Using Asset Prices to Measure the Cost of Business Cycles

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Abstract
We propose a method to measure the welfare cost of economic fluctu- ations that does not require full specification of consumer preferences and instead uses asset prices. The method is based on the marginal cost of con- sumption fluctuations, the per unit benefit of a marginal reduction in con- sumption fluctuations expressed as a percentage of consumption. We show that this measure is an upper bound for the benefit of reducing all consump- tion fluctuations. We also clarify the link between the cost of consumption uncertainty, the equity premium, and the slope of the real term structure. To measure the marginal cost of fluctuations, we fit a variety of pricing kernels that reproduce key asset pricing statistics. We find that consumers would be willing to pay a very high price for a reduction in overall consumption uncertainty. However, for consumption fluctuations corresponding to busi- ness cycle frequencies, we estimate the marginal cost to be about 0.55% of lifetime consumption based on the period 1889—1997 and about 0.30% based on 1954—97.

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