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Risk matters: Breaking certainty equivalence in linear approximations

Juan Parra-Alvarez (), Hamza Polattimur and Olaf Posch ()

Journal of Economic Dynamics and Control, 2021, vol. 133, issue C

Abstract: In this paper we use the property that certainty equivalence, as implied by a first-order approximation to the solution of stochastic discrete-time models, breaks in its equivalent continuous-time version. We derive a risk-sensitive first-order perturbation solution for a general class of rational expectations models. We show that risk matters economically in a real business cycle (RBC) model with habit formation and capital adjustment costs, and that neglecting risk leads to substantial pricing errors. A first-order perturbation provides a sensible approximation to the effects of risk in continuous-time models. It reduces pricing errors by around 90% relative to the certainty equivalent linear approximation.

Keywords: Certainty equivalence; Perturbation methods; Pricing errors (search for similar items in EconPapers)
JEL-codes: C02 C61 C63 E13 E32 G12 (search for similar items in EconPapers)
Date: 2021
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:133:y:2021:i:c:s0165188921001834

DOI: 10.1016/j.jedc.2021.104248

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Journal of Economic Dynamics and Control is currently edited by J. Bullard, C. Chiarella, H. Dawid, C. H. Hommes, P. Klein and C. Otrok

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