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- Title
Evaluating linear approximations in a twocountry model with occasionally binding borrowing constraints.
- Authors
Anagnostopoulos, Alexis; Xin Tang
- Abstract
Under a linear approximation, a standard two-country business cycles model with incomplete markets delivers consumption and debt dynamics that are non-stationary (unit root) and a bond price that is independent of the wealth distribution. We argue that these twofeatures are due to the local nature of the approximation and we show that they survive even when second or third order local approximations are used. However, these features disappear when debt limits and the associated precautionary motives are taken into account by a standard, global solution method. We subsequently investigate whether this qualitative difference has significant quantitative implications regarding the linear solution as an approximation to the model's equilibrium dynamics. Policy function differences between the local and global solutions can be large and remain significant even in the case of debt limits as loose as the natural debt limit. These differences can lead to significant discrepancies in implied simulated second moments. In a benchmark calibration, the cross-country correlation of consumption is 0.61 under linearization, but only 0.38 when a policy iteration algorithm is used.
- Subjects
APPROXIMATION theory; LOANS; CONSUMPTION (Economics); DEBT; GOVERNMENT debt limit; ALGORITHMS; STATISTICAL correlation
- Publication
B.E. Journal of Macroeconomics, 2015, Vol 15, Issue 1, p43
- ISSN
2194-6116
- Publication type
Article
- DOI
10.1515/bejm-2013-0175