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A Note on the Accuracy of Markov-Chain Approximations to Highly Persistent AR(1)-Processes

This 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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Paper provided by Stockholm School of Economics in its series SSE/EFI Working Paper Series in Economics and Finance with number 656.

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Length: 9 pages
Date of creation: 12 Mar 2007
Date of revision:
Handle: RePEc:hhs:hastef:0656
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  1. Kjetil Storesletten & Chris Telmer & Amir Yaron, 1997. "Consumption and risk sharing over the life cycle," GSIA Working Papers 228, Carnegie Mellon University, Tepper School of Business.
  2. Glenn R. Hubbard & Jonathan Skinner & Stephen P. Zeldes, . "Precautionary Saving and Social Insurance," Rodney L. White Center for Financial Research Working Papers 3-95, Wharton School Rodney L. White Center for Financial Research.
  3. S. Rao Aiyagari, 1993. "Uninsured idiosyncratic risk and aggregate saving," Working Papers 502, Federal Reserve Bank of Minneapolis.
  4. Tauchen, George & Hussey, Robert, 1991. "Quadrature-Based Methods for Obtaining Approximate Solutions to Nonlinear Asset Pricing Models," Econometrica, Econometric Society, vol. 59(2), pages 371-96, March.
  5. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
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