business cycle volatility and welfare

Furceri, D. and G. Karras. 2007. "Country Size and Business Cycle Volatility: Scale Really Matters." Journal of the Japanese and International Economies, 21(4), 424-34.

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Is business-cycle volatility worthy to be considered as an indicator of economic performance, along such other established measures as economic growth and income per capita? While in the highly influential monograph Models of Business Cycles Robert Lucas (1987) famously argued that the costs associated with business cycles are virtually nonexistent, more recent research has challenged Lucas’s conclusions. For example, Mendoza (2000), Jones (1999), Matheron and Maury (2000), Epaulard and Pommeret (2003) showed that business cycle volatility reduces welfare, not least because of its negative effect on growth. Krusell and Smith (1999), and Storesletten et al. (2001) showed that in a model with heterogeneous agents the benefits from eliminating business cycle fluctuations are sizeable. More recently, Barlevy (2004) argues that economic fluctuations remarkably decrease welfare by affecting the growth rate of consumption. At the same time, a growing empirical literature starting with Ramey and Ramey (1995) has showed that cyclical volatility negatively affects growth and investment.We conclude that business-cycle volatility matters. Thus, if country size can be shown to have a significant effect on volatility, it follows that country size matters too.
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