environmental protection rare disasters and discount rates the stern review s evaluation of environmental protection stresses low discount rates and uncertainty about environmental effects an appropriate model for analysing this uncertainty and the associated discount rates requires sufficient risk aversion and fat tailed uncertainty to account for the observed equity premium calibrations based on epstein zin preferences and existing analyses of rare macroeconomic disasters suggest that optimal environmental investment can be a significant share of gdp even with reasonable rates of time preference optimal environmental investment increases with risk aversion and the probability and typical size of environmental disasters but decreases with uncertainty about policy effectiveness

using asset prices to measure the cost of business cycles we measure the cost of consumption fluctuations using an approach that does not require the specification of preferences and instead uses asset prices we measure the marginal cost of consumption fluctuations the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of lifetime consumption we find that the gains from eliminating all consumption uncertainty are very large however for consumption fluctuations corresponding to business cycle frequencies we estimate the marginal cost to be between 0 08 percent and 0 49 percent of lifetime consumption

optimal liberalization of financial markets abstract as financial markets become completely liberalized countries gain from improved risk sharing but less wealthy countries can no longer profit from borrowing abroad at the lower rate and reinvesting at home at the higher rate with decreasing rather than constant returns to capital the gain from risk sharing is more likely to dominate the loss of the difference between the borrowing rate abroad and the decreasing reinvestment rate at home complete liberalization is likely to be optimal for less wealthy countries unless their labor endowment is large their productivity is large or holdings by foreigners are small as in china

trying to explain home bias in equities and consumption investors hold a substantially larger proportion of their wealth portfolios in domestic assets than standard portfolio theory would suggest a phenomenon called equity home bias in the absence of this bias investors would optimally diversify domestic output risk using foreign equities therefore consumption growth rates would tend to co move across countries even when output growth rates do not empirically however consumption growth rates tend to have a lower correlation across countries than do output growth rates a phenomenon i call consumption home bias in this paper i discuss these two biases and their potential relationship as suggested by the literature

costs of business cycles for unskilled workers abstract unskilled workers are subject to a much larger risk of unemployment during recessions than are skilled workers moreover unskilled workers earn less income which limits their ability to self insure we examine how this heterogeneity in unemployment risk and income across different skill groups translates into heterogeneity in the cost of business cycles we find that the welfare cost of business cycles for unskilled workers is substantially higher than the welfare cost for skilled workers

incentive problems and the pattern of international risk sharing abstract this paper analyzes the implications of moral hazard and a lack of contract enforcement for risk sharing across countries and regions we demonstrate that both incentive problems can considerably restrict efficient risk sharing however we show that the cross sectional risk sharing component is much more affected than the intertemporal component we argue that this may help to explain several stylized facts of international risk sharing such as the low degree of insurance against permanent shocks

volatility risk and economic welfare this paper examines the effects of time varying volatility on welfare i construct a tractable endogenous growth model with recursive preferences stochastic volatility and capital adjustment costs the model shows that a rise in volatility can decelerate growth in the absence of any level shocks in contrast to level risk which is always welfare reducing for a risk averse household volatility risk can increase or decrease welfare depending on model parameters when calibrated to u s data the model finds that the welfare cost of volatility risk is largely negligible under plausible model parameterizations

pooling risk among countries suppose that international sharing risk worldwide or with large numbers of countries were costly how much risk sharing could be gained in small sets or pools of countries to answer this question we compute the means and variances of poolwide gross domestic product growth for all possible pools of any size drawn from a sample of 74 countries and compare them with the means and variances of consumption growth in each country individually from the difference we infer potential diversification and welfare gains as much as two thirds of the first best full worldwide welfare gains can be obtained in groupings of as few as seven countries the largest potential gains arise from pools consisting of countries in different regions and including countries with weak institutions we argue that international risk sharing fails to emerge because the largest potential gains are among countries that do not trust each other s willingness and ability to abide by international contractual obligations

why do stocks and consumption imply such different gains from international risk sharing abstract estimates of the gains to international risk sharing based upon stock returns tend to find dramatically higher gains than do estimates from consumption based models in this paper i examine the reasons for these differences using a common theoretical framework for both approaches i find that the differences are largely due to the much higher variability of stock returns and its implied intertemporal substitution in marginal utility also contrary to conventional wisdom the differences in gains from the two approaches do not arise from treating stock returns as exogenous rather than endogenous

