Perturbation Methods

Jesús Fernández-Villaverde

University of Pennsylvania

July 10, 2011

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 1 / 91

 Introduction

Introduction

Remember that we want to solve a functional equation of the form:

H (d ) = 0

for an unknown decision rule d.

Perturbation solves the problem by specifying:

n
d n (x, θ ) = ∑ θ i (x x0 )i
i =0

We use implicit-function theorems to …nd coe¢ cients θ i ’s.

Inherently local approximation. However, often good global properties.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 2 / 91
 Introduction

Motivation
Many complicated mathematical problems have:

1 either a particular case

2 or a related problem.

that is easy to solve.

Often, we can use the solution of the simpler problem as a building

block of the general solution.

Very successful in physics.

Sometimes perturbation is known as asymptotic methods.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 3 / 91
 Introduction

The World Simplest Perturbation

p
What is 26?

Without your Iphone calculator, it is a boring arithmetic calculation.

But note that:

p q p
26 = 25 (1 + 0.04) = 5 1.04 5 1.02 = 5.1

Exact solution is 5.099.

p
We have solved a much simpler problem ( 25) and added a small
coe¢ cient to it.

More in general
q p
p
y= x 2 (1 + ε ) = x 1 + ε

where x is an integer and ε the perturbation parameter.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 4 / 91
 Introduction

Applications to Economics

Judd and Guu (1993) showed how to apply it to economic problems.

Recently, perturbation methods have been gaining much popularity.

In particular, second- and third-order approximations are easy to

compute and notably improve accuracy.

A …rst-order perturbation theory and linearization deliver the same

output.

Hence, we can use much of what we already know about linearization.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 5 / 91

 Introduction

Regular versus Singular Perturbations

Regular perturbation: a small change in the problem induces a small

change in the solution.

Singular perturbation: a small change in the problem induces a large

change in the solution.

Example: excess demand function.

Most problems in economics involve regular perturbations.

Sometimes, however, we can have singularities. Example: introducing

a new asset in an incomplete markets model.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 6 / 91

 Introduction

References
General:
1 A First Look at Perturbation Theory by James G. Simmonds and
James E. Mann Jr.
2 Advanced Mathematical Methods for Scientists and Engineers:
Asymptotic Methods and Perturbation Theory by Carl M. Bender,
Steven A. Orszag.

Economics:
1 Perturbation Methods for General Dynamic Stochastic Models” by
Hehui Jin and Kenneth Judd.
2 Perturbation Methods with Nonlinear Changes of Variables” by
Kenneth Judd.
3 A gentle introduction: “Solving Dynamic General Equilibrium Models
Using a Second-Order Approximation to the Policy Function” by
Martín Uribe and Stephanie Schmitt-Grohe.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 7 / 91
 A Baby Example

A Baby Example: A Basic RBC

Model:
∞
max E0 ∑ βt log ct
t =0

s.t. ct + kt +1 = e zt ktα + (1 δ) kt , 8 t > 0

zt = ρzt 1 + σεt , εt N (0, 1)

Equilibrium conditions:
1 1
= βEt 1 + αe zt +1 ktα+11 δ
ct ct + 1
ct + kt +1 = e zt ktα + (1 δ) kt
zt = ρzt 1 + σεt

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 8 / 91

 A Baby Example

Computing a Solution
The previous problem does not have a known “paper and pencil”
solution except when (unrealistically) δ = 1.
Then, income and substitution e¤ect from a technology shock cancel
each other (labor constant and consumption is a …xed fraction of
income).
Equilibrium conditions with δ = 1:
1 αe zt +1 ktα+11
= βEt
ct ct + 1
ct + kt +1 = e zt ktα
zt = ρzt 1 + σεt
By “guess and verify”:
ct = ( 1 αβ) e zt ktα
kt +1 = αβe zt ktα
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 9 / 91
 A Baby Example

Another Way to Solve the Problem

Now let us suppose that you missed the lecture when “guess and
verify” was explained.

You need to compute the RBC.

What you are searching for? A decision rule for consumption:

ct = c (kt , zt )

and another one for capital:

kt +1 = k (kt , zt )

Note that our d is just the stack of c (kt , zt ) and k (kt , zt ).

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 10 / 91
 A Baby Example

Equilibrium Conditions

We substitute in the equilibrium conditions the budget constraint and

the law of motion for technology.

And we write the decision rules explicitly as function of the states.

Then:

1 αe ρzt +σεt +1 k (kt , zt )α 1

= βEt
c (kt , zt ) c (k (kt , zt ) , ρzt + σεt +1 )
c (kt , zt ) + k (kt , zt ) = e zt ktα

System of functional equations.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 11 / 91

 A Baby Example

Main Idea

Transform the problem rewriting it in terms of a small perturbation

parameter.

Solve the new problem for a particular choice of the perturbation

parameter.

This step is usually ambiguous since there are di¤erent ways to do so.

Use the previous solution to approximate the solution of original the

problem.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 12 / 91

 A Baby Example

A Perturbation Approach

Hence, we want to transform the problem.

Which perturbation parameter? Standard deviation σ.

Why σ? Discrete versus continuous time.

Set σ = 0 )deterministic model, zt = 0 and e zt = 1.

We know how to solve the deterministic steady state.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 13 / 91

 A Baby Example

A Parametrized Decision Rule

We search for decision rule:

ct = c (kt , zt ; σ)

and
kt +1 = k (kt , zt ; σ)

Note new parameter σ.

We are building a local approximation around σ = 0.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 14 / 91

 A Baby Example

Taylor’s Theorem

Equilibrium conditions:

!
1 αe ρzt +σεt +1 k (kt , zt ; σ)α 1
Et β =0
c (kt , zt ; σ) c (k (kt , zt ; σ) , ρzt + σεt +1 ; σ)
c (kt , zt ; σ) + k (kt , zt ; σ) e zt ktα = 0

We will take derivatives with respect to kt , zt , and σ.

Apply Taylor’s theorem to build solution around deterministic steady

state. How?

