Spurious Welfare Reversals in International Business Cycle Models

41 Pages Posted: 23 May 2001

See all articles by Sunghyun Henry Kim

Sunghyun Henry Kim

Sungkyunkwan University - Department of Economics

Jinill Kim

Korea University

Date Written: December 2000


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.

Keywords: linearization, stochastic steady state, welfare, risk sharing

JEL Classification: F3, F4, E3

Suggested Citation

Kim, Sunghyun Henry and Kim, Jinill, Spurious Welfare Reversals in International Business Cycle Models (December 2000). Available at SSRN: https://ssrn.com/abstract=270849 or http://dx.doi.org/10.2139/ssrn.270849

Sunghyun Henry Kim (Contact Author)

Sungkyunkwan University - Department of Economics ( email )

110-745 Seoul

Jinill Kim

Korea University ( email )

1 Anam-dong 5 ka
Seoul, 136-701

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