Job Displacement Risk and the Cost of Business Cycles

This paper analyzes the welfare costs of business cycles when workers face uninsurable job displacement risk that has a cyclical component. Using a simple general equilibrium model with incomplete markets, this paper shows the following result: for sufficiently high degree of risk aversion (at least one), cyclical variations in the long-term earnings losses of displaced workers can generate arbitrarily large cost of business cycles even if the second moments of the distribution of individual income changes are constant over the cycle. Thus, the previous literature, which has either disregarded long-term earnings losses of displaced workers or dealt with them only indirectly using second-moment analysis, might have severely under-estimated the welfare cost of business cycles. In addition to the theoretical analysis, this paper also conducts a quantitative study of the cost of business cycles using empirical evidence on the long-term earnings losses of U.S. workers. The quantitative analysis suggests that cyclical variations in job displacement risk generate sizable cost of business cycles. JEL Classification: E21, E32, E63, D52