Several papers have documented spurious welfare reversals: incomplete-markets economy produces a higher level of welfare than the complete-markets economy. This paper first demonstrates how conventional linearization 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. This paper then proposes an approximation method that modifies the conventional linearization by a bias correction. This method can be easily implemented and approximates welfare as accurately as a second-order perturbation method.
Bibliographical noteFunding Information:
We appreciate comments and suggestions from an anonymous referee, Marianne Baxter, Henning Bohn, Yongsung Chang, Jon Faust, John Harris, Ken Judd, Jinhyo Kim, Bob King, Andy Levin, Chris Otrok, Chris Sims, Mike Woodford, Jonathan Wright, and seminar participants at Stanford Institute for Theoretical Economics 1999 summer workshop, the Korea macroeconomics workshop, 1999 Society for Computational Economics conference, 1999 T2M conference, University of Pennsylvania, Clark University, UCSB, UQAM, Georgetown University, the Federal Reserve Board, and the Bank of Canada. J. Kim’s work on this project was supported by a Bankard grant from the University of Virginia.
- Bias correction
- Risk sharing
- Stochastic steady state
ASJC Scopus subject areas
- Economics and Econometrics