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 15 / 91

 A Baby Example

Asymptotic Expansion I

ct = c (kt , zt ; σ)jk ,0,0 = c (k, 0; 0)

+ck (k, 0; 0) (kt k ) + cz (k, 0; 0) zt + cσ (k, 0; 0) σ
1 1
+ ckk (k, 0; 0) (kt k )2 + ckz (k, 0; 0) (kt k ) zt
2 2
1 1
+ ck σ (k, 0; 0) (kt k ) σ + czk (k, 0; 0) zt (kt k )
2 2
1 2 1
+ czz (k, 0; 0) zt + cz σ (k, 0; 0) zt σ
2 2
1 1
+ cσk (k, 0; 0) σ (kt k ) + cσz (k, 0; 0) σzt
2 2
1 2
+ cσ2 (k, 0; 0) σ + ...
2

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 16 / 91

 A Baby Example

Asymptotic Expansion II

kt +1 = k (kt , zt ; σ)jk ,0,0 = k (k, 0; 0)

+kk (k, 0; 0) (kt k ) + kz (k, 0; 0) zt + kσ (k, 0; 0) σ
1 1
+ kkk (k, 0; 0) (kt k )2 + kkz (k, 0; 0) (kt k ) zt
2 2
1 1
+ kk σ (k, 0; 0) (kt k ) σ + kzk (k, 0; 0) zt (kt k )
2 2
1 2 1
+ kzz (k, 0; 0) zt + kz σ (k, 0; 0) zt σ
2 2
1 1
+ kσk (k, 0; 0) σ (kt k ) + kσz (k, 0; 0) σzt
2 2
1 2
+ kσ2 (k, 0; 0) σ + ...
2

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 17 / 91

 A Baby Example

Comment on Notation

From now on, to save on notation, I will write

" #
1 αe ρzt +σεt +1 k (kt ,zt ;σ)α 1
β 0
F (kt , zt ; σ) = Et c (kt ,zt ;σ ) c (k (k t ,zt ;σ),ρzt +σεt +1 ;σ) =
c (kt , zt ; σ) + k (kt , zt ; σ) e zt ktα 0

Note that:

F (kt , zt ; σ) = H (ct , ct +1 , kt , kt +1 , zt ; σ)
= H (c (kt , zt ; σ) , c (k (kt , zt ; σ) , zt +1 ; σ) , kt , k (kt , zt ; σ) , zt ; σ)

I will use Hi to represent the partial derivative of H with respect to

the i component and drop the evaluation at the steady state of the
functions when we do not need it.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 18 / 91

 A Baby Example

Zeroth-Order Approximation

First, we evaluate σ = 0:

F (kt , 0; 0) = 0

Steady state:
1 αk α 1
=β
c c
or
1
1 = αβk α
Then: α 1
c = c (k, 0; 0) = (αβ) 1 α (αβ) 1 α

1
k = k (k, 0; 0) = (αβ) 1 α

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 19 / 91

 A Baby Example

First-Order Approximation

We take derivatives of F (kt , zt ; σ) around k, 0, and 0.

With respect to kt :
Fk (k, 0; 0) = 0

With respect to zt :
Fz (k, 0; 0) = 0

With respect to σ:
Fσ (k, 0; 0) = 0

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 20 / 91

 A Baby Example

Solving the System I

Remember that:

F (kt , zt ; σ)
= H (c (kt , zt ; σ) , c (k (kt , zt ; σ) , zt +1 ; σ) , kt , k (kt , zt ; σ) , zt ; σ) = 0

Because F (kt , zt ; σ) must be equal to zero for any possible values of

kt , zt , and σ, the derivatives of any order of F must also be zero.

Then:

Fk (k, 0; 0) = H1 ck + H2 ck kk + H3 + H4 kk = 0
Fz (k, 0; 0) = H1 cz + H2 (ck kz + ck ρ) + H4 kz + H5 = 0
Fσ (k, 0; 0) = H1 cσ + H2 (ck kσ + cσ ) + H4 kσ + H6 = 0

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 21 / 91

 A Baby Example

Solving the System II

A quadratic system:
Fk (k, 0; 0) = H1 ck + H2 ck kk + H3 + H4 kk = 0
Fz (k, 0; 0) = H1 cz + H2 (ck kz + ck ρ) + H4 kz + H5 = 0
of 4 equations on 4 unknowns: ck , cz , kk , and kz .
Procedures to solve quadratic systems:
1 Blanchard and Kahn (1980).
2 Uhlig (1999).
3 Sims (2000).
4 Klein (2000).

All of them equivalent.

Why quadratic? Stable and unstable manifold.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 22 / 91
 A Baby Example

Solving the System III

Also, note that:
Fσ (k, 0; 0) = H1 cσ + H2 (ck kσ + cσ ) + H4 kσ + H6 = 0
is a linear, and homogeneous system in cσ and kσ .
Hence:
cσ = kσ = 0

This means the system is certainty equivalent.

Interpretation)no precautionary behavior.
Di¤erence between risk-aversion and precautionary behavior. Leland
(1968), Kimball (1990).
Risk-aversion depends on the second derivative (concave utility).
Precautionary behavior depends on the third derivative (convex
marginal utility).
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 23 / 91
 A Baby Example

Comparison with LQ and Linearization

After Kydland and Prescott (1982) a popular method to solve
economic models has been to …nd a LQ approximation of the
objective function of the agents.

Close relative: linearization of equilibrium conditions.

When properly implemented linearization, LQ, and …rst-order

perturbation are equivalent.

Advantages of perturbation:

1 Theorems.

2 Higher-order terms.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 24 / 91
 A Baby Example

Some Further Comments

Note how we have used a version of the implicit-function theorem.

Important tool in economics.

Also, we are using the Taylor theorem to approximate the policy

function.

Alternatives?

