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Finite State Markov-Chain Approximations to Highly Persistent Processes

  • Karen A. Kopecky

    (Department of Economics, The University of Western Ontario)

  • Richard M. H. Suen


    (Department of Economics, University of California Riverside)

This paper re-examines the Rouwenhorst method of approximating first-order autoregressive processes. This method is appealing because it can match the conditional and unconditional mean, the conditional and unconditional variance and the first-order autocorrelation of any AR(1) process. This paper provides the first formal proof of this and other results. When comparing to five other methods, the Rouwenhorst method has the best performance in approximating the business cycle moments generated by the stochastic growth model. It is shown that, equipped with the Rouwenhorst method, an alternative approach to generating these moments has a higher degree of accuracy than the simulation method.

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Paper provided by University of California at Riverside, Department of Economics in its series Working Papers with number 200904.

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Length: 52 pages
Date of creation: May 2009
Date of revision: May 2009
Handle: RePEc:ucr:wpaper:200904
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  1. Jerome Adda & Russell W. Cooper, 2003. "Dynamic Economics: Quantitative Methods and Applications," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262012014, June.
  2. Robert G. King & Sergio T. Rebelo, 2000. "Resuscitating Real Business Cycles," NBER Working Papers 7534, National Bureau of Economic Research, Inc.
  3. Taylor, John B & Uhlig, Harald, 1990. "Solving Nonlinear Stochastic Growth Models: A Comparison of Alternative Solution Methods," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 1-17, January.
  4. Kopecky, Karen A. & Suen, Richard M. H., 2009. "Finite State Markov-Chain Approximations to Highly Persistent Processes," MPRA Paper 15122, University Library of Munich, Germany.
  5. Damba Lkhagvasuren & Ragchaasuren Galindev, 2008. "Discretization of Highly-Persistent Correlated AR(1) Shocks," Working Papers 08012, Concordia University, Department of Economics, revised Nov 2008.
  6. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  7. Tauchen, George, 1986. "Finite state markov-chain approximations to univariate and vector autoregressions," Economics Letters, Elsevier, vol. 20(2), pages 177-181.
  8. Tauchen, George, 1990. "Solving the Stochastic Growth Model by Using Quadrature Methods and Value-Function Iterations," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 49-51, January.
  9. S. B. Aruoba & Jesús Fernández-Villaverde & Juan F. Rubio-Ramirez, 2005. "Comparing Solution Methods for Dynamic Equilibrium Economies," Levine's Bibliography 122247000000000855, UCLA Department of Economics.
  10. 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.
  11. Craig Burnside, 1998. "Discrete State-Space Methods for the Study of Dynamic Economies," QM&RBC Codes 125, Quantitative Macroeconomics & Real Business Cycles.
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