Evaluating model risk in stochastic DICE

by

Stephan Bastiaan Sparreboom (SNR: 1272435)

A thesis submitted in partial fulfillment of the requirements for the degree of

Bachelor in Econometrics and Operations Research

Tilburg School of Economics and Management

Tilburg University

Supervised by: dr. Nikolaus Schweizer

Date: April 7, 2023

Abstract

This Bachelor thesis introduces a stochastic dynamic integrated climate-economy

model (SDICE), in which multiple sources of uncertainty are accounted for. In
order to assess the validity of this model, it is compared to the deterministic
DICE model (Nordhaus, 2017), a similar SDICE model (Ikefuji, Leaven, Mag-
nus and Muris, 2020) and its model risk is evaluated. Our model is run and the
results are compared to the earlier mentioned models. Furthermore, a worst-
case approach is used to check the model risk. The results indicate that our
model performs better than the deterministic model, but slightly worse than
the stochastic model. In addition to this, we find that incorporating more un-
certainty into the model increases the model risk. Finally, is concluded that a
policy maker can make effective use of our new SDICE model, if his objective
is to assess multiple uncertainties simultaneously.

1
Contents

1 Introduction 3

2 Stochastic DICE model 6

3 Solving the SDICE model 9

3.1 Problem description . . . . . . . . . . . . . . . . . . . . . . . . . 9
3.2 Solution algorithm . . . . . . . . . . . . . . . . . . . . . . . . . 11
3.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
3.3.1 Emission control rate µt . . . . . . . . . . . . . . . . . . 14
3.3.2 Consumption Ct . . . . . . . . . . . . . . . . . . . . . . 15
3.3.3 Temperature Ht . . . . . . . . . . . . . . . . . . . . . . . 15
3.3.4 Welfare Wt . . . . . . . . . . . . . . . . . . . . . . . . . 16
3.3.5 SDICE with DICE controls . . . . . . . . . . . . . . . . 17

4 Model Risk 18
4.1 Worst-case framework . . . . . . . . . . . . . . . . . . . . . . . 18
4.2 Implementation . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
4.3 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
4.3.1 SDICE compared to SDICE1 . . . . . . . . . . . . . . . 21
4.3.2 SDICE compared to SDICE2 . . . . . . . . . . . . . . . 22
4.3.3 SDICE compared to SDICE3 . . . . . . . . . . . . . . . 22
4.3.4 SDICE compared to SDICE4 . . . . . . . . . . . . . . . 23

5 Discussion 24
5.1 SDICE results . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
5.2 SDICE comments . . . . . . . . . . . . . . . . . . . . . . . . . 25
5.3 Model risk results . . . . . . . . . . . . . . . . . . . . . . . . . . 26
5.4 Model risk comments . . . . . . . . . . . . . . . . . . . . . . . . 27

6 Conclusion 28

7 Bibliography 29

8 Appendix 30

2
Chapter 1

Introduction

Climate Change is one of the most discussed long-term problems society faces.
On the short-term, society will see a limited impact. Nonetheless, in the long
run, we will see the negative impacts (Tol, 2020). To reduce the impact of cli-
mate change emissions of greenhouse gasses should be reduced. However, the
costs for these reductions are hard to quantify. To model the impact of climate
change on society and the economy, Integrated Assessment Models (IAM) are
used. These models describe the effect of certain policies on the interaction
between climate and economy.
The Dynamic Integrated Climate-Economy model (DICE) is one of the
three IAM models used by the United States government to assess the impact
of climate change policies. The first version of this model dates back to 1992
and has been updated over the years. It is based on six state variables (CO2
concentration in the atmosphere, shallow and lower oceans; temperature in
the atmosphere and lower oceans; and capital), three policy variables (invest-
ment, consumption, and emission control rate), which are all evaluated for
time periods of five years. The model also takes several exogenous processes
into account (e.g. level of population and productivity factor). Even though
the model does have various limitations, it is seen as one of the most useful
climate-economy models. (Ackerman, Decanio, Howarth and Sheeran, 2009).
The DICE model reflects a deterministic optimization problem, which can
be solved in Excel or GAMS, a modeling system for mathematical optimiza-
tion. Due to its deterministic nature, the DICE-model does not account for
uncertainty in the world, indicating it is not an accurate reflection of the real
world. In order to get a more realistic model it is possible to incorporate
uncertainties into the model by introducing stochastic shocks. These shocks
represent an unexpected change in the state of the world, for example a higher
emission than predicted. The DICE models with stochastic shocks are called
SDICE.
Research about a stochastic implementation for the DICE model is limited
(Matsui, Myrvoll, Murakami and Shevcenko, 2021). However, some research
is available on the stochastic model with implemented shocks. Cai, Judd and
Lontzek (2012) formulate SDICE as a dynamic programming problem with
stochastic shocks. They use the outdated 2007 DICE model, but their solu-

