The Market Cost of Business Cycle Fluctuations

We propose a novel approach to measure the cost of aggregate economic fluctuations that does not require complete specification of investors’ risk preferences or their beliefs. With data on consumption and asset prices, an information-theoretic method is used to recover an information kernel (I-SDF). The I-SDF prices asset returns much better than tightly parametrized structural models, thereby offering a reliable candidate for the measurement of the welfare cost of business cycles. Our method enables the estimation of both the unconditional (or, average) cost of fluctuations, as well as the cost conditional on the state of the economy. We find that the cost of fluctuations is strongly time varying and countercyclical and that the cost of business cycle fluctuations is substantial, accounting for a quarter to a third of the cost of all consumption uncertainty.

This paper was accepted by Lukas Schmid, finance.

Supplemental Material: The online appendices and data files are available at https://doi.org/10.1287/mnsc.2023.00484.