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 25 / 91

 A Baby Example

Second-Order Approximation
We take second-order derivatives of F (kt , zt ; σ) around k, 0, and 0:

Fkk (k, 0; 0) = 0
Fkz (k, 0; 0) = 0
Fk σ (k, 0; 0) = 0
Fzz (k, 0; 0) = 0
Fz σ (k, 0; 0) = 0
Fσσ (k, 0; 0) = 0
Remember Young’s theorem!
We substitute the coe¢ cients that we already know.
A linear system of 12 equations on 12 unknowns. Why linear?
Cross-terms kσ and zσ are zero.
Conjecture on all the terms with odd powers of σ.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 26 / 91
 A Baby Example

Correction for Risk

We have a term in σ2 .

Captures precautionary behavior.

We do not have certainty equivalence any more!

Important advantage of second-order approximation.

Changes ergodic distribution of states.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 27 / 91

 A Baby Example

Higher-Order Terms

We can continue the iteration for as long as we want.

Great advantage of procedure: it is recursive!

Often, a few iterations will be enough.

The level of accuracy depends on the goal of the exercise:

1 Welfare analysis: Kim and Kim (2001).

2 Empirical strategies: Fernández-Villaverde, Rubio-Ramírez, and Santos

(2006).

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 28 / 91

 A Numerical Example

A Numerical Example

Parameter β α ρ σ
Value 0.99 0.33 0.95 0.01

Steady State: c = 0.388069 k = 0.1883

First-order terms:
ck (k, 0; 0) = 0.680101 kk (k, 0; 0) = 0.33
cz (k, 0; 0) = 0.388069 kz (k, 0; 0) = 0.1883
Second-order terms:
ckk (k, 0; 0) = 2.41990 kkk (k, 0; 0) = 1.1742
ckz (k, 0; 0) = 0.680099 kkz (k, 0; 0) = 0.33
czz (k, 0; 0) = 0.388064 kzz (k, 0; 0) = 0.1883
cσ2 (k, 0; 0) ' 0 kσ2 (k, 0; 0) ' 0
cσ (k, 0; 0) = kσ (k, 0; 0) = ck σ (k, 0; 0) = kk σ (k, 0; 0) =
cz σ (k, 0; 0) = kz σ (k, 0; 0) = 0.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 29 / 91
 A Numerical Example

Comparison

ct = 0.6733e zt kt0.33
ct ' 0.388069 + 0.680101 (kt k ) + 0.388069zt
2.41990 0.388064 2
(kt k )2 + 0.680099 (kt k ) zt + zt
2 2
and:

kt +1 = 0.3267e zt kt0.33
kt +1 ' 0.1883 + 0.33 (kt k ) + 0.1883zt
1.1742 0.1883 2
(kt k )2 + 0.33 (kt k ) zt + zt
2 2

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 30 / 91

 A Numerical Example

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 31 / 91

 A Numerical Example

A Computer

In practice you do all this approximations with a computer:

1 First-, second-, and third-order: Matlab and Dynare.

2 Higher-order: Mathematica, Dynare++, Fortran code by Jinn and

Judd.

Burden: analytical derivatives.

Why are numerical derivatives a bad idea?

Alternatives: automatic di¤erentiation?

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 32 / 91

 A Numerical Example

Local Properties of the Solution

Perturbation is a local method.
It approximates the solution around the deterministic steady state of
the problem.
It is valid within a radius of convergence.
What is the radius of convergence of a power series around x? An
r 2 R∞ 0
+ such that 8x , jx
0 z j < r , the power series of x 0 will
converge.

A Remarkable Result from Complex Analysis

The radius of convergence is always equal to the distance from the center
to the nearest point where the policy function has a (non-removable)
singularity. If no such point exists then the radius of convergence is in…nite.

Singularity here refers to poles, fractional powers, and other branch

powers or discontinuities of the functional or its derivatives.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 33 / 91
 A Numerical Example

Remarks

Intuition of the theorem: holomorphic functions are analytic.

Distance is in the complex plane.

Often, we can check numerically that perturbations have good non

local behavior.

However: problem with boundaries.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 34 / 91

 A Numerical Example

Non Local Accuracy Test

Proposed by Judd (1992) and Judd and Guu (1997).

Given the Euler equation:

1 αe zt +1 k i (kt , zt )α 1
i
= Et
c (kt , zt ) c i (k i (kt , zt ), zt +1 )
we can de…ne:
αe zt +1 k i (kt , zt )α 1
EE i (kt , zt ) 1 c i (kt , zt ) Et
c i (k i (kt , zt ), zt +1 )

Units of reporting.

Interpretation.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 35 / 91
 A Numerical Example

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 36 / 91

 The General Case

The General Case

Most of previous argument can be easily generalized.

The set of equilibrium conditions of many DSGE models can be

written as (note recursive notation)

Et H(y , y 0 , x, x 0 ) = 0,

where yt is a ny 1 vector of controls and xt is a nx 1 vector of

states.

De…ne n = nx + ny .

Then H maps R ny R ny R nx R nx into R n .

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 37 / 91
 The General Case

Partitioning the State Vector

The state vector xt can be partitioned as x = [x1 ; x2 ]t .

x1 is a (nx ne ) 1 vector of endogenous state variables.

x2 is a ne 1 vector of exogenous state variables.

Why do we want to partition the state vector?

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 38 / 91

 The General Case

Exogenous Stochastic Process

x20 = Λx2 + ση e e0
Process with 3 parts:
1 The deterministic component Λx2 :
1 Λ is a ne ne matrix, with all eigenvalues with modulus less than one.
2 More general: x20 = Γ(x2 ) + ση e e0 , where Γ is a non-linear function
satisfying that all eigenvalues of its …rst derivative evaluated at the
non-stochastic steady state lie within the unit circle.
2 The scaled innovation η e e0 where:
1 η e is a known ne ne matrix.
2 e is a ne 1 i.i.d innovation with bounded support, zero mean, and
variance/covariance matrix I .
3 The perturbation parameter σ.
We can accommodate very general structures of x2 through changes
in the de…nition of the state space: i.e. stochastic volatility.
Note we do not impose Gaussianity.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 39 / 91
 The General Case

The Perturbation Parameter

The scalar σ 0 is the perturbation parameter.

If we set σ = 0 we have a deterministic model.

Important: there is only ONE perturbation parameter. The matrix η e

takes account of relative sizes of di¤erent shocks.

