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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.

Suggested Citation

  • Jinill Kim & Sunghyun Henry Kim, 1999. "Inaccuracy of Loglinear Approximation in Welfare Calculations: the Case of International Risk Sharing," Computing in Economics and Finance 1999 251, Society for Computational Economics.
  • Handle: RePEc:sce:scecf9:251

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    References listed on IDEAS

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    Cited by:

    1. Schmitt-Grohe, Stephanie & Uribe, Martin, 2004. "Solving dynamic general equilibrium models using a second-order approximation to the policy function," Journal of Economic Dynamics and Control, Elsevier, vol. 28(4), pages 755-775, January.
    2. Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "Stabilization Policy and the Costs of Dollarization," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(2), pages 482-509, May.
    3. Bohn, Henning, 2009. "Intergenerational risk sharing and fiscal policy," Journal of Monetary Economics, Elsevier, vol. 56(6), pages 805-816, September.

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