Solving DSGE Models - When Local Approximations Fail
57 Pages Posted: 26 Jun 2017 Last revised: 15 Jan 2019
Date Written: December 1, 2017
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
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