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The benefits of stabilization policies revisited

D'Orlando, Fabio and Ferrante, Francesco (2015): The benefits of stabilization policies revisited.

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Abstract

Traditional theoretical literature which neglects the benefits of stabilization policies (e.g., Lucas 1987 and 2003) ultimately relies on the small impact that macroeconomic volatility has on aggregate income and consumption. In this article, we argue that such an approach is both theoretically and empirically weak. From the theoretical viewpoint, the cost of volatility should be measured including not only monetary magnitudes, but also those psychological costs whose relevance has been stressed by behavioural economics and which are correlated with the number of unemployment episodes. We refer here to the implications for experienced utility of loss aversion, the endowment effect and hedonic adaptation. This theoretical problem is coupled with the empirical finding that the effects of downturns are not randomly distributed and serially uncorrelated, i.e., they affect more frequently those who have less (in terms of skills, income and wealth) and who suffer greater wellbeing losses from each shock. It follows that the traditional (and Lucas) analysis disregards the main causes of wellbeing losses determined by downturns. Hence, it cannot be considered as a theoretically sound basis for denying the usefulness of policies aimed at preventing downturns and/or of micro regulation policies aimed at preventing the impact of downturns and labour force reallocation on the labour market.

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