On Aghion's and Blanchard's "On the Speed of Transition in Central Europe"

Eric Nævdal and Martin Wagner

No 175, Economics Series from Institute for Advanced Studies

Abstract: In this paper we derive the correct solution of optimal closure of the state sector studied in Section 6.4 of Aghion and Blanchard (1994). Aghion and Blanchard only present an 'approximate' solution which entails a constant unemployment rate in what they call a turnpike approximation. We show that optimal unemployment paths have two features. First, unemployment is increasing up to a certain point in time, when, second, the remaining inefficient state sector is closed down. At that point in time, which we may define as the end of transition, unemployment is discontinuous. The approximate solution presented by Aghion and Blanchard is thus found to lead to welfare losses compared to the optimal policy. In particular, the unemployment rate corresponding to the solution presented in Aghion and Blanchard is too low. Our solution is formally based on transforming the dynamic optimization problem to a scrap value problem with free terminal time.

Keywords: Transition; Optimal unemployment rate; Dynamic optimization (search for similar items in EconPapers)
JEL-codes: C61 E61 P20 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac and nep-tra
Date: 2005-09
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