3
tion approach is at the base of the current model. According to them, solving
SDICE as a dynamic programming problem is an efficient and feasible ap-
proach.
The approach of Cai et al. (2012) is extended by Ikefuji et al. (2020), in
which four stochastic shocks are introduced. Ikefuji et al. (2020) propose a
stochastic economy-climate framework and a solution method to solve SDICE.
In this framework only one of the four stochastic shocks is applied at a time.
(In addition it gives the possibility to incorporate heavy tailed stochasticy,
something beyond the scope for this thesis). Their solution method utilizes
Least Squares Monte Carlo, an approach introduced by Longstaff and Schwarz
(2001), to value American options. This approach is applied to SDICE in order
to get least squares coefficients for the state variables of the model.
Ikefuji et al. (2020) find that applying uncertainty to DICE can have a
substantial impact on the results of the model. This should be taken into ac-
count by users of the model, e.g. policy makers. They note that the results of
the model should not be taken literally. But the interaction between the main
variables and results should be seen as a guideline to assess policy decisions.
This thesis will touch light on the SDICE model of Ikefuji et al. (2020),
in which 4 stochastic shocks are introduced. These shocks are integrated in
the deterministic model, such that only one shock is active at a time. This
change of the deterministic model will be extended in this paper to incorporate
all shocks simultaneously. This thesis aims to explore the validity of this new
model. The research questions we explore are:

• What are the differences between the deterministic DICE model and the
new SDICE model?

• What are the differences between our SDICE model and the SDICE
model from Ikefuji et al. (2020)?

• What is the model risk of the new SDICE model?

To answer the three questions we compare the results of the new model to the
deterministic model (Nordhaus, 2017) and to the SDICE-model of Ikefuji et
al. (2020).
First of all, our model is run and the results will be compared to the re-
sults from the original deterministic model (Nordhaus, 2017) as well as to the
results from Ikefuji et al. (2020). The comparison will focus on the first 20
time periods, to find the "short term" results of the model. The state variables
and welfare will be compared between the models to find whether our model
gives plausible results.
Secondly, the model risk of the proposed SDICE model will be evaluated.
Model risk in this context is described as the loss of value due to an inaccu-
rate model. This inaccuracy can be caused by e.g. the misuse of the model,
incorrect assumptions or inappropriate use of the model. Model risk is hard to
quantify. However, there are techniques to approach this quantification. One
of these techniques is the worst-case or minmax approach. In this approach,
multiple models are considered and the loss is minimized in the worst-case

4
scenario of each model. The minmax approach has been advocated in decision
theory as early as 1989 by Gilboa and Schmeidler (1989). It is extended to
measure model risk by Cont (2006), in which the worst-case approach is used
to measure model uncertainty in light of derivative pricings.
In this paper, we will apply the worst-case framework of Glasserman and
Xu (2014) to our SDICE model, in order to assess model risk. Their framework
is based on "relative entropy", in which they assess model risk by comparing
quantities of interest of an original model to an alternative model. This alter-
native model is a change from the original model, for example by multiplying
parameters of the original model. In order to assess model risk, the worst-
case scenarios of both models, bounded by a relative entropy constraint, are
determined. If the worst-case scenarios of a model, given a maximum relative
entropy, performs worse than those of a different model, we can conclude that
model risk in the former model is higher.
This paper proceeds as follows. In chapter 2, the stochastic DICE model
is given. In chapter 3 we introduce the discrete-time stochastic programming
problem for SDICE, the algorithm to solve this problem and its results. Next,
in chapter 4 the framework for model risk is laid out and applied to our model.
Then, chapter 5 contains the discussion about our SDICE model and the model
risk. Next, in chapter 6 the conclusion of this paper is given. Finally, the ref