Markov-Chain Approximations for Life-Cycle Models

Non-stationary income processes are standard in quantitative life-cycle models, prompted by the observation that within-cohort income inequality increases with age.

With
Giulio Fella, Jutong Pan

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) and Rouwenhorst’s (1995) discretization methods to non-stationary AR(1) processes. We evaluate the performance of both methods in the context of a canonical finite-horizon, income-fluctuation problem with a non-stationary income process. We find that the generalized Rouwenhorst’s method performs extremely well even with a relatively small number of states.

DRAFT (PDF)

Citation

@techreport{fgp2017approximations,
  title={Markov-Chain Approximations for Life-Cycle Models},
  author={Fella, Giulio and Gallipoli, Giovanni and Pan, Jutong},
  year={2017},
  note = {Working Paper},
  institution={UBC, Vancouver School of Economics}
}