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