agent's preference parameters, the cost of volatility may be greater than measures based on an exogenous process for consumption. However, when applied to the US economy, our measure shows little differences compared to the one derived under the assumption that the consumption process is exogenous. Yet, we show that this may not be the case for more volatile economies. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/S1094-2025(03)00016-4
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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 6 (2003)
Issue (Month): 3 (July)
Pages: 672-684
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Handle: RePEc:red:issued:v:6:y:2003:i:3:p:672-684

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Related research
Keywords: welfare costs of fluctuations; recursive utility; endogenous growth; risk;

Other versions of this item:

Find related papers by JEL classification:
E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
E60 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - General

References listed on IDEAS
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Full references

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. Robert M. Townsend & Kenichi Ueda, 2007. "Welfare Gains from Financial Liberalization," IMF Working Papers 07/154, International Monetary Fund. [Downloadable!]
  2. Olaf, POSCH & Klaus, WAELDE, 2005. "Natural volatility, welfare and taxation," Discussion Papers (ECON - Département des Sciences Economiques) 2005009, Université catholique de Louvain, Département des Sciences Economiques. [Downloadable!]
    Other versions:
  3. Ricardo Reis, 2005. "The Time-Series Properties of Aggregate Consumption: Implications for the Costs of Fluctuation," NBER Working Papers 11297, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  4. Gadi Barlevy, 2003. "The Cost of Business Cycles Under Endogenous Growth," NBER Working Papers 9970, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  5. Franck Portier & Luis A. Puch, . "The Welfare Cost of Business Cycles in an Economy with Nonclearing Markets," Working Papers 2005-18, FEDEA. [Downloadable!]
    Other versions:
  6. Gadi Barlevy, 2004. "The Cost of Business Cycles and the Benefits of Stabilization: A Survey," NBER Working Papers 10926, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  7. Pengfei Wang & Yi Wen, 2007. "Endogenous volatility, endogenous growth, and large welfare gains from stabilization policies," Working Papers 2006-032, Federal Reserve Bank of St. Louis. [Downloadable!]
  8. Gadi Barlevy, 2005. "The cost of business cycles and the benefits of stabilization," Economic Perspectives, Federal Reserve Bank of Chicago, issue Q I, pages 32-49. [Downloadable!]
  9. Aude POMMERET & William T. SMITH, 2004. "Fertility, Volatility, and Growth," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 04.08, Université de Lausanne, Faculté des HEC, DEEP. [Downloadable!]
    Other versions:
  10. Robert J. Barro, 2007. "Rare Disasters, Asset Prices, and Welfare Costs," NBER Working Papers 13690, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
    Other versions:
  11. Robert E. Lucas, 2003. "Macroeconomic Priorities," American Economic Review, American Economic Association, vol. 93(1), pages 1-14, March. [Downloadable!]
  12. Stéphane Pallage & Michel A. Robe & Catherine Bérubé, 2006. "The Potential of Foreign Aid as Insurance," IMF Staff Papers, Palgrave Macmillan Journals, vol. 53(3), pages 5. [Downloadable!] (restricted)
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