Markov-Chain Approximations for Life-Cycle Models


Non-stationary income processes are standard in quantitative life-cycle models. Their approximation is key for numerical implementations. We develop methods to apply standard discretization algorithms within non-stationary life-cycle settings and assess their relative performance. In one extension we examine income processes in which shocks to earnings are modeled as draws from a mixture of Normal distributions and describe simple and tractable approaches to numerically describe non-Normal earnings distributions.

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Abstract. Non-stationary income processes are standard in quantitative life-cycle models, prompted by the observation that within-cohort income inequality increases with age. This paper generalizes Tauchen (1986), Adda and Cooper (2003), and Rouwenhorst’s (1995) discretization methods to non-stationary AR(1) processes. We evaluate the performance of these methods in the context of a canonical life-cycle,income-fluctuation problem with a non-stationary income process. We also examine the case in which innovations to the persistent component of earnings are modeled as draws from a mixture of Normal distributions. We find that the generalized Rouwenhorst’s method performs consistently better than the others even with a relatively small number of states.

Citation

@article{fgp2019approximations,
  title={Markov-Chain Approximations for Life-Cycle Models},
  author={Fella, Giulio and Gallipoli, Giovanni and Pan, Jutong},
  journal={Review of Economic Dynamics},
  year={2019},
  volume = {34},
  pages = {183-201}
}