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Two Pitfalls of Linearization Methods


  • The views in this paper are solely the responsibility of the authors and should not be interpreted as reflecting the views of the Board of Governors of the Federal Reserve System or any other person associated with the Federal Reserve System. We appreciate discussion with Pierpaolo Benigno and Mike Woodford and editorial comments by Jason Steinman.


This paper illustrates two types of pitfalls when linearization methods are improperly applied. First, if we linearize the constraints before deriving the optimality conditions, the derived conditions are not correct up to first order. Second, even when we obtain the behavior of the economy that is correct to the first order, applying this behavior to welfare implications may lead to incorrect results. We also review different ways to avoid those pitfalls.