The costs of business cycles with market incompleteness I

Abstract

This paper re-examines the welfare costs of busness cylces with market incompleteness. We show that the consideration of limited asset market participation in a real business cycle model makes it possible for welfare costs to increase substantially in response to business cycle risks. A high Sharpe ratio, i.e. the risk-return trade-off in financial markets is key to generating welfare estimates two orders of magnitude larger than Lucas (1987)'s ones.