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In this paper we use the property that certainty equivalence, as implied by a first-order approximation to the solution of stochastic discrete-time models, breaks in its equivalent continuous-time version. We derive a risk-sensitive first-order perturbation solution for a general class of rational expectations models. We show that risk matters economically in a real business cycle (RBC) model with habit formation and capital adjustment costs, and that neglecting risk leads to substantial pricing errors. A first-order perturbation provides a sensible approximation to the effects of risk in continuous-time models. It reduces pricing errors by around 90% relative to the certainty equivalent linear approximation.
Original language | English |
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Article number | 104248 |
Journal | Journal of Economic Dynamics and Control |
Volume | 133 |
Number of pages | 25 |
ISSN | 0165-1889 |
DOIs | |
Publication status | Published - Dec 2021 |
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