Why bounded support? Samuelson (1970) and Jin and Judd (2002).

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 40 / 91

 The General Case

Solution of the Model

The solution to the model is of the form:

y = g (x; σ)
x = h(x; σ) + σηe0
0

where g maps R nx R + into R ny and h maps R nx R + into R nx .

The matrix η is of order nx ne and is given by:

∅
η=
ηe

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 41 / 91

 The General Case

Perturbation

We wish to …nd a perturbation approximation of the functions g and

h around the non-stochastic steady state, xt = x̄ and σ = 0.

We de…ne the non-stochastic steady state as vectors (x̄, ȳ ) such that:

H(ȳ , ȳ , x̄, x̄ ) = 0.

Note that ȳ = g (x̄; 0) and x̄ = h(x̄; 0). This is because, if σ = 0,

then Et H = H.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 42 / 91

 The General Case

Plugging-in the Proposed Solution

Substituting the proposed solution, we de…ne:

F (x; σ) Et H(g (x; σ), g (h(x; σ) + ησe0 , σ), x, h(x; σ) + ησe0 ) = 0

Since F (x; σ) = 0 for any values of x and σ, the derivatives of any

order of F must also be equal to zero.

Formally:

Fx k σj (x; σ) = 0 8x, σ, j, k,

where Fx k σj (x, σ) denotes the derivative of F with respect to x taken

k times and with respect to σ taken j times.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 43 / 91
 The General Case

First-Order Approximation
We look for approximations to g and h around (x, σ) = (x̄, 0):
g (x; σ) = g (x̄; 0) + gx (x̄; 0)(x x̄ ) + gσ (x̄; 0)σ
h(x; σ) = h(x̄; 0) + hx (x̄; 0)(x x̄ ) + hσ (x̄; 0)σ
As explained earlier,
g (x̄; 0) = ȳ
and
h(x̄; 0) = x̄.
The four unknown coe¢ cients of the …rst-order approximation to g
and h are found by using:
Fx (x̄; 0) = 0
and
Fσ (x̄; 0) = 0
Before doing so, I need to introduce the tensor notation.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 44 / 91
 The General Case

Tensors
General trick from physics.
An nth -rank tensor in a m-dimensional space is an operator that has n
indices and mn components and obeys certain transformation rules.
[Hy ]iα is the (i, α) element of the derivative of H with respect to y :
1 The derivative of H with respect to y is an n ny matrix.
2 Thus, [Hy ]iα is the element of this matrix located at the intersection of
the i-th row and α-th column.
nnx ∂ H i ∂g α ∂h β
Thus, [Hy ]iα [gx ]αβ [hx ]j = ∑α=
β y
1 ∑ β =1 ∂y α ∂x β ∂x j .
3

[Hy 0 y 0 ]iαγ :
1 Hy 0 y 0 is a three dimensional array with n rows, ny columns, and ny
pages.
2 Then [Hy 0 y 0 ]iαγ denotes the element of Hy 0 y 0 located at the
intersection of row i, column α and page γ.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 45 / 91
 The General Case

Solving the System I

gx and hx can be found as the solution to the system:

[Fx (x̄; 0)]ij = [Hy 0 ]iα [gx ]αβ [hx ]j + [Hy ]iα [gx ]jα + [Hx 0 ]iβ [hx ]j + [Hx ]ij =
β β

i = 1, . . . , n; j, β = 1, . . . , nx ; α = 1, . . . , ny

Note that the derivatives of H evaluated at (y , y 0 , x, x 0 ) = (ȳ , ȳ , x̄, x̄ )

are known.

Then, we have a system of n nx quadratic equations in the n nx

unknowns given by the elements of gx and hx .

We can solve with a standard quadratic matrix equation solver.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 46 / 91

 The General Case

Solving the System II

gσ and hσ are identi…ed as the solution to the following n equations:
[Fσ (x̄; 0)]i =
Et f[Hy 0 ]iα [gx ]αβ [hσ ] β + [Hy 0 ]iα [gx ]αβ [η ]φ [e0 ]φ + [Hy 0 ]iα [gσ ]α
β

+[Hy ]iα [gσ ]α + [Hx 0 ]iβ [hσ ] β + [Hx 0 ]iβ [η ]φ [e0 ]φ g

β

i = 1, . . . , n; α = 1, . . . , ny ; β = 1, . . . , nx ; φ = 1, . . . , ne .
Then:
[Fσ (x̄; 0)]i = [Hy 0 ]iα [gx ]αβ [hσ ] β + [Hy 0 ]iα [gσ ]α + [Hy ]iα [gσ ]α + [fx 0 ]iβ [hσ ] β = 0;
i = 1, . . . , n; α = 1, . . . , ny ; β = 1, . . . , nx ; φ = 1, . . . , ne .
Certainty equivalence: this equation is linear and homogeneous in gσ
and hσ . Thus, if a unique solution exists, it must satisfy:
hσ 6 = 0
gσ = 0
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 47 / 91
 The General Case

Second-Order Approximation I

The second-order approximations to g around (x; σ) = (x̄; 0) is

[g (x; σ)]i = [g (x̄; 0)]i + [gx (x̄; 0)]ia [(x x̄ )]a + [gσ (x̄; 0)]i [σ]
1
+ [gxx (x̄; 0)]iab [(x x̄ )]a [(x x̄ )]b
2
1
+ [gx σ (x̄; 0)]ia [(x x̄ )]a [σ]
2
1
+ [gσx (x̄; 0)]ia [(x x̄ )]a [σ]
2
1
+ [gσσ (x̄; 0)]i [σ][σ]
2
where i = 1, . . . , ny , a, b = 1, . . . , nx , and j = 1, . . . , nx .

