Welfare Cost of Business Cycles When Markets are Incomplete

This paper analyzes the welfare costs of business cycles when workers face uninsurable idiosyncratic labor income risk that has a cyclical component. In accordance with the previous literature, this paper decomposes individual labor income risk into an aggregate and an idiosyncratic component and assumes that these two components are stochastically independent. In contrast to the previous literature, this paper allows the idiosyncratic component to be multi-dimensional. The paper shows that the extension to the case of multidimensional risk increases the welfare costs of business cycles if the relative importance of the individual sources of idiosyncratic risk varies over the business cycle. For the case of worker displacement with logutility preferences, the introduction of multiple sources of idiosyncratic risk can increase the welfare cost of business cycles from .3% (the one-dimensional case) to up to 1.4%. In other words, the introduction of multiple sources of idiosyncratic risk has the potential to increase the welfare costs of business cycles substantially. JEL Classification: D52, E32