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Spurious Welfare Reversals in International Business Cycle Models

  • Jinill Kim

    ()

  • Sunghyun Henry Kim

    ()

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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File URL: http://www.virginia.edu/economics/RePEc/vir/virpap/papers/virpap319.pdf
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Paper provided by University of Virginia, Department of Economics in its series Virginia Economics Online Papers with number 319.

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Length: 42 pages
Date of creation: Oct 1999
Date of revision:
Handle: RePEc:vir:virpap:319
Contact details of provider: Web page: http://www.virginia.edu/economics/home.html

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  1. repec:cup:macdyn:v:1:y:1997:i:1:p:45-75 is not listed on IDEAS
  2. Chris Otrok, 1999. "On Measuring the Welfare Cost of Business Cycles," Virginia Economics Online Papers 318, University of Virginia, Department of Economics.
  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.
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  11. 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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  13. 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.
  14. Wouter J. Den Haan & Albert Marcet, 1994. "Accuracy in Simulations," Review of Economic Studies, Oxford University Press, vol. 61(1), pages 3-17.
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  30. 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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