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 48 / 91

 The General Case

Second-Order Approximation II

The second-order approximations to h around (x; σ) = (x̄; 0) is

[h(x; σ)]j = [h(x̄; 0)]j + [hx (x̄; 0)]ja [(x x̄ )]a + [hσ (x̄; 0)]j [σ]
1
+ [hxx (x̄; 0)]jab [(x x̄ )]a [(x x̄ )]b
2
1
+ [hx σ (x̄; 0)]ja [(x x̄ )]a [σ]
2
1
+ [hσx (x̄; 0)]ja [(x x̄ )]a [σ]
2
1
+ [hσσ (x̄; 0)]j [σ][σ],
2
where i = 1, . . . , ny , a, b = 1, . . . , nx , and j = 1, . . . , nx .

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 49 / 91

 The General Case

Second-Order Approximation III

The unknowns of these expansions are [gxx ]iab , [gx σ ]ia , [gσx ]ia , [gσσ ]i ,
[hxx ]jab , [hx σ ]ja , [hσx ]ja , [hσσ ]j .

These coe¢ cients can be identi…ed by taking the derivative of F (x; σ)

with respect to x and σ twice and evaluating them at (x; σ) = (x̄; 0).

By the arguments provided earlier, these derivatives must be zero.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 50 / 91

 The General Case

Solving the System I

We use Fxx (x̄; 0) to identify gxx (x̄; 0) and hxx (x̄; 0):

[Fxx (x̄; 0)]ijk =

[Hy 0 y 0 ]iαγ [gx ]γδ [hx ]kδ + [Hy 0 y ]iαγ [gx ]kγ + [Hy 0 x 0 ]iαδ [hx ]kδ + [Hy 0 x ]iαk [gx ]αβ [hx ]j
β

+[Hy 0 ]iα [gxx ]αβδ [hx ]kδ [hx ]j + [Hy 0 ]iα [gx ]αβ [hxx ]jk
β β

+ [Hyy 0 ]iαγ [gx ]γδ [hx ]kδ + [Hyy ]iαγ [gx ]kγ + [Hyx 0 ]iαδ [hx ]kδ + [Hyx ]iαk [gx ]jα
+[Hy ]iα [gxx ]jk
α

+ [Hx 0 y 0 ]iβγ [gx ]γδ [hx ]kδ + [Hx 0 y ]iβγ [gx ]kγ + [Hx 0 x 0 ]iβδ [hx ]kδ + [Hx 0 x ]iβk [hx ]j
β

+[Hx 0 ]iβ [hxx ]jk

β

+[Hxy 0 ]ij γ [gx ]γδ [hx ]kδ + [Hxy ]ij γ [gx ]kγ + [Hxx 0 ]ij δ [hx ]kδ + [Hxx ]ijk = 0;
i = 1, . . . n, j, k, β, δ = 1, . . . nx ; α, γ = 1, . . . ny .

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 51 / 91

 The General Case

Solving the System II

We know the derivatives of H.

We also know the …rst derivatives of g and h evaluated at

(y , y 0 , x, x 0 ) = (ȳ , ȳ , x̄, x̄ ).

Hence, the above expression represents a system of n nx nx linear

equations in then n nx nx unknowns elements of gxx and hxx .

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 52 / 91

 The General Case

Solving the System III

Similarly, gσσ and hσσ can be obtained by solving:

[Fσσ (x̄; 0)]i = [Hy 0 ]iα [gx ]αβ [hσσ ] β

+[Hy 0 y 0 ]iαγ [gx ]γδ [η ]δξ [gx ]αβ [η ]φ [I ]ξ
β φ

+[Hy 0 x 0 ]iαδ [η ]δξ [gx ]αβ [η ]φ [I ]ξ

β φ

+[Hy 0 ]iα [gxx ]αβδ [η ]δξ [η ]φ [I ]ξ + [Hy 0 ]iα [gσσ ]α

β φ

+[Hy ]iα [gσσ ]α + [Hx 0 ]iβ [hσσ ] β

+[Hx 0 y 0 ]iβγ [gx ]γδ [η ]δξ [η ]φ [I ]ξ
β φ

+[Hx 0 x 0 ]iβδ [η ]δξ [η ]φ [I ]ξ = 0;

β φ

i = 1, . . . , n; α, γ = 1, . . . , ny ; β, δ = 1, . . . , nx ; φ, ξ = 1, . . . , ne

a system of n linear equations in the n unknowns given by the elements of

gσσ and hσσ .
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 53 / 91
 The General Case

Cross Derivatives
The cross derivatives gx σ and hx σ are zero when evaluated at (x̄, 0).
Why? Write the system Fσx (x̄; 0) = 0 taking into account that all
terms containing either gσ or hσ are zero at (x̄, 0).
Then:
[Fσx (x̄; 0)]ij = [Hy 0 ]iα [gx ]αβ [hσx ]j + [Hy 0 ]iα [gσx ]αγ [hx ]jγ +
β

[Hy ]iα [gσx ]jα + [Hx 0 ]iβ [hσx ]j = 0;

β

i = 1, . . . n; α = 1, . . . , ny ; β, γ, j = 1, . . . , nx .
a system of n nx equations in the n nx unknowns given by the
elements of gσx and hσx .
The system is homogeneous in the unknowns.
Thus, if a unique solution exists, it is given by:
gσx = 0
hσx = 0
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 54 / 91
 The General Case

Structure of the Solution

The perturbation solution of the model satis…es:

gσ (x̄; 0) = 0
hσ (x̄; 0) = 0
gx σ (x̄; 0) = 0
hx σ (x̄; 0) = 0

Standard deviation only appears in:

1 A constant term given by 12 gσσ σ2 for the control vector yt .
2 The …rst nx ne elements of 21 hσσ σ2 .

Correction for risk.

Quadratic terms in endogenous state vector x1 .
Those terms capture non-linear behavior.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 55 / 91
 The General Case

Higher-Order Approximations

We can iterate this procedure as many times as we want.

We can obtain n-th order approximations.

Problems:

1 Existence of higher order derivatives (Santos, 1992).

2 Numerical instabilities.

3 Computational costs.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 56 / 91

 Change of Variables

Erik Eady
It is not the process of linearization that limits insight.
It is the nature of the state that we choose to linearize about.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 57 / 91

 Change of Variables

Change of Variables

We approximated our solution in levels.

We could have done it in logs.

Why stop there? Why not in powers of the state variables?

