Asset Bubbles and the Cost of Economic Fluctuations

Abstract

Lucas (1987, 2003) estimates that the cost of economic fluctuations is low; a social planner would pay no more than 0.1% of (permanent) consumption to eliminate all future business cycle fluctuations. The current paper extends Lucas’ calculations by studying the costs of fluctuations arising from asset bubbles. We estimate two classes of costs: consumption volatility due to asset bubbles in a representative agent economy and consumption volatility that arises because households have heterogeneous exposure to the bubble assets. We show that the magnitude of welfare costs is primarily driven by the existence of heterogeneity. Our benchmark calibration implies that the asset bubbles of the last decade generated a social welfare cost equal to a permanent 3% reduction in the level of national consumption. If assets are held proportionately across the population, these welfare costs fall by an order of magnitude. Our calculations are sensitive to the details of the calibration, including the degree of balance sheet and trading heterogeneity, the coefficient of relative risk aversion, and the magnitude of the asset bubble. Our preferred specifications generate welfare costs ranging from 1% to 10% of (permanent) national consumption.