Occasionally Binding Constraints in Large Models: A Review of Solution Methods
Policy-makers use macroeconomic models to forecast the economy, analyze important events and assess the impact of key public (macroeconomic) policy actions. Detailed microeconomic featuressuch as decisions and interactions of firms and households—provide a rich theoretical foundation for the analysis. Solving complex models is difficult, and analysts often approximate the model by linearizing the equations.
Linearization makes the model easier to solve. But the benefits come at the loss of important details of the behaviour of people and businesses in the model economy. A common type of feature lost in this approximation is occasionally binding constraints (OBCs). Perhaps the best-known example of an OBC is the zero lower bound on nominal interest rates—the presence of a point beyond which the central bank would not further cut interest rates.
This paper considers various methods available to use with a linearized model to account for OBCs. Such accounting restores the important features associated with the model design. I show that all methods are broadly comparable, but dynareOBC (a tool kit used with the software Dynare) is faster and can be more accurate.