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

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Author Info
Jinill Kim () (University of Virginia)
Sunghyun Henry Kim () (Brandeis University)

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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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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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  2. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  3. Mendoza, Enrique G, 1995. "The Terms of Trade, the Real Exchange Rate, and Economic Fluctuations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(1), pages 101-37, February. [Downloadable!] (restricted)
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  5. Christopher Otrok, 2000. "On Measuring the Welfare Cost of Business Cycles," Econometric Society World Congress 2000 Contributed Papers 1094, Econometric Society. [Downloadable!]
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  6. Henning Bohn, . "Risk Sharing in a Stochastic Overlapping Generations Economy," University of California at Santa Barbara, Economics Working Paper Series 3-98, Department of Economics, UC Santa Barbara. [Downloadable!]
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  7. repec:cup:macdyn:v:1:y:1997:i:1:p:45-75 is not listed on IDEAS
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  9. Dale Henderson & Jinill Kim, 1999. "Exact Utilities under Alternative Monetary Rules in a Simple Macro Model with Optimizing Agents," International Tax and Public Finance, Springer, vol. 6(4), pages 507-535, November. [Downloadable!] (restricted)
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  10. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, vol. 28(1), pages 3-24, August. [Downloadable!] (restricted)
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  11. Cho, Jang-Ok & Cooley, Thomas F & Phaneuf, Louis, 1997. "The Welfare Cost of Nominal Wage Contracting," Review of Economic Studies, Blackwell Publishing, vol. 64(3), pages 465-84, July. [Downloadable!] (restricted)
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  12. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October. [Downloadable!] (restricted)
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  13. Obstfeld, M., 1998. "Risk and Exchange Rate," Papers 193, Princeton, Woodrow Wilson School - Public and International Affairs.
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  14. Ireland, Peter N., 1997. "A small, structural, quarterly model for monetary policy evaluation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 83-108, December. [Downloadable!] (restricted)
  15. 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. [Downloadable!] (restricted)
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  19. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-75, August. [Downloadable!] (restricted)
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  20. Mark Bils & Yongsung Chang, 1999. "Wages and the Allocation of Hours and Effort," NBER Working Papers 7309, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  21. 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. [Downloadable!]
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(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Schmitt-Grohé, Stephanie & Uribe, Martín, 2001. "Solving Dynamic General Equilibrium Models Using a Second-Order Approximation to the Policy Function," CEPR Discussion Papers 2963, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
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  2. Stephanie Schmitt-Grohe & Martin Uribe, 2000. "Stabilization Policy and the Costs of Dollarization," Departmental Working Papers 200006, Rutgers University, Department of Economics. [Downloadable!]
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