Paper #836

Title:

Markups, gaps and the welfare costs of business fluctuations

Authors:

Jordi Galí, Mark Gertler and J. David López-Salido

Date:

May 2005

Abstract:

In this paper we present a simple theory-based measure of the variations in aggregate economic efficiency: the gap between the marginal product of labor and the household’s consumption/leisure tradeoff. We show that this indicator corresponds to the inverse of the markup of price over social marginal cost, and give some evidence in support of this interpretation. We then show that, with some auxilliary assumptions our gap variable may be used to measure the efficiency costs of business fluctuations. We find that the latter costs are modest on average. However, to the extent the flexible price equilibrium is distorted, the gross efficiency losses from recessions and gains from booms may be large. Indeed, we find that the major recessions involved large efficiency losses. These results hold for reasonable parameterizations of the Frisch elasticity of labor supply, the coefficient of relative risk aversion, and steady state distortions.

Keywords:

Business Cycles, Countercyclical Markups, Welfare Costs

JEL codes:

E32

Area of Research:

Macroeconomics and International Economics

Published in:

The Review of Economics and Statistics, February 2007, Vol. 89, No. 1, pp. 44-59

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