The implication of subsistence consumption for economic welfare

•The welfare consequences of subsistence consumption are studied using an RBC model.•The welfare cost of business cycles increases in the level of subsistence consumption.•Consumption volatility increases in subsistence consumption.•Disutility from working becomes higher as subsistence level increases.•Subsistence makes consumption more responsive to shocks.

Using a subsistence consumption-augmented real business cycle model, we show that, for any given exogenous growth rates or parameter values, high initial subsistence levels increase the welfare cost of business cycles. This happens because subsistence consumption increases consumption volatility. Our finding suggests that eliminating economic fluctuations can be more beneficial to less-developed economies in which subsistence consumption is a high fraction of aggregate consumption. However, fast-growing economies exhibit a lower discrepancy of welfare costs between rich and poor countries, a result that also highlights the importance of growth-enhancing policies.