A Note on the Accuracy of Markov-Chain Approximations to Highly Persistent AR(1)-Processes
AbstractThis note examines the accuracy of methods that are commonly used to approximate AR(1)-processes with discrete Markov chains. The quadrature-based method suggested by Tauchen and Hussey (1991) generates excellent approximations with a small number of nodes when the autocorrelation is low or modest. This method however has problems when the autocorrelation is high, as it typically is found to be in recent empirical studies of income processes. I suggest an alternative weighting function for the Tauchen-Hussey method, and I also note that the older method suggested by Tauchen (1986) is relatively robust to high autocorrelation.
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Bibliographic InfoPaper provided by Stockholm School of Economics in its series Working Paper Series in Economics and Finance with number 656.
Length: 9 pages
Date of creation: 12 Mar 2007
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numerical methods; income processes; autoregressive process;
Other versions of this item:
- Flodén, Martin, 2008. "A note on the accuracy of Markov-chain approximations to highly persistent AR(1) processes," Economics Letters, Elsevier, vol. 99(3), pages 516-520, June.
- C60 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - General
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