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Markov-Chain Approximations for Life-Cycle Models

Giulio Fella, Giovanni Gallipoli () and Jutong Pan

Review of Economic Dynamics, 2019, vol. 34, 183-201

Abstract: Non-stationary income processes are standard in quantitative life-cycle models, prompted by the observation that within-cohort income inequality increases with age. This paper generalizes Tauchen (1986), Adda and Cooper (2003), and Rouwenhorst's (1995) discretization methods to non-stationary AR(1) processes. We evaluate the performance of these methods in the context of a canonical life-cycle, income-fluctuation problem with a non-stationary income process. We also examine the case in which innovations to the persistent component of earnings are modeled as draws from a mixture of Normal distributions. We find that the generalized Rouwenhorst method performs consistently better than the others even with a relatively small number of states. (Copyright: Elsevier)

Keywords: Numerical methods; Finite-state approximations (search for similar items in EconPapers)
JEL-codes: C36 (search for similar items in EconPapers)
Date: 2019
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DOI: 10.1016/j.red.2019.03.013

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