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Second-Order Approximation of Dynamic Models with Time-Varying Risk

  • Gianluca Benigno
  • Pierpaolo Benigno
  • Salvatore Nisticò

This paper provides first and second-order approximation methods for the solution of non-linear dynamic stochastic models in which the exogenous state variables follow conditionally-linear stochastic processes displaying time-varying risk. The first-order approximation is consistent with a conditionally-linear model in which risk is still time-varying but has no distinct role -- separated from the primitive stochastic disturbances -- in influencing the endogenous variables. The second-order approximation of the solution, instead, is sufficient to get this role. Moreover, risk premia, evaluated using only a first-order approximation of the solution, will be also time varying.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16633.

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Date of creation: Dec 2010
Date of revision:
Publication status: published as Benigno, Gianluca & Benigno, Pierpaolo & Nisticò, Salvatore, 2013. "Second-order approximation of dynamic models with time-varying risk," Journal of Economic Dynamics and Control, Elsevier, vol. 37(7), pages 1231-1247.
Handle: RePEc:nbr:nberwo:16633
Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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