Solving the incomplete market model with aggregate uncertainty using a perturbation method

Abstract

We use a perturbation method to solve the incomplete markets model with aggregate uncertainty described in den Haan et al. [Computational suite of models with heterogeneous agents: incomplete markets and model uncertainty. Journal of Economic Dynamics & Control, this issue]. To apply that method, we use a “barrier method” to replace the original problem with occasionally binding inequality constraints by one with only equality constraints. We replace the structure with a continuum of agents by a setting in which a single infinitesimal agent faces prices generated by a representative-agent economy. We also solve a model variant with a large (but finite) number of agents. Our perturbation-based method is much simpler and faster than other methods.