commodity trade and international risk sharing how much do financial markets matter abstract this paper evaluates the social gains from international risk sharing in some simple general equilibrium models with output uncertainty a simulation model calibrated to selected moments of u s and japanese data estimates the incremental loss from a ban on international portfolio diversification to be on the order of 0 20 percent of output per year even the theoretical gains from asset trade may disappear under alternative sets of assumptions on preferences and technology the paper argues that the small magnitude of potential trade gains may help explain the apparently inconsistent findings of empirical studies on the degree of international capital mobility

doubts or variability reinterpreting most of the market price of risk as a price of model uncertainty eradicates a link between asset prices and measures of the welfare costs of aggregate fluctuations that was proposed by hansen et al 1999 tallarini 2000 and alvarez and jermann 2004 prices of model uncertainty contain information about the benefits of removing model uncertainty not the consumption fluctuations that lucas 1987 2003 studied a max min expected utility theory lets us reinterpret tallarini s riskaversion parameter as measuring a representative consumer s doubts about the model specification we use model detection instead of risk aversion experiments to calibrate that parameter plausible values of detection error probabilities give prices of model uncertainty that approach the hansen and jagannathan 1991 bounds fixed detection error probabilities give rise to virtually identical asset prices as well as virtually identical costs of model uncertainty for tallarini s two models of consumption growth

the welfare cost of macroeconomic uncertainty in the post war period abstract with standard assumptions on preferences and a fully fledged econometric model we computed the welfare costs of macroeconomic uncertainty for post war u s using the beveridge nelson decomposition welfare costs are about 0 9 per capita consumption 175 77 a year and marginal welfare costs are about twice as large

volatility growth and welfare this paper constructs an endogenous growth model driven by self ful lling expectation shocks to explain the stylized fact that the average growth rate of gdp is related negatively to volatility and positively to capacity utilization the implied welfare gain from further stabilizing the u s economy is about a quarter of annual consumption which is consistent in order of magnitude with estimates based on the empirical studies of ramey and ramey 1995 and alvarez and jermann 2004 hence policies designed to reduce uctuations can generate large welfare gains because smaller uctuations are associated with permanently higher rates of growth

the consequences of rigid wages in search models the standard theory of equilibrium unemployment the mortensen pissarides search and matching model cannot explain the magnitude of the business cycle fluctuations in two of its central elements unemployment and vacancies modifying the model to make the present value of wages unresponsive to current labor market conditions amplifies fluctuations in unemployment and vacancies by an order of magnitude significantly improving the performance of the model despite this the welfare consequences of such rigid wages is negligible jel e24 e32 j30 j41 j63 j64

equilibrium consumption and precautionary savings in a stochastically growing economy abstract the derivation of a closed form solution for consumption based on the constant elasticity utility function in the presence of stochastic labor income has proved to be intractable this paper derives a closed form equilibrium relationship between consumption and wealth one that holds along a balanced growth path in a stochastic romer endogenous growth model by employing more general recursive preferences we can disentangle the coefficient of relative risk aversion from the intertemporal elasticity of substitution the effects of key structural parameters on equilibrium consumption and its tradeoff with leisure are analyzed a significant aspect of our analysis concerns the extent to which current risk in the economy is shared between labor and capital this plays an important role in determining the impact of risk on the economy in general and on consumption in particular formal analysis is supplemented with extensive numerical simulations

long dark shadows or innovative spirits the effects of smoothing business cycles on economic growth a survey of the literature abstract it is argued that fiscal policy can play a part in preventing a possible downward spiral or be instrumental in achieving a higher long term path of growth never before has this argument been advanced as frequently as in the current economic crisis however the economic literature an overview of which is given here does not provide an unambiguous answer either theoretically or empirically to the question of the relationship between the smoothing of cyclical fluctuations and long term growth in this context two main contrasting explanatory paradigms can be identified schumpeter s concept of creative destruction and the learning by doing hypothesis even if it were possible to identify the relationship more clearly on this basis it is important not to lose sight of the problems associated with the real time assessment of the current economic situation time lags and political economic incentives even in difficult times

how big are potential welfare gains from international risksharing abstract there is extensive evidence that risksharing across countries is far from perfect some have attributed this to small benefits from risksharing gains from riskpooling that have been reported range from negligible to enormous this paper documents to what extent the results are sensitive to the parameterization of preferences the stochastic process of the endowment and its measurement we find that gains from risksharing are quite sizable for realistic assumptions about the underlying factors for oecd countries they are equivalent to a permanent increase in tradables consumption in the range of 1 1 to 3 5 for a 50 year horizon and 2 5 to 7 4 for a 100 year horizon

