Welfare cost of business cycles

rdf:langString Welfare cost of business cycles

rdf:langString In macroeconomics, the cost of business cycles is the decrease in social welfare, if any, caused by business cycle fluctuations. Nobel economist Robert Lucas proposed measuring the cost of business cycles as the percentage increase in consumption that would be necessary to make a representative consumer indifferent between a smooth, non-fluctuating, consumption trend and one that is subject to business cycles. Under the assumptions that business cycles represent random shocks around a trend growth path, Robert Lucas argued that the cost of business cycles is extremely small, and as a result the focus of both academic economists and policy makers on economic stabilization policy rather than on long term growth has been misplaced. Lucas himself, after calculating this cost back in 1987, reoriented his own macroeconomic research program away from the study of short run fluctuations. However, Lucas' conclusion is controversial. In particular, Keynesian economists typically argue that business cycles should not be understood as fluctuations above and below a trend. Instead, they argue that booms are times when the economy is near its potential output trend, and that recessions are times when the economy is substantially below trend, so that there is a large output gap. Under this viewpoint, the welfare cost of business cycles is larger, because an economy with cycles not only suffers more variable consumption, but also lower consumption on average.