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How Misleading is Linearization? Evaluating the Dynamics of the Neoclassical Growth Model

  • Manoj Atolia

    ()

    (Department of Economics, Florida State University)

  • Santanu Chatterjee

    ()

    (Terry College of Business, University of Georgia)

  • Stephen J. Turnovsky

    ()

    (Department of Economics, University of Washington)

The standard procedure for analyzing transitional dynamics in non-linear macro models has been to employ linear approximations. This raises the central question of this paper: How reliable is this procedure in evaluating the dynamic adjustments to policy changes or structural shocks? This question is significant since one of the basic objectives of contemporary micro-based macroeconomic models is the analysis of intertemporal welfare. We analyze this issue in the context of a neoclassical Ramsey growth model, with two alternative specifications of productive government spending, by employing both linearization and non-linear solution techniques. We find that if government expenditure is introduced as a flow and the dynamic adjustment is fast, linearization may be a reasonably good approximation of the true dynamics even for fairly large policy shocks. In contrast, if government expenditure assumes the form of a stock, leading to more sluggish adjustment, linearization is more problematic. The linearization procedure may yield misleading predictions, both qualitatively and quantitatively. These occur at the beginning of the transition and therefore weigh heavily in intertemporal welfare calculations. These patterns are verified for temporary shocks as well.

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File URL: ftp://econpapers.fsu.edu/RePEc/fsu/wpaper/wp2008_11_01.pdf
File Function: First version, 2008-01
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Paper provided by Department of Economics, Florida State University in its series Working Papers with number wp2008_11_01.

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Length: 46
Date of creation: Jan 2008
Date of revision: Sep 2008
Handle: RePEc:fsu:wpaper:wp2008_11_01
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