Calculating Short-Run Adjustments: Sensitivity to Non-Linearities in a Representative Agent Framework.

Two common properties of macroeconomic models are non-linearities and dynamics characterised by a non-zero number of unstable eigenvalues. Under these circumstances, a common approach is to make analysis more tractable by linearising the model in the neighbourhood of an appropriate steady-state. The linearised model is then employed to calculate short-run adjustments following exogenous shocks. This can lead to different results than would be derived from the correct (non-linear) model. This paper investigates the magnitude of errors that come about as a consequence of using a linear approximation to a well-known representative agent model. This is achieved by taking a calibrated version of the Matsuyama (1987) model of a small open economy.