Solving DSGE Models - When Local Approximations Fail

57 Pages Posted: 26 Jun 2017 Last revised: 15 Jan 2019

See all articles by Nikolai Gräber

Nikolai Gräber

University of Muenster - Finance Center Muenster

Malte Schumacher

University of Zurich - Department of Business Administration

Date Written: December 1, 2017

Abstract

This paper studies the effect of persistent growth risks on the solution accuracy of dynamic stochastic general equilibrium models. We compare the reliability of perturbation and projection based solution methods for various model economies. We find that a perturbation based solution method does not suffice whenever the economy is exposed to risks with long-lasting effects. Besides slightly misstating macroeconomic moments the perturbation based solution strongly understates the mean risk-free rate and the wealth-consumption ratio. Further, we identify parameters driving the approximation error and compare different degrees of approximation. We show that projection methods do a better job at approximating asset pricing and welfare quantities than perturbation methods even for low order polynomials.

Keywords: Growth risks, DSGE models, solution methods

JEL Classification: C63, D58, G12

Suggested Citation

Gräber, Nikolai and Schumacher, Malte, Solving DSGE Models - When Local Approximations Fail (December 1, 2017). Available at SSRN: https://ssrn.com/abstract=2992200 or http://dx.doi.org/10.2139/ssrn.2992200

Nikolai Gräber

University of Muenster - Finance Center Muenster ( email )

Universitatsstr. 14-16
Muenster, 48143
Germany

Malte Schumacher (Contact Author)

University of Zurich - Department of Business Administration ( email )

Rämistrasse 71
Zurich, CH-8006
Switzerland

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