Welfare Cost of Business Cycle and the Dynamics of Consumption Variance

Abstract

This paper investigates the welfare cost of business cycles in the U.S. economy over the period 1959–2019. In contrast to the existing literature, we allow for both structural breaks in the unconditional variance of consumption shocks and conditional heteroskedasticity. Our results provide strong evidence of structural breaks associated with distinct regimes in the consumption process, but no evidence of heteroskedasticity. Taking these regimes into account, we find that the welfare cost of business cycles declines substantially between the initial and the final regime. In our preferred specification under unitary relative risk aversion, the estimated welfare cost falls from 0.60 % to 0.12 % of consumption, suggesting that the marginal welfare gain from eliminating the remaining uncertainty faced by consumers has become very small.