Solving heterogeneous-agent models by projection and perturbation

Reiter, Michael

Solving heterogeneous-agent models by projection and perturbation

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Reiter, M. Solving heterogeneous-agent models by projection and perturbation. 2006. handle: http://hdl.handle.net/10230/959

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Abstract

The paper proposes a numerical solution method for general equilibrium models with a continuum of heterogeneous agents, which combines elements of projection and of perturbation methods. The basic idea is to solve first for the stationary solution of the model, without aggregate shocks but with fully specified idiosyncratic shocks. Afterwards one computes a first-order perturbation of the solution in the aggregate shocks. This approach allows to include a high-dimensional representation of the cross-sectional distribution in the state vector. The method is applied to a model of household saving with uninsurable income risk and liquidity constraints. The model includes not only productivity shocks, but also shocks to redistributive taxation, which cause substantial short-run variation in the cross-sectional distribution of wealth. If those shocks are operative, it is shown that a solution method based on very few statistics of the distribution is not suitable, while the proposed method can solve the model with high accuracy, at least for the case of small aggregate shocks. Techniques are discussed to reduce the dimension of the state space such that higher order perturbations are feasible. Matlab programs to solve the model can be downloaded.