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Faculty of Economics

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Rendahl, P.

Inequality constraints and Euler equation based solution methods

The Economic Journal

Vol. 125(585) pp. 1110-1135 (2015)

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 faster but have problematic or unknown convergence properties. This paper attempts to bridge this gap. I show that a common iterative procedure on the first-order conditions { 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 a large 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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Cambridge Working Paper in Economics Version of Paper: Inequality Constraints and Euler Equation based Solution Methods, Rendahl, P., (2013)

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