Oliver De Groot (University of St. Andrews): Global vs. local methods in the analysis of open-economy models with incomplete markets

Oliver De Groot (University of St. Andrews): Global vs. local methods in the analysis of open-economy models with incomplete markets

Co-authors: C. Bora Durdu and Enrique Mendoza

Abstract

Local and global (“exact”) solution methods are widely used in international macroeconomics to study incomplete markets models in which precautionary savings drive wealth dynamics. Local methods are faster and free from the curse of dimensionality, but can only approximate the exact solution. We evaluate the accuracy of three local methods that assume a debt-elastic interest rate (log-linear, second-order, and risk-adjusted steady-state) by comparing them with the exact solutions for three small-open-economy models: a canonical endowment-economy model, an RBC model, and a model with an occasionally binding collateral constraint. Comparing results in the time and frequency domains yields two main findings. First, local methods are generally inaccurate, unless the local approximations are centred around the “exact” steady state from the global solutions (i.e., accurate local solutions require solving first with a global method). Second, even then the local methods do not capture well all the statistical properties of the global solution. These findings suggest caution in interpreting results from local methods, and favour using global methods except when the curse of dimensionality makes them impractical.

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