| Satyajit Chatterjee, Federal Reserve Bank of Philadelphia Dean Corbae, Universiity of Pittsburgh |
| The Welfare Gains of Eliminating a Depression-like State |
| Session: C-10-16 Tuesday 15 August 2000 by Corbae, Dean |
| The aim of our paper is to examine the potential welfare costs of infrequent but large declines in economic activity. In particular, the large decline in economic activity we have in mind is of the sort which occurred in the U.S. during the Depression years. We find that even if the probability of falling into a Depression-like state is very small (one-twentieth of one percent), the potential welfare cost stemming from this possibility can range between 0.6 to 1.1 percent of annual consumption. This loss is more than 80 times the welfare cost of cyclical fluctuations calculated by Lucas (for comparable risk aversion parameter) and is of the same order of magnitude as some estimates of the welfare loss from the taxation of capital income. These results are obtained for an environment that resembles the one in Imrohoroglu (1989). There are a large number of workers who encounter stochastic employment opportunities. The probability of finding employment depends on the aggregate state of the economy. One of these aggregate states corresponds to a Depression-like outcome where the probability of finding employment in the private market sector is substantially and persistently low relative to the other aggregate states. Workers cannot buy insurance against shocks to their employment status, but they can self-insure themselves by costlessly storing the single consumption good. The welfare loss from the possibility of a Depression-like state is calculated as the fraction of consumption workers are willing to pay to live in an environment with zero probability of a Depression-like state. |