Job Displacement Risk and the Cost of Business Cycles

This paper analyzes the welfare costs of business cycles when workers face uninsurable job displacement risk. The paper uses a simple macroeconomic model with incomplete markets to show that cyclical variations in the long-term earnings losses of displaced workers can generate arbitrarily large cost of business cycles even if the variance of individual income changes is constant over the cycle. In addition to the theoretical analysis, this paper conducts a quantitative study of the cost of business cycles using empirical evidence on the long-term earnings losses of US workers. The quantitative analysis shows that realistic variations in job displacement risk generate sizable costs of business cycles, even though a second-moment analysis would suggest negligible costs. (JEL E21, E24, E32, J63)