Working Paper No. 08-31/r the (un)importance of Unemployment Fluctuations for the Welfare Cost of Business Cycles

This paper studies the cost of business cycles within a real business cycle model with search and matching frictions in the labor market. We endogenously link both the cyclical fluctuations and the mean level of unemployment to the aggregate business cycle risk. The key result of the paper is that business cycles are costly: Fluctuations over the cycle induce a higher average unemployment rate since employment is non-linear in the job-finding rate and the past unemployment rate. We show this analytically for a special case of the model. We then calibrate the model to U.S. data. For the calibrated model, too, business cycles cause higher average unemployment; the welfare cost of business cycles can easily be an order of magnitude larger than Lucas’ (1987) estimate. The cost of business cycles is the higher the lower the value of non-employment, or, respectively, the lower the disutility of work. The ensuing cost of business cycles rises further when workers’ skills depreciate during unemployment. JEL Classification System: E32,E24,J64