Several papers on international business cycles have documented spurious welfare reversals, in that incomplete market economies can produce higher welfare than the complete market economy. This paper demonstrates how conventional linearization, as used in King, Plosser, and Rebelo (1988), can generate approximation errors that are large enough to result in such reversals. Using a two-country production economy without capital, we argue that spurious welfare reversals are not only possible but also plausible under reasonable parameter values. As a constructive alternative, this paper proposes an approximation method that modifies the conventional linearization method by a bias correction---the linear approximation around a 'stochastic' steady state. We show that this method can be easily implemented to accurately approximate the exact solution and therefore produce the correct welfare ordering. The accuracy of the proposed method is far better than that of the conventional linearization method and as good as that of a method involving a second-order expansion.
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Paper provided by University of Virginia, Department of Economics in its series Virginia Economics Online Papers with number
319.
Find related papers by JEL classification: F3 - International Economics - - International Finance F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
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