Inequality Constraints and Euler Equation Based Solution Methods
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Authors
Rendahl, Pontus
Abstract
Solving dynamic models with inequality constraints poses a challenging problem for two major reasons: dynamic programming techniques are reliable but often slow, while Euler equation based methods are fast but have problematic or unknown convergence properties. This paper attempts to bridge this gap. I show that a common iterative procedure on the Euler equation - usually referred to as time iteration - delivers a sequence of approximate policy functions that converges to the true solution under a wide range of circumstances. These circumstances extend to an arbitrarily large, but nite, set of endogenous and exogenous state-variables as well as a very broad spectrum of occasionally binding constraints.
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Keywords
Inequality constraints; Envelope theorem; Time iteration
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Faculty of Economics