asset bubbles and the cost of economic fluctuations lucas 1987 2003 estimates that the cost of economic fluctuations is low a social planner would pay no more than 0 1 of permanent consumption to eliminate all future business cycle fluctuations the current paper extends lucas calculations by studying the costs of fluctuations arising from asset bubbles we estimate two classes of costs consumption volatility due to asset bubbles in a representative agent economy and consumption volatility that arises because households have heterogeneous exposure to the bubble assets we show that the magnitude of welfare costs is primarily driven by the existence of heterogeneity our benchmark calibration implies that the asset bubbles of the last decade generated a social welfare cost equal to a permanent 3 reduction in the level of national consumption if assets are held proportionately across the population these welfare costs fall by an order of magnitude our calculations are sensitive to the details of the calibration including the degree of balance sheet and trading heterogeneity the coefficient of relative risk aversion and the magnitude of the asset bubble our preferred specifications generate welfare costs ranging from 1 to 10 of permanent national consumption

international risk sharing and european monetary unification abstract we explore income and consumption smoothing patterns among european community ec countries and among oecd countries during the period 1966 90 we find that for oecd as well as for ec countries about 40 percent of shocks to gdp are smoothed at the one year frequency with about half the smoothing achieved through national government budget deficits and half by corporate saving at the three year differencing frequency only 25 percent of shocks to gdp are smoothed mainly via government lending and borrowing in the absence of alternative income and consumption smoothing mechanisms the restrictions on budget deficits imposed by the maastricht treaty should be relaxed to allow governments to run large temporary deficits in response to output shocks

rationalizable strategic behavior and the problem of perfection this paper explores the fundamental problem of what can be inferred about the outcome of a noncooperative game from the rationality of the players and from the information they possess the answer is summarized in a solution concept called rationalizability strategy profiles that are rationalizable are not always nash equilibria conversely the information in an extensive form game often allows certain unreasonable nash equilibria to be excluded from the set of rationalizable profiles a stronger form of rationalizability is appropriate if players are known to be not merely rational but also cautious what constitutes rational behavior in a noncooperative strategic situation this paper explores the issue in the context of a wide class of finite noncooperative games in extensive form the traditional answer relies heavily upon the idea of nash equilibrium nash 17 the position developed here however is that as a criterion for judging a profile of strategies to be reasonable choices for players in a game the nash equilibrium property is neither necessary nor sufficient some nash equilibria are intuitively unreasonable and not all reasonable strategy profiles are nash equilibria the fact that a nash equilibrium can be intuitively unattractive is well known the equilibrium may be imperfect introduced into the literature by selten 20 the idea of imperfect equilibria has prompted game theorists to search for a narrower definition of equilibrium while this research some of which will be discussed here has been extremely instructive it remains inconclusive theorists often agree about what should happen in particular games but to capture this intuition in a general solution concept has proved to be very difficult if this paper is successful it should make some progress in that direction the other side of the coin has received less scrutiny can all non nash profiles really be excluded on logical grounds i believe not the standard justifications for considering only nash profiles are circular in nature or make gratuitous assumptions about players decision criteria or beliefs the following discussion of these points is extremely brief due to space constraints more detailed arguments may be found in pearce 18

financial integration and growth in a risky world abstract we revisit the debate on the benefits of financial integration in a two country neoclassical growth model with aggregate uncertainty the framework accounts simultaneously for gains from a more efficient capital allocation and gains from risk sharing together with their interaction global numerical methods allow for meaningful welfare comparisons gains from integration are quantitatively small even for riskier and capital scarce emerging economies these countries import capital for efficiency reasons before exporting it for self insurance leading to capital flows and growth reversals along the transition this opens the door to richer empirical implications than previously considered in the literature

welfare gains from international risksharing abstract this paper uses consumption data to compute yet unexploited welfare gains that can be achieved through risksharing among twenty oecd countries there is both aggregate national consumption risk and nondiversifiable individual specific risk countries engage in an optimal risksharing arrangement to pool risk associated with the aggregate consumption endowment streams welfare gains are associated with reduced consumption variability and with the international pricing of the consumption streams of individual countries the paper considers the standard vnm time additive preferences as well as nonexpected utility and habit formation preferences large unexploited gains are found under all sets of preferences leading to an international risksharing puzzle

the spirit of capitalism asset pricing and growth in a small open economy abstract conventional models of economic behavior have failed to account for a number of observed empirical regularities in macroeconomics and international economics this may be due to preference specifications in conventional models in this paper we consider preferences with the spirit of capitalism the desire to accumulate wealth as a way of acquiring status we analyze a number of potential effects of international catching up and the spirit of capitalism on savings growth portfolio allocation and asset pricing moreover we obtain a multi factor capital asset pricing model capm our results show that status concerns have non trivial effects on savings growth portfolio allocation asset prices and the foreign exchange risk premium

evaluating risky consumption paths the role of intertemporal substitutability abstract in dynamic stochastic welfare comparisons a failure clearly to distinguish between risk aversion and intertemporal substitutability can result in misleading assessments of the impact of risk aversion on the welfare costs of consumption risk changes the problem arises in any setting in which uncertainty is propagated over time notably but not exclusively in economies with stochastic consumption trends regardless of the preference setup adopted an increase in risk aversion amplifies the per period costs of risks the weights consumers use to cumulate the per period costs of risks with persistent effects should however depend on intertemporal substitutability as well as on risk aversion under time separable expected utility preferences an increase in the period utility function s curvature therefore alters the welfare effect of risk for reasons that are in part unrelated to risk aversion to illustrate these points i reconsider lucas s estimate of the cost of consumption instability for the postwar united states

rare disasters asset prices and welfare costs a representative consumer model with epstein zin weil preferences and i i d shocks including rare disasters accords with observed equity premia and risk free rates if the coefficient of relative risk aversion equals 3 4 if the intertemporal elasticity of substitution exceeds one an increase in uncertainty lowers the price dividend ratio for equity and a rise in the expected growth rate raises this ratio calibrations indicate that society would willingly reduce gdp by around 20 percent each year to eliminate rare disasters the welfare cost from usual economic fluctuations is much smaller though still important corresponding to lowering gdp by about 1 5 percent each year

the time series properties of aggregate consumption implications for the costs of fluctuations the properties of the stochastic process followed by aggregate consumption affect the estimates of the costs of fluctuations this paper pursues two approaches to modeling consumption dynamics and measuring how much society dislikes fluctuations one statistical and one economic the statistical approach estimates the properties of consumption and calculates the costs of having consumption fluctuating around its mean growth the paper finds that persistence is a crucial determinant of the costs and that the high persistence in the data severely distorts conventional measures it shows how to compute valid estimates and confidence intervals the economic approach uses a calibrated model of optimal consumption and measures the costs of eliminating income shocks this uncovers a further cost of uncertainty through its impact on precautionary savings and investment the two approaches lead to costs of fluctuations that are higher than the common wisdom between 0 5 and 5 of per capita consumption jel e32 e21 e60

taxation risk taking and growth a continuous time stochastic general equilibrium analysis with labor leisure choice abstract this paper investigates the equilibrium relationship between taxation portfolio choice risk taking and capital accumulation specifically it examines how taxes affect risk taking and capital accumulation we extend the existing literature by relaxing two crucial assumptions in modelling risk taking behavior i that the investment opportunity set is fixed and ii that there is no distinction between attitudes towards risk and behavior towards intertemporal substitution we extend the investment opportunity set of individuals through optimally determined human capital and distinguish intertemporal substitution from attitudes towards risk via a recursive utility function in the presence of these extensions the paper successfully derives a closed form solution to the stochastic growth model with stochastic wage income

on the welfare costs of business cycle fluctuations and economic growth variation in the 20th century and beyond lucas 1987 has shown a surprising result in business cycle research the welfare cost of business cycles are very small our paper has several original contributions first in computing welfare costs we propose a novel setup that separates the eects of uncertainty stemming from business cycle uctuations and economic growth variation second we extend the sample from which to compute the moments of consumption the whole of the literature chose primarily to we gratefully acknowledge the comments of caio almeida carlos e da costa robert f engle pedro c ferreira antonio fiorencio rodolfo manuelli samuel pessoa and octavio tourinho on this or on earlier versions of this paper all errors are ours we thank cnpq brazil faperj and inct for nancial support y corresponding author

perturbation solution and welfare costs of business cycles in dsge models abstract lucas 1987 argues that the removal of cyclical fluctuations would barely improve economic welfare he considers a risk averse consumer valuing exogenously given streams of consumption c t c e g t e 2 2 t driven by an iid sequence of draws t from a standard normal distribution this allows him to change the size 2 of the fluctuations without changing the mean of the process in production economies too uncertainty is typically introduced in form of multiplicative log normally distributed shocks so that mean preserving spreads can be analyzed in an analogous way however only few stochastic dynamic general equilibrium dsge models admit an analytic solution the most prevalent method to solve these models perturbation methods obtain an approximation to the stochastic model by perturbing the solution of the model s deterministic counterpart with respect to the uncertainty parameter yet widely available formulae to compute perturbation solutions are based only on the perturbation of t and do not adequately capture the additional deviation 2 2 in the mean between the stochastic model and its deterministic version we show within a model admitting an analytical solution that a second order approximation of the welfare criterion also requires to perturb the mean thus welfare measures based on the standard procedures for second order solutions are seriously biased by a purely exogenous mean effect we develop a general procedure of computing second order accurate approximations of welfare gains or losses in the canonical dsge model by extending the computation of second order solutions pioneered by schmitt grohe and uribe 2004 to allow for mean preserving increases in the size of shocks we apply our method to the model considered by cho et al 2015 and show that different from the results reported by these authors removing the cycle is always welfare improving welfare measures computed from weighted residuals methods confirm the logic behind our perturbation approach and verify the accuracy of our estimates

cost of business cycles with indivisibilities and liquidity constraints it is almost universally agreed that individuals face incomplete insurance markets and cannot perfectly insure against the idiosyncratic risk in this paper simple general equilibrium models with incomplete insurance markets are examined in order to assess the impact of imperfect insurance on the magnitude of the welfare costs of business cycles two versions of incomplete insurance markets are considered and certain statistical properties of the equilibrium stochastic processes in these environments are compared with those of a perfect insurance economy

on the welfare cost of economic fluctuations in developing countries macroeconomic fluctuations are much stronger in developing countries than in the united states yet while a large literature debates the welfare cost of economic fluctuations in the united states it remains an open question how large that cost is in developing countries using several models we provide such a measure we find that the welfare cost of consumption volatility per se is far from trivial and averages a substantial multiple of the corresponding u s estimate moreover in many poor countries the welfare gain from eliminating volatility may in fact exceed the welfare gain from an additional percentage point of growth forever

seigniorage as a tax a quantitative evaluation in this paper we construct a computable general equilibrium model calibrate it to selected data for the american economy and use it to explore the efficacy of the seigniorage tax associated with various monetary arrangements we find that the key feature of any monetary tax arrangement is its equilibrium after tax real return schedule on liquid assets held by the households we also find that considerable seigniorage which we define to be the diserence between government expenditures other than interest paid on government debt and taxes collected can be large we find that the seigniorage tax is a poor one relative to a tax on labor income ln particular we find that if the after tax real return on saving deposits is 5 percent as it was on average in the 1974 1978 period welfare is one half percent of consumption lower than it would be if the after tax real return were zero as it approximately was in both the 1964 1968 and 19841988 periods the work builds on that of a imrohoroglu 1990 who finds that for worlds in which non interest bearing nominal assets are the only liquid assets the cost of constant inflation is far greater than the area under the empirical demand for money relation with such arrangements the after tax real return is the negative of the inflation rate the key feature of her model is that agents hold money in order to smooth consumption in the face of idiosyncratic income variability for which there

home bias and international risk sharing twin puzzles separated at birth abstract we document that international home bias in debt and equity holdings declined during the period 1993 2003 at the same time as international risk sharing increased using panel data regressions for oecd countries we demonstrate that less home bias is associated with more international risk sharing more generally we show that more financial integration is associated with more risk sharing when we measure financial integration as the ratio of foreign assets to gross domestic product our results indicate that risk sharing and international financial integration are closely related empirical phenomena

the cost of business cycles under endogenous growth robert e lucas jr argued that the welfare gains from reducing aggregate consumption volatility are negligible subsequent work that revisited his calculation continued to find small welfare benefits further reinforcing the perception that business cycles do not matter this paper argues instead that fluctuations can affect welfare by affecting the growth rate of consumption i show that fluctuations can reduce growth starting from a given initial consumption which can imply substantial welfare effects as lucas himself observed empirical evidence suggests the welfare effects are likely to be substantial about two orders of magnitude greater than lucas original estimates

intertemporal substitution risk aversion and economic performance in a stochastically growing open economy abstract the constant elasticity utility function implies that the intertemporal elasticity of substitution is the inverse of the coefficient of relative risk aversion with empirical evidence suggesting that this relationship may or may not hold studies of risk and growth should decouple these two parameters this paper provides an analytical characterization and numerical simulations of the equilibrium of a stochastically growing small open economy under general recursive preferences we show that errors committed by using the constant elasticity utility function even for small violations of the compatibility condition can be substantial our results suggest that the constant elasticity utility function should be employed with caution