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Solving DSGE Models - When Local Approximations Fail

71 Pages Posted: 26 Jun 2017  

Nikolai Gräber

University of Muenster - Finance Center Muenster

Malte Schumacher

University of Zurich - Department of Business Administration

Date Written: June 21, 2017

Abstract

This paper studies the effect of persistent growth risks on the solution accuracy of dynamic stochastic general equilibrium models. We find that whenever the economy is exposed to risks with long-lasting effects a local Taylor-expansion based solution method does not suffice. In particular, this affects asset pricing quantities and welfare implications. We compare perturbed solutions for various economies with solutions obtained with a projection algorithm. It is shown that besides slightly misstating macroeconomic moments a perturbed 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. Finally, we show that a Chebyshev projection does a better job at approximating asset pricing and welfare quantities than a Taylor-expansion 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 (June 21, 2017). Available at SSRN: https://ssrn.com/abstract=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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