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School of Economics and Finance

No. 827: Markov-Chain Approximations for Life-Cycle Models

Giulio Fella , Queen Mary University of London
Giovanni Gallipoli , University of British Columbia
Jutong Pan , University of British Columbia

July 20, 2017

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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-uctuation 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.

J.E.L classification codes: C63

Keywords:Numerical methods, finite state approximations