TY  - JOUR
AU  - Alvarez,Fernando
AU  - Jermann,Urban J.
TI  - Using Asset Prices to Measure the Cost of Business Cycles
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 7978
PY  - 2000
Y2  - October 2000
UR  - http://www.nber.org/papers/w7978
L1  - http://www.nber.org/papers/w7978.pdf
N1  - Author contact info:
Fernando E. Alvarez
University of Chicago
Department of Economics
1126 East 59th Street
Chicago, IL 60637
Tel: 773/702-4412
Fax: 773/702-8490
E-Mail: f-alvarez1@uchicago.edu

Urban Jermann
Finance Department
Wharton School of the University of Pennsylvania
3620 Locust Walk
Philadelphia, PA  19104
Tel: 215/898-4184
Fax: 215/898-6200
E-Mail: jermann@wharton.upenn.edu
AB  - We propose a method to measure the welfare cost of economic fluctuations that does not require full specification of consumer preferences and instead uses asset prices.  The method is based on the marginal cost of consumption fluctuations, the per unit benefit of a marginal reduction in consumption fluctuations expressed as a percentage of consumption.  We show that this measure is an upper bound for the benefit of reducing all consumption 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 business 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.
ER  -