NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

On the Welfare Costs of Consumption Uncertainty

Robert J. Barro

NBER Working Paper No. 12763
Issued in December 2006
NBER Program(s):   EFG   ME   PE

Satisfactory calculations of the welfare cost of aggregate consumption uncertainty require a framework that replicates major features of asset prices and returns, such as the high equity premium and low risk-free rate. A Lucas-tree model with rare but large disasters is such a framework. In a baseline simulation, the welfare cost of disaster risk is large -- society would be willing to lower real GDP by about 20% each year to eliminate all disaster risk, including wars. In contrast, the welfare cost from usual economic fluctuations is much smaller, though still important -- corresponding to lowering GDP by around 1.5% each year.

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Document Object Identifier (DOI): 10.3386/w12763

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