Paper #890

Title:

Stabilization versus insurance: Welfare effects of procyclical taxation under incomplete markets

Authors:

James S. Costain and Michael Reiter

Date:

November 2004 (Revised: August 2005)

Abstract:

We construct and calibrate a general equilibrium business cycle model with unemployment and precautionary saving. We compute the cost of business cycles and locate the optimum in a set of simple cyclical fiscal policies. Our economy exhibits productivity shocks, giving firms an incentive to hire more when productivity is high. However, business cycles make workers' income riskier, both by increasing the unconditional probability of unusually long unemployment spells, and by making wages more variable, and therefore they decrease social welfare by around one-fourth or one-third of 1% of consumption. Optimal fiscal policy offsets the cycle, holding unemployment benefits constant but varying the tax rate procyclically to smooth hiring. By running a deficit of 4% to 5% of output in recessions, the government eliminates half the variation in the unemployment rate, most of the variation in workers'aggregate consumption, and most of the welfare cost of business cycles.

Keywords:

Real business cycles, matching, precautionary saving, unemployment insurance, fiscal policy, incomplete markets, heterogeneity, computation

JEL codes:

E24, E32, E62, E63, H21, J64, J65

Area of Research:

Macroeconomics and International Economics

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