Abstract
This paper illustrates two types of pitfalls when linearization methods are improperly applied. First, if we linearize the constraints before deriving the optimality conditions, the derived conditions are not correct up to first order. Second, even when we obtain the behavior of the economy that is correct to the first order, applying this behavior to welfare implications may lead to incorrect results. We also review different ways to avoid those pitfalls.
Original language | English |
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Pages (from-to) | 995-1001 |
Number of pages | 7 |
Journal | Journal of Money, Credit and Banking |
Volume | 39 |
Issue number | 4 |
DOIs | |
Publication status | Published - 2007 Jun |
Externally published | Yes |
Keywords
- Linear-quadratic method
- Linearization
- Second-order approximation
- Welfare
ASJC Scopus subject areas
- Accounting
- Finance
- Economics and Econometrics