Analyzing Economic Policy Using High Order Perturbations

In this chapter I demonstrate the use of high order general perturbations to analyze policy changes in dynamic economic models. The inclusion of high moments in approximating the behavior of dynamic models is particularly necessary for welfare analysis. I apply the method of general perturbations to the analysis of permanent changes to a flat rate tax on the return to capital in the context of the standard Ramsey optimal growth model. Reliance on simple linearizations or quadratic approximations are adequate for generating impulse responses for the variables of interest or the welfare analysis of small policy changes. However when considering the welfare implications of sizable policy changes, the failure to include higher moments can lead not only to quantitatively serious inaccuracies, but even to spurious welfare reversals.