On the Welfare Costs of Consumption Uncertainty

Date Published:

Abstract:

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 the 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. 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.

Notes: