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Spurious Welfare Reversals in International Business Cycle Models

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  • Jinill Kim and Sunghyun Henry Kim

Abstract

Papers on international business cycles have documented spurious welfare reversals: incomplete markets produce a higher level of welfare than the complete market. This paper first demonstrates how conventional linearization, as used in King, Plosser, and Rebelo (1988), can generate approximation errors that can result in welfare reversals. Using a two-country production economy, we argue that spurious welfare reversals are not only possible but also plausible under reasonable values for model parameters including labor supply elasticity. As a constructive alternative, this paper then proposes an approximation method that modifies the conventional linearization by a bias correction---the linear approximation around a `stochastic' steady state. We show that this method can be easily implemented and very well approximates the exact solution. The accuracy of the proposed method is by far better than that of the conventional linearization method and as good as that of a perturbation method involving a second-order expansion.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 3.

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Date of creation: 01 Apr 2001
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Handle: RePEc:sce:scecf1:3

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Keywords: linearization; stochastic steady state; welfare; risk sharing;

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