Measuring the Ex-Ante Social Cost of Aggregate Volatility

Ex-ante cost of aggregate fluctuations consist of all individual and social cost expanded by optimizing agents aiming to prevent or reduce fluctuations of consumption. These are measured by the cost of resources used to attain the level of consumption volatility currently observed. This paper proposes that the ex-ante component of cost is important and large. The unifying principle in measuring these cost arises from the fact that agents utilize resources for reserves used for self insurance against uninsurable aggregate fluctuations. Firms accumulate excess capacity in response to fluctuations in demand; our financial sector uses substantial resources to mitigate the effect of market fluctuations and to permit aggregate risk sharing. We estimate that the order of magnitude of the ex-ante social cost of aggregate fluctuations exceeds 5% of GNP. Our formulation suggests that stabilization policy mitigates the effects of aggregate volatility by offering important insurance services. This complements the traditional view of stabilization policy as one designed to bolster the economy’s output so that it attains its potential by providing adequate demand. The insurance perspective of stabilization policy, which we offer here, suggests that without public policy each agent selects optimal private resources to be used for self insurance against aggregate volatility. Stabilization policy is then a public good which enables individual agents to reduce the private cost of self insurance.