Judd (2002) has provided methods for changes of variables.

We apply and extend ideas to the stochastic neoclassical growth

model.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 58 / 91

 Change of Variables

A General Transformation

We look at solutions of the form:

µ ζ
cµ c0 = a kζ k0 + bz

k 0γ
γ ζ
k0 = c kζ k0 + dz

Note that:

1 If γ, ζ, and µ are 1, we get the linear representation.

2 As γ, ζ and µ tend to zero, we get the loglinear approximation.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 59 / 91

 Change of Variables

Theory
The …rst-order solution can be written as
f (x ) ' f (a ) + (x a ) f 0 (a )

Expand g (y ) = h (f (X (y ))) around b = Y (a), where X (y ) is the

inverse of Y (x ).

Then:
g (y ) = h (f (X (y ))) = g (b ) + gα (b ) (Y α (x ) bα )
where gα = hA fi A Xαi comes from the application of the chain rule.

From this expression it is easy to see that if we have computed the

values of fi A , then it is straightforward to …nd gα .
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 60 / 91
 Change of Variables

Coe¢ cients Relation

Remember that the linear solution is:

k0 k0 = a1 ( k k0 ) + b1 z
(l l0 ) = c1 (k k0 ) + d1 z

Then we show that:

γ ζ γ 1
a3 = γζ k0 a1 b3 = γk0 b1
µ µ 1 1 ζ µ 1
c3 = ζ l0 k0 c1 d3 = µl0 d1

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 61 / 91

 Change of Variables

Finding the Parameters

Minimize over a grid the Euler Error.

Some optimal results

Euler Equation Errors

γ ζ µ SEE
1 1 1 0.0856279
0.986534 0.991673 2.47856 0.0279944

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 62 / 91

 Change of Variables

Sensitivity Analysis

Di¤erent parameter values.

Most interesting …nding is when we change σ:

Optimal Parameters for di¤erent σ’s

σ γ ζ µ
0.014 0.98140 0.98766 2.47753
0.028 1.04804 1.05265 1.73209
0.056 1.23753 1.22394 0.77869

A …rst-order approximation corrects for changes in variance!

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 63 / 91

 Change of Variables

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 64 / 91

 Change of Variables

A Quasi-Optimal Approximation
Sensitivity analysis reveals that for di¤erent parametrizations

γ'ζ

This suggests the quasi-optimal approximation:

k 0γ
γ γ
k0 = a3 k γ k0 + b3 z
µ γ
lµ l0 = c3 k γ k0 + d3 z

If we de…ne kb = k γ k0 and bl = l µ
γ µ
l0 we get:

kb0 = a3 kb + b3 z
bl = c3 kb + d3 z

Linear system:
1 Use for analytical study.
2 Use for estimation with a Kalman Filter.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 65 / 91
 Perturbing the Value Function

Perturbing the Value Function

We worked with the equilibrium conditions of the model.

Sometimes we may want to perform a perturbation on the value

function formulation of the problem.

Possible reasons:

1 Gain insight.

2 Di¢ culty in using equilibrium conditions.

3 Evaluate welfare.

4 Initial guess for VFI.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 66 / 91
 Perturbing the Value Function

Basic Problem

Imagine that we have:

" #
1 γ
c
V (kt , zt ) = max (1 β) t + βEt V (kt +1 , zt +1 )
ct 1 γ
s.t. ct + kt +1 = e zt ktθ + (1 δ) kt
zt = λzt 1 + σεt , εt N (0, 1)

Write it as:
" #
1 γ
c
V (kt , zt ; χ) = max (1 β) t + βEt V (kt +1 , zt +1 ; χ)
ct 1 γ
s.t. ct + kt +1 = e zt ktθ + (1 δ) kt
zt = λzt 1 + χσεt , εt N (0, 1)

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 67 / 91

 Perturbing the Value Function

Alternative

Another way to write the value function is:

V (kt , zt ; χ) =
" 1 γ
#
max
(1 β) c1t γ +
ct βEt V e zt ktθ + (1 δ) kt ct , λzt + χσεt +1 ; χ

This form makes the dependences in the next period states explicit.

The solution of this problem is value function V (kt , zt ; χ) and a

policy function for consumption c (kt , zt ; χ).

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 68 / 91

 Perturbing the Value Function

Expanding the Value Function

The second-order Taylor approximation of the value function around the
deterministic steady state (kss , 0; 0) is:
V (kt , zt ; χ) '
Vss + V1,ss (kt kss ) + V2,ss zt + V3,ss χ
1 1 1
+ V11,ss (kt kss )2 + V12,ss (kt kss ) zt + V13,ss (kt kss ) χ
2 2 2
1 1 1
+ V21,ss zt (kt kss ) + V22,ss zt2 + V23,ss zt χ
2 2 2
1 1 1
+ V31,ss χ (kt kss ) + V32,ss χzt + V33,ss χ2
2 2 2
where
Vss = V (kss , 0; 0)
Vi ,ss = Vi (kss , 0; 0) for i = f1, 2, 3g
Vij ,ss = Vij (kss , 0; 0) for i, j = f1, 2, 3g
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 69 / 91
 Perturbing the Value Function

Expanding the Value Function

By certainty equivalence, we will show below that:

V3,ss = V13,ss = V23,ss = 0

Taking advantage of the equality of cross-derivatives, and setting

χ = 1, which is just a normalization:

V (kt , zt ; 1) ' Vss + V1,ss (kt kss ) + V2,ss zt

1 1
+ V11,ss (kt kss )2 + V22,ss ztt2
2 2
1
+V12,ss (kt kss ) z + V33,ss
2
Note that V33,ss 6= 0, a di¤erence from the standard linear-quadratic
approximation to the utility functions.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 70 / 91
 Perturbing the Value Function

Expanding the Consumption Function

The policy function for consumption can be expanded as:

ct = c (kt , zt ; χ) ' css + c1,ss (kt kss ) + c2,ss zt + c3,ss χ

where:

c1,ss = c1 (kss , 0; 0)
c2,ss = c2 (kss , 0; 0)
c3,ss = c3 (kss , 0; 0)

Since the …rst derivatives of the consumption function only depend on

the …rst and second derivatives of the value function, we must have
c3,ss = 0 (precautionary consumption depends on the third derivative
of the value function, Kimball, 1990).

