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
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)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:dyncon:v:133:y:2021:i:c:s0165188921001834
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