The market cost of business cycle fluctuations

We propose a novel approach to measure the cost of aggregate economic fluctuations, that does not require complete specification of investors’ risk preferences or their beliefs. With data on consumption and asset prices, an information-theoretic method is used to recover an information kernel (I-SDF). The I-SDF accurately prices broad cross-sections of assets, thereby offering a reliable candidate for the measurement of the welfare cost of business cycles. Our method enables the estimation of both the unconditional (or, average) cost of fluctuations as well as the cost conditional on each possible economic state. We find that the cost of fluctuations is strongly time-varying and countercyclical and that the cost of business cycle fluctuations is substantial, accounting for a quarter to a third of the cost of all consumption uncertainty