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 71 / 91

 Perturbing the Value Function

Linear Components of the Value Function

To …nd the linear approximation to the value function, we take

derivatives of the value function with respect to controls (ct ), states
(kt , zt ), and the perturbation parameter χ.

Notation:

1 Vi ,t : derivative of the value function with respect to its i-th argument,

evaluated in (kt , zt ; χ) .

2 Vi ,ss : derivative evaluated in the steady state, (kss , 0; 0).

3 We follow the same notation for higher-order (cross-) derivatives.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 72 / 91

 Perturbing the Value Function

Derivatives
Derivative with respect to ct :
γ
(1 β ) ct βEt V1,t +1 = 0
Derivative with respect to kt :

V1,t = βEt V1,t +1 θe zt ktθ 1

+1 δ

Derivative with respect to zt :

h i
V2,t = βEt V1,t +1 e zt ktθ + V2,t +1 λ

Derivative with respect to χ:

V3,t = βEt [V2,t +1 σεt +1 + V3,t +1 ]
In the last three derivatives, we apply the envelope theorem to
eliminate the derivatives of consumption with respect to kt , zt , and χ.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 73 / 91
 Perturbing the Value Function

System of Equations I

Now, we have the system:

ct + kt +1 = e zt ktθ + (1 δ) kt
1 γ
ct
V (kt , zt ; χ) = (1 β) + βEt V (kt +1 , zt +1 ; χ)
1 γ
γ
(1 β ) ct βEt V1,t +1 = 0
V1,t = βEt V1,t +1 θe zt ktθ 1 + 1 δ
h i
V2,t = βEt V1,t +1 e zt ktθ + V2,t +1 λ
V3,t = βEt [V2,t +1 σεt +1 + V3,t +1 ]
zt = λzt 1 + χσεt

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 74 / 91

 Perturbing the Value Function

System of Equations II
If we set χ = 0 and compute the steady state, we get a system of six
equations on six unknowns, css , kss , Vss , V1,ss , V2,ss , and V3,ss :
css + δkss = kssθ
1 γ
css
Vss = (1 β) + βVss
1 γ
(1 β) css γ βV1,ss = 0
V1,ss = βV1,ss θkssθ 1 + 1 δ
h i
V2,ss = β V1,ss kssθ + V2,ss λ
V3,ss = βV3,ss
From the last equation: V3,ss = 0.
1 γ
From the second equation: Vss = c1ss γ .
1 β γ
From the third equation: V1,ss = β css .
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 75 / 91
 Perturbing the Value Function

System of Equations III

After cancelling redundant terms:

css + δkss = kssθ

1 = β θkssθ 1 + 1 δ
h i
V2,ss = β V1,ss kssθ + V2,ss λ

Then:
1
1 1 θ 1
kss = 1+δ
θ β
css = kssθ δkss
1 β θ γ
V2,ss = k c
1 βλ ss ss
V1,ss > 0 and V2,ss > 0, as predicted by theory.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 76 / 91
 Perturbing the Value Function

Quadratic Components of the Value Function

From the previous derivations, we have:
γ
(1 β) c (kt , zt ; χ) βEt V1,t +1 = 0
V1,t = βEt V1,t +1 θe zt ktθ 1 + 1 δ
h i
V2,t = βEt V1,t +1 e zt ktθ + V2,t +1 λ
V3,t = βEt [V2,t +1 σεt +1 + V3,t +1 ]
where:
kt +1 = e zt ktθ + (1 δ) kt c (kt , zt ; χ)
zt = λzt 1 + χσεt , εt N (0, 1)
We take derivatives of each of the four equations w.t.r. kt , zt , and χ.
We take advantage of the equality of cross derivatives.
The envelope theorem does not hold anymore (we are taking
derivatives of the derivatives of the value function).
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 77 / 91
 Perturbing the Value Function

First Equation I
We have:
γ
(1 β) c (kt , zt ; χ) βEt V1,t +1 = 0

Derivative with respect to kt :

γ 1
(1 β) γc (kt , zt ; χ) c1,t
h i
βEt V11,t +1 e zt θktθ 1
+1 δ c1,t =0

In steady state:
h i
1 1
βV11,ss (1 β) γcss γ c1,ss = β V11,ss θkssθ +1 δ

or
V11,ss
c1,ss = γ 1
βV11,ss (1 β) γcss
where we have used that 1 = β θkssθ 1 +1 δ .
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 78 / 91
 Perturbing the Value Function

First Equation II

Derivative with respect to zt :

γ 1
(1 β) γc (kt , zt ; χ) c2,t
βEt V11,t +1 e zt ktθ c2,t + V12,t +1 λ = 0

In steady state:

1
βV11,ss (1 β) γcss γ c2,ss = β V11,ss ktθ + V12,ss λ

or
β
c2,ss = γ 1
V11,ss kssθ + V12,ss λ
βV11,ss (1 β) γcss

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 79 / 91

 Perturbing the Value Function

First Equation III

Derivative with respect to χ:

γ 1
(1 β) γc (kt , zt ; χ) c3,t
βEt ( V11,t +1 c3,t + V12,t +1 σεt +1 + V13,t +1 ) = 0

In steady state:
1
βV11,ss (1 β) γcss γ c3,ss = βV13,ss

or
β
c3,ss = V13,ss
γ 1
βV11,ss (1 β) γcss

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 80 / 91

 Perturbing the Value Function

Second Equation I
We have:
V1,t = βEt V1,t +1 θe zt ktθ 1
+1 δ

Derivative with respect to kt :

" #
V11,t +1 θe zt ktθ 1 + 1 δ c1,t θe zt ktθ 1
+1 δ
V11,t = βEt
2
+V1,t +1 θ (θ 1) e zt ktθ

In steady state:

