Published and unpublished papers by Wei Xiao

Prospect Theory and the Welfare Cost of Business Cycles

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Jointly with Nazneen Ahmad. Southwestern Journal of Economics 10 (2007), 3 – 24 (Download).

According to Lucas’s provocative argument, the welfare cost of business cycles is negligible. In this paper we re-investigate this issue by incorporating features of the Prospect Theory into individual preferences. The Prospect Theory proposes that agents care about the changes in their wealth rather than the level of their wealth, and they are also more sensitive to losses in their financial wealth than gains. We find in our empirical test that an individual investor would give up about 6% of the returns she receives from risky investment to eliminate all fluctuations in her assets. We take this as an indication that the costs of business cycles are much larger than what Lucas suggests.


Written by wxiao

January 21, 2009 at 7:22 pm

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