Solving Models with Jump Discontinuities in Policy Functions

Solving Models with Jump Discontinuities in Policy Functions We compare global methods for solving models with jump discontinuities in the policy function. We find that differences between value function iteration (VFI) and other methods are economically significant and Euler equation errors fail to be a sufficient measure of accuracy in such models. VFI fails to accurately identify both the location and size of jump discontinuities, while the endogenous grid method (EGM) and the finite element method (FEM) are much better at approximating this class of models. We further show that combining VFI with a local interpolation step (VFI‐INT) is sufficient to obtain accurate approximations. The combination of computational speed, relatively easy implementation and adaptability make VFI‐INT especially suitable for approximating models with jump discontinuities in policy functions: while EGM is the fastest method, it is relatively complex to implement; implementation of VFI‐INT is relatively straightforward and it is much faster than FEM. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Oxford Bulletin of Economics & Statistics Wiley

Solving Models with Jump Discontinuities in Policy Functions

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Publisher
Wiley Subscription Services, Inc., A Wiley Company
Copyright
Copyright © 2018 The Department of Economics, University of Oxford and John Wiley & Sons Ltd
ISSN
0305-9049
eISSN
1468-0084
D.O.I.
10.1111/obes.12203
Publisher site
See Article on Publisher Site

Abstract

We compare global methods for solving models with jump discontinuities in the policy function. We find that differences between value function iteration (VFI) and other methods are economically significant and Euler equation errors fail to be a sufficient measure of accuracy in such models. VFI fails to accurately identify both the location and size of jump discontinuities, while the endogenous grid method (EGM) and the finite element method (FEM) are much better at approximating this class of models. We further show that combining VFI with a local interpolation step (VFI‐INT) is sufficient to obtain accurate approximations. The combination of computational speed, relatively easy implementation and adaptability make VFI‐INT especially suitable for approximating models with jump discontinuities in policy functions: while EGM is the fastest method, it is relatively complex to implement; implementation of VFI‐INT is relatively straightforward and it is much faster than FEM.

Journal

Oxford Bulletin of Economics & StatisticsWiley

Published: Jan 1, 2018

References

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