DP3212 Markups, Gaps and the Welfare Costs of Business Fluctuations

Author(s): Jordi Galí, Mark Gertler, Jose David Lopez-Salido
Publication Date: February 2002
Keyword(s): business cycles, countercyclical markups, welfare costs
JEL(s): E30
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3212

In this Paper we present a simple, theory-based measure of the variations in aggregate economic efficiency associated with business fluctuations. We decompose this indicator, which we refer to as ?the gap?, into two constituent parts: a price markup and a wage markup, and show that the latter accounts for the bulk of the fluctuations in our gap measure. Finally, we derive a measure of the welfare costs of business cycles that is directly related to our gap variable, and which takes into account explicitly the existence of a varying aggregate inefficiency. When applied to postwar US data, for plausible parametrizations, our measure suggests welfare losses of fluctuations that are of a higher order of magnitude than those derived by Lucas (1987). It also suggests that the major postwar recessions involved substantial efficiency costs.