Markups and the Welfare Cost of Business Cycles: A Reappraisal

Journal article: Gali et al. (2007) have recently shown quantitatively that fluctuations in the efficiency of resource allocation do not generate sizable welfare costs. In their economy, which is distorted by monopolistic competition in the steady state, we show that they underestimate the welfare cost of these fluctuations by ignoring the negative effect of aggregate volatility on average consumption and leisure. As monopolistic suppliers, both firms and workers aim to preserve their expected markups; the interaction between aggregate fluctuations and price-setting behavior results in average consumption and employment levels that are lower than their counterparts in the flexible-price economy. This level effect increases the efficiency cost of business cycles. It is all the more sizable with the degree of inefficiency in the steady state, lower labor-supply elasticities, and when prices instead of wages are rigid.

Author(s)

Jean-Olivier Hairault, François Langot

Journal
  • Journal of Money, Credit and Banking
Date of publication
  • 2012
Keywords JEL
E12 E32
Keywords
  • Business cycle costs
  • Inefficiency gap
  • New-Keynesian Macroeconomics
Pages
  • 995-1014
Version
  • 1
Volume
  • 44