On the Accuracy of Linear DSGE Solution Methods and the Consequences for Log-Normal Asset Pricing
Abstract
"This paper demonstrates an economically significant loss of accuracy in standard,
generalized Schur (or QZ) decomposition based solutions methods for linear dynamic
stochastic general equilibrium (DSGE) models. This is illustrated in a simple productionbased
asset pricing model with external habit formation, calibrated to match post-war
US consumption growth and the equity premium. When there is insufficient eigenvalue
separation about the unit circle, QZ-based numerical solutions miss the equity premium by
up to several annualized percentage points. While none of the numerical solution methods
gave any indication of this error, easily implementable backward-error metrics are shown
to successfully warn of such potential inaccuracies."