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

  • Jinill Kim

    ()

    (University of Virginia)

  • Sunghyun Henry Kim

    ()

    (Brandeis University)

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
Contact details of provider: Postal: CEF99, Boston College, Department of Economics, Chestnut Hill MA 02467 USA
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Web page: http://fmwww.bc.edu/CEF99/

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