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Inaccuracy of Loglinear Approximation in Welfare Calculations: the Case of International Risk Sharing

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  • Jinill Kim

    ()
    (University of Virginia)

  • Sunghyun Henry Kim

    ()
    (Brandeis University)

Abstract

This paper investigates the accuracy of the log-linear approximation method in welfare calculations, especially in measuring welfare gains of international risk sharing. We derive closed-form solutions for a two-country complete market economy using log-linearization and a nonlinear solution method and compare risk-sharing gains over financial autarky. We document that the loglinearized model underestimates risk-sharing gains by up to 20% of world consumption under certain parameter values with endogenous labor supply. While the nonlinear solution generates 4% risk-sharing gains, the loglinear approximation results in a loss of 16%. Loglinear approximation errors are large enough to generate welfare reversal between autarky and complete market economies, a violation of the first welfare theorem. This result can be crucial because a large number of papers adopt loglinearization method in calculating welfare.

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Bibliographic Info

Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 1999 with number 251.

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Date of creation: 01 Mar 1999
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Handle: RePEc:sce:scecf9:251

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References

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  1. Devereux, Michael B. & Saito, Makoto, 1997. "Growth and risk-sharing with incomplete international assets markets," Journal of International Economics, Elsevier, vol. 42(3-4), pages 453-481, May.
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  8. Julio Rotemberg & Michael Woodford, 1997. "An Optimization-Based Econometric Framework for the Evaluation of Monetary Policy," NBER Chapters, in: NBER Macroeconomics Annual 1997, Volume 12, pages 297-361 National Bureau of Economic Research, Inc.
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  14. repec:cup:macdyn:v:1:y:1997:i:1:p:45-75 is not listed on IDEAS
  15. Mark Bils & Yongsung Chang, 1999. "Wages and the Allocation of Hours and Effort," NBER Working Papers 7309, National Bureau of Economic Research, Inc.
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Cited by:
  1. Henning Bohn, 2004. "Intergenerational Risk Sharing and Fiscal Policy," 2004 Meeting Papers 22, Society for Economic Dynamics.
  2. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 482-509, May.
  3. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," Departmental Working Papers 200106, Rutgers University, Department of Economics.

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