Happiness is the same price as red bottoms? Welfare Cost of Business Cycle with Consumption Disasters

Sammanfattning: This paper constructs a model, calibrated towards the Swedish economy, with heterogeneous agents in the economy who make decisions to maximize their expected utilities, subjected both to aggregate risks and idiosyncratic risks. In setting up the model, I try to match the unit-root nature of total factor of productivity and the unit-root component in the aggregate consumption time series, with rare consumption disasters incorporated. The potential welfare from removing aggregate risks is much higher than Lucas' original estimates, hovering around three to ten percentage of an ordinary consumer's lifetime consumption. The cost associated with idiosyncratic risks are even greater. With proper parameterization, it can be over half of a consumer's lifetime consumption. By changing the interest rate, the government can increase society's welfare by reducing income disparity. Then I examine the effect of the existing policies in Sweden and find that it is a relatively efficient system that improves the welfare by more than thirty percent. A mixed strategy of monetary and fiscal policies is then proposed to increase the welfare, based on the cost and benefit analysis. Income disparity, in this model, is crucial in determining the welfare of the whole economy, and the government should spend more resource on curbing income disparity in order to improve the welfare for all.