Supersedes Working Paper 03-20 – On the Welfare Gains of Eliminating a Small Likelihood of Economic Crises: A Case for Stabilization Policies?
An economic crisis is defined as an increase in unemployment of the magnitude observed during the Great Depression. For the U.S., the maximum-likelihood estimate of entering a depression is found to be about once every 83 years. The welfare gain from setting this small probability to zero can range between 1 and 7 percent of annual consumption in perpetuity. For most estimates, more than half of these large gains result from a reduction in individual consumption volatility.
Revision forthcoming in the Journal of Monetary Economics.