By Michal Horvath
This paper shows that numerical solutions to models with incomplete markets and aggregate uncertainty obtained using the Krusell and Smith (1998) algorithm are sensitive to the parameterization of the grid in the aggregate asset holdings direction. Higher moments of the cross-sectional distribution of asset holdings can be particularly affected, which is important for welfare analysis. Using grids that are denser around the mean of the ergodic distribution of individual asset holdings can enhance the consistency of the results across parameterizations. The accuracy of the approximation to individual decision functions can be much improved this way.
Solving heterogeneous agent models with aggregate shocks is very difficult. The Krusell-Smith method has considerably simplified this for some models, but it is not without pitfalls as this paper shows. The choice of grid points can matter and the solution id unfortunately to use more well placed points.