Research Working Paper

Alternative Methods of Solving State-Dependent Pricing Models

By Edward S. Knotek II and Stephen Terry
December 2008
RWP 08-10
Research Division
Federal Reserve Bank of Kansas City

Abstract

We use simulation-based techniques to compare and contrast two methods for solving state-dependent pricing models: discretization, which solves and simulates the model on a grid; and collocation, which relies on Chebyshev polynomials. While both methods produce qualitatively similar results, statistically significant quantitative differences do arise. We present evidence favoring discretization over collocation in this context, given a lack of robustness in the latter.

Key words: state-dependent prices, discretization, collocation, value function iteration

JEL Classification Numbers: E31, E37, C63, C68

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