Measuring the Cost of Business Cycles with Preferences that Rationalize the Equity Premium

Lucas (2003) argues that the potential gains from eliminating business cycle fluc-tuations are small, both in an absolute sense and when compared to the potential gains from other reforms. His estimates are obtained using standard preferences. In this paper, I show that a model consistent with observed data on asset returns leads to very different conclusions. Calibrating preferences to observed asset mar-ket data raises the estimated welfare gains from completely eliminating aggregate fluctuations by approximately two orders of magnitude. Most of the gains, however, come from the elimination of low frequency contributions. ∗Thanks to Alan Yang and SWEAT seminar participants at Toronto for their comments. "Once one starts thinking about [growth], it’s hard to think about any-thing else&quot