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Faculty of Economics

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Rendahl, P.

Inequality Constraints and Euler Equation based Solution Methods


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.

Keywords: Inequality constraints, Envelope theorem, Time iteration

JEL Codes: C61 C63 C68

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Published Version of Paper: Inequality constraints and Euler equation based solution methods, Rendahl, P., The Economic Journal (2015)

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