Finance and Economics Discussion Series (FEDS)
December 2007
Two Pitfalls of Linearization Methods
Jinill Kim and Sunghyun Henry Kim
Abstract:
This paper illustrates two types of pitfalls in using linearization methods. First, if constraints are linearized before deriving optimality conditions, the derived conditions are not correct up to first order. Second, even when the behavior of the economy is correct to the first order, applying this behavior to welfare implications may lead to incorrect results.
Full Paper (Screen Reader Version)Keywords: Linearization, linear-quadratic method, second-order approximation, welfare
PDF: Full Paper
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