Welfare Implications of Asset Pricing Facts: Should Central Banks Fill Gaps or Remove Volatility?

I find that removing consumption volatility is a priority over filling the gap between consumption and its flexible-price counterpart, or inflation targeting, in a model that matches empirical measures of the welfare costs of consumption fluctuations. Nearly 30 years of financial market data suggest sizable welfare costs of fluctuations that can be decomposed into a term structure that is downward-sloping on average, especially during downturns. This evidence offers guidance in selecting a model to study the benefits of macroeconomic stabilization from a structural perspective. The addition of nonlinear external habit formation to a textbook New Keynesian model can rationalize the evidence, and it offers a framework suitable for studying the desirability of removing fluctuations. The model is nearly observationally equivalent in its quantity implications to a standard New Keynesian model with CRRA utility, but the asset pricing and optimal policy implications are dramatically different. In the model, a central bank that minimizes consumption volatility generates welfare improvements relative to an inflation targeting regime that are equivalent to a 25 percent larger consumption stream.