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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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  9. repec:cup:macdyn:v:1:y:1997:i:1:p:45-75 is not listed on IDEAS
  10. Dale W. Henderson & Jinill Kim, 1999. "Exact utilities under alternative monetary rules in a simple macro model with optimizing agents," International Finance Discussion Papers 635, Board of Governors of the Federal Reserve System (U.S.).
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  18. Harold L. Cole & Maurice Obstfeld, 1989. "Commodity Trade and International Risk Sharing: How Much Do Financial Markets Matter?," NBER Working Papers 3027, National Bureau of Economic Research, Inc.
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  20. Tesar, Linda L., 1995. "Evaluating the gains from international risksharing," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 42(1), pages 95-143, June.
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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, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January.
  3. Stephanie Schmitt-Grohe & Martin Uribe, 2000. "Stabilization Policy and the Costs of Dollarization," Departmental Working Papers 200006, Rutgers University, Department of Economics.

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