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Spurious welfare reversals in international business cycle models

  • Kim, Jinill
  • Kim, Sunghyun Henry

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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Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 60 (2003)
Issue (Month): 2 (August)
Pages: 471-500

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Handle: RePEc:eee:inecon:v:60:y:2003:i:2:p:471-500
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505552

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  1. Collard, Fabrice & Juillard, Michel, 2001. "Accuracy of stochastic perturbation methods: The case of asset pricing models," Journal of Economic Dynamics and Control, Elsevier, vol. 25(6-7), pages 979-999, June.
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  4. Kim, Jinill & Kim, Sunghyun Henry & Levin, Andrew, 2003. "Patience, persistence, and welfare costs of incomplete markets in open economies," Journal of International Economics, Elsevier, vol. 61(2), pages 385-396, December.
  5. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
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  10. Jinill Kim & Dale Henderson, 2002. "Inflation Targeting and Nominal Income Growth Targeting: When and Why Are They Suboptimal?," Computing in Economics and Finance 2002 59, Society for Computational Economics.
  11. Maurice Obstfeld & Kenneth Rogoff, 1998. "Risk and Exchange Rates," NBER Working Papers 6694, National Bureau of Economic Research, Inc.
  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.
  13. van Wincoop, Eric, 1999. "How big are potential welfare gains from international risksharing?," Journal of International Economics, Elsevier, vol. 47(1), pages 109-135, February.
  14. Taylor, John B & Uhlig, Harald, 1990. "Solving Nonlinear Stochastic Growth Models: A Comparison of Alternative Solution Methods," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 1-17, January.
  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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  17. Woodford Michael, 2002. "Inflation Stabilization and Welfare," The B.E. Journal of Macroeconomics, De Gruyter, vol. 2(1), pages 1-53, February.
  18. Jang-Ok Cho & Thomas F. Cooley & Louis Phaneuf, 1997. "The Welfare Cost of Nominal Wage Contracting," Review of Economic Studies, Oxford University Press, vol. 64(3), pages 465-484.
  19. Henning Bohn, 1999. "Online Appendix to Should the Social Security Trust Fund hold Equities? An Intergenerational Welfare Analysis," Technical Appendices bohn99, Review of Economic Dynamics.
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  24. repec:cup:macdyn:v:1:y:1997:i:1:p:45-75 is not listed on IDEAS
  25. 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.).
  26. 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.
  27. Benigno, Gianluca & Benigno, Pierpaolo, 2001. "Monetary Policy Rules and the Exchange Rate," CEPR Discussion Papers 2807, C.E.P.R. Discussion Papers.
  28. King, Robert G. & Plosser, Charles I. & Rebelo, Sergio T., 1988. "Production, growth and business cycles : II. New directions," Journal of Monetary Economics, Elsevier, vol. 21(2-3), pages 309-341.
  29. 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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