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Spurious Welfare Reversals in International Business Cycle Models

  • Jinill Kim and Sunghyun Henry Kim

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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Paper provided by Society for Computational Economics in its series Computing in Economics and Finance 2001 with number 3.

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Date of creation: 01 Apr 2001
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Handle: RePEc:sce:scecf1:3
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  1. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1987. "International real business cycles," Working Papers 426, Federal Reserve Bank of Minneapolis.
  2. 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.
  3. Kim, Jinill & Henderson, Dale W., 2005. "Inflation targeting and nominal-income-growth targeting: When and why are they suboptimal?," Journal of Monetary Economics, Elsevier, vol. 52(8), pages 1463-1495, November.
  4. Andrew Levin & Christopher J. Erceg & Dale W. Henderson, 1999. "Optimal Monetary Policy with Staggered Wage and Price Contracts," Computing in Economics and Finance 1999 1151, Society for Computational Economics.
  5. Michael Woodford, 2001. "Inflation Stabilization and Welfare," NBER Working Papers 8071, National Bureau of Economic Research, Inc.
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  8. 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.
  9. 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.
  10. Gaspar, Jess & L. Judd, Kenneth, 1997. "Solving Large-Scale Rational-Expectations Models," Macroeconomic Dynamics, Cambridge University Press, vol. 1(01), pages 45-75, January.
  11. Jang-Ok Cho & Thomas Cooley & Louis Phaneuf, 1994. "The Welfare Costs of Nominal Wage Contracting," Cahiers de recherche CREFE / CREFE Working Papers 30, CREFE, Université du Québec à Montréal, revised 22 Jan 1996.
  12. Chris Otrok, 1999. "On Measuring the Welfare Cost of Business Cycles," Virginia Economics Online Papers 318, University of Virginia, Department of Economics.
  13. Collard, Fabrice & Juillard, Michel, 1999. "Accuracy of stochastic perturbuation methods: the case of asset pricing models," CEPREMAP Working Papers (Couverture Orange) 9922, CEPREMAP.
  14. Jinill Kim, Sunghyun Kim, and Andrew Levin, 2001. "Patience, Persistence, and Welfare Costs of Incomplete Markets in Open Economies," Computing in Economics and Finance 2001 7, Society for Computational Economics.
  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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  19. John Y. Campbell & Luis M. Viceira, 2000. "Who Should Buy Long-Term Bonds?," Harvard Institute of Economic Research Working Papers 1895, Harvard - Institute of Economic Research.
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  24. 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.).
  25. 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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  28. repec:fth:calaec:4-98 is not listed on IDEAS
  29. repec:cup:macdyn:v:1:y:1997:i:1:p:45-75 is not listed on IDEAS
  30. Lewis, Karen K., 2000. "Why do stocks and consumption imply such different gains from international risk sharing?," Journal of International Economics, Elsevier, vol. 52(1), pages 1-35, October.
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