1 2
V11,ss = V11,ss c1,ss + βV1,ss θ (θ 1) kssθ
β
or
β 2
V11,ss = 1
V1,ss θ (θ 1) kssθ
1 β + c1,ss

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 81 / 91

 Perturbing the Value Function

Second Equation II

Derivative with respect to zt :

2 3
V11,t +1 e zt ktθ c2,t θe zt ktθ 1 + 1 δ
V12,t = βEt 4 5
+V12,t +1 λ θe zt ktθ 1 + 1 δ + V1,t +1 θe zt ktθ 1

In steady state:

1
V12,ss = V11,ss kssθ c2,ss + V12,ss λ + βV1,ss θktθ

or h i
1 1
V12,ss = V11,ss kssθ c2,ss + βV1,ss θkssθ
1 λ

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 82 / 91

 Perturbing the Value Function

Second Equation III

Derivative with respect to χ:

V13,t = βEt [ V11,t +1 c3,t + V12,t +1 σεt +1 + V13,t +1 ]

In steady state,

V13,ss = β [ V11,ss c3,ss + V13,ss ] )

β
V13,ss = V11,ss c3,ss
β 1

but since we know that:

β
c3,ss = V13,ss
γ 1
βV11,ss (1 β) γcss

the two equations can only hold simultaneously if V13,ss = c3,ss = 0.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 83 / 91
 Perturbing the Value Function

Third Equation I
We have h i
V2,t = βEt V1,t +1 e zt ktθ + V2,t +1 λ

Derivative with respect to zt :

V11,t +1 e zt ktθ c2,t e zt ktθ + V12,t +1 λe zt ktθ

V22,t = βEt
+V1,t +1 e zt ktθ + V21,t +1 λ e zt ktθ c2,t + V22,t +1 λ2

In steady state:

V11,ss ktθ c2,ss kssθ + V12,ss λkssθ + V1,ss kssθ

V22,t = β )
+V21,ss λ kssθ c2,ss + V22,ss λ2
β V11,ss ktθ c2,ss kssθ + 2V12,ss λkssθ
V22,ss =
1 βλ2 +V1,ss kssθ V12,ss λc2,ss

where we have used V12,ss = V21,ss .

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 84 / 91
 Perturbing the Value Function

Third Equation II

Derivative with respect to χ:

V11,t +1 e zt ktθ c3,t + V12,t +1 e zt ktθ σεt +1 + V13,t +1 e zt ktθ

V23,t = βEt
V21,t +1 λc3,t + V22,t +1 λσεt +1 + V23,t +1 λ

In steady state:
V23,ss = 0

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 85 / 91

 Perturbing the Value Function

Fourth Equation

We have
V3,t = βEt [V2,t +1 σεt +1 + V3,t +1 ] .

Derivative with respect to χ:

V21,t +1 c3,t σεt +1 + V22,t +1 σ2 ε2t +1 + V23,t +1 σεt +1

V33,t = βEt
V31,t +1 c3,t + V32,t +1 σεt +1 + V33,t +1

In steady state:
β
V33,ss = V22,ss
1 β

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 86 / 91

 Perturbing the Value Function

System I

V11,ss
c1,ss = γ 1
βV11,ss (1 β) γcss
β
c2,ss = γ 1
V11,ss kssθ + V12,ss λ
βV11,ss (1 β) γcss
β
V11,ss = 1
1) kssθ 2
V1,ss θ (θ
1 β + c1,ss
1 h i
V12,ss = V11,ss kssθ c2,ss + βV1,ss θkssθ 1
1 λ
β V11,ss ktθ c2,ss kssθ + 2V12,ss λkssθ
V22,ss =
1 βλ2 +V1,ss kssθ V12,ss λc2,ss
β
V33,ss = σ2 V22,ss
1 β
plus c3,ss = V13,ss = V23,ss = 0.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 87 / 91
 Perturbing the Value Function

System II

This is a system of nonlinear equations.

However, it has a recursive structure.

By substituting variables that we already know, we can …nd V11,ss .

Then, using this results and by plugging c2,ss , we have a system of

two equations, on two unknowns, V12,ss and V22,ss .

Once the system is solved, we can …nd c1,ss , c2,ss , and V33,ss directly.

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 88 / 91

 Perturbing the Value Function

The Welfare Cost of the Business Cycle

An advantage of performing the perturbation on the value function is

that we have evaluation of welfare readily available.

Note that at the deterministic steady state, we have:

1
V (kss , 0; χ) ' Vss + V33,ss
2
Hence 12 V33,ss is a measure of the welfare cost of the business cycle.

This quantity is not necessarily negative: it may be positive. For

example, in an RBC with leisure choice (Cho and Cooley, 2000).

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 89 / 91

 Perturbing the Value Function

Our Example

1 γ
css
We know that Vss = 1 γ.
We can compute the decrease in consumption τ that will make the
household indi¤erent between consuming (1 τ ) css units per period
with certainty or ct units with uncertainty.
Thus:
1 γ
css 1 (css (1 τ ))1 γ
+ V33,ss = )
1 γ 2 1 γ
1
(1 τ )1 γ
1 css1 γ
= (1 γ) V33,ss
2
or 1
1 γ1 1 γ
τ=1 1+ 1
V
γ 2 33,ss
css

Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 90 / 91

 Perturbing the Value Function

A Numerical Example
We pick standard parameter values by setting
β = 0.99, γ = 2, δ = 0.0294, θ = 0.3, and λ = 0.95.
We get:
V (kt , zt ; 1) ' 0.54000 + 0.00295 (kt kss ) + 0.11684zt
2
0.00007 (kt kss ) 0.00985zt2
0.97508σ2 0.00225 (kt kss ) zt
c (kt , zt ; χ) ' 1.85193 + 0.04220 (kt kss ) + 0.74318zt
DYNARE produces the same policy function by linearizing the
equilibrium conditions of the problem.
The welfare cost of the business cycle (in consumption terms) is
8.8475e-005, lower than in Lucas (1987) because of the smoothing
possibilities allowed by capital.
Use as an initial guess for VFI.
Jesús Fernández-Villaverde (PENN) Perturbation Methods July 10, 2011 91 / 91