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Article

Welfare Cost of Model Uncertainty in a Small Open Economy

Department of Industrial Engineering, Universidad Diego Portales, 441 Ejercito Ave, Santiago 8370191, Chile
Entropy 2020, 22(11), 1221; https://doi.org/10.3390/e22111221
Received: 4 September 2020 / Revised: 14 October 2020 / Accepted: 22 October 2020 / Published: 27 October 2020
(This article belongs to the Special Issue Information Theory and Economic Network)
This paper extends the canonical small open-economy real-business-cycle model, when considering model uncertainty. Domestic households have multiplier preferences, which leads them to take robust decisions in response to possible model misspecification for the economy’s aggregate productivity. Using perturbation methods, the paper extends the literature on real business cycle models by deriving a closed-form solution for the combined welfare effect of the two sources of uncertainty, namely risk and model uncertainty. While classical risk has an ambiguous effect on welfare, the addition of model uncertainty is unambiguously welfare-deteriorating. Hence, the overall effect of uncertainty on welfare is ambiguous, depending on consumers preferences and model parameters. The paper provides numerical results for the welfare effects of uncertainty measured by units of consumption equivalence. At moderate (high) levels of risk aversion, the effect of risk on household welfare is positive (negative). The addition of model uncertainty—for all levels of concern about model uncertainty and most risk aversion values—turns the overall effect of uncertainty on household welfare negative. It is important to remark that the analytical decomposition and combination of the effects of the two types of uncertainty considered here and the resulting ambiguous effect on overall welfare have not been derived in the previous literature on small open economies. View Full-Text
Keywords: model uncertainty; small open economy; model misspecification; welfare cost of uncertainty model uncertainty; small open economy; model misspecification; welfare cost of uncertainty
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MDPI and ACS Style

Tapia Stefanoni, J. Welfare Cost of Model Uncertainty in a Small Open Economy. Entropy 2020, 22, 1221. https://doi.org/10.3390/e22111221

AMA Style

Tapia Stefanoni J. Welfare Cost of Model Uncertainty in a Small Open Economy. Entropy. 2020; 22(11):1221. https://doi.org/10.3390/e22111221

Chicago/Turabian Style

Tapia Stefanoni, Jocelyn. 2020. "Welfare Cost of Model Uncertainty in a Small Open Economy" Entropy 22, no. 11: 1221. https://doi.org/10.3390/e22111221

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