Please use this identifier to cite or link to this item: https://hdl.handle.net/10419/217001 
Year of Publication: 
2020
Series/Report no.: 
CESifo Working Paper No. 8250
Publisher: 
Center for Economic Studies and ifo Institute (CESifo), Munich
Abstract: 
In this paper we use the property that certainty equivalence, as implied by a first-order approximation to the solution of stochastic discrete-time models, breaks in its equivalent continuous-time version. We study the extent to which a first-order approximated solution built by perturbation methods accounts for risk. We show that risk matters economically in a real business cycle (RBC) model with habit formation and capital adjustment costs and that neglecting risk leads to substantial pricing errors. A first-order approximation in continuous time reduces pricing errors by 90 percent relative to the certainty equivalent linear solution.
Subjects: 
certainty equivalence
perturbation methods
pricing errors
JEL: 
C02
C61
C63
E13
E32
G12
Document Type: 
Working Paper
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