Assessing the accuracy of the aggregate law of motion in models with heterogeneous agents

Wouter J. Den Haan

116 citations0/0 files storedUvA-DARE (University of Amsterdam)

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Economic theories and models Economic Growth and Productivity Complex Systems and Time Series Analysis

Abstract

This paper shows that the R2 and the standard error have fatal flaws and are inadequate accuracy tests. Using data from a Krusell-Smith economy, I show that approximations for the law of motion of aggregate capital, for which the true standard deviation of aggregate capital is up to 14% (119%) higher than the implied value and which are thus clearly inaccurate, can have an R2 as high as 0.9999 (0.99). Key in generating a more powerful test is that predictions of the aggregate law of motion are not updated with the aggregated simulated individual data.

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References

1998Income and Wealth Heterogeneity in the Macroeconomy 2000A Guide to Modern Econometrics 2007Asset pricing with idiosyncratic risk and overlapping generations 1997INCOME AND WEALTH HETEROGENEITY, PORTFOLIO CHOICE, AND EQUILIBRIUM ASSET RETURNS 2008Solving heterogeneous-agent models by projection and perturbation 2007Asset Pricing with Limited Risk Sharing and Heterogeneous Agents 1989Solving Nonlinear Stochastic Growth Models: A Comparison of Alternative Solution Methods 2009Solving the incomplete markets model with aggregate uncertainty using the Krusell–Smith algorithm and non-stochastic simulations

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