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

Two common properties of macroeconomic models are saddle-path instability and the existence of non-linearities. 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 results that differ from those derived from the correct (non-linear) model. In this paper, we investigate the magnitude of errors arising as a consequence of using a linear approximation to a well-known representative agent model. We do this by taking a calibrated version of the Matsuyama (1987) model of a small open economy.