The welfare costs of business cycles unveiled: Measuring the extent of stabilization policies

Abstract

How can we measure the welfare benefit of ongoing stabilization policies? We develop a methodology to calculate the welfare cost of business cycles taking into account that observed consumption is partially smoothed. We propose a decomposition that disentangles consumption into a mix of laissez-faire and riskless components, decoupled by a parameter that captures the span of stabilization power. We estimate this parameter profiting from two distinct variance regimes measured in the historical consumption data and an identification strategy for the mapping between the span for each of these periods. In our preferred specification, we find that the welfare cost of total fluctuations is 11 percent of lifetime consumption, of which 82 percent is smoothed by the status quo policies, yielding a residual 1.8 percent of consumption to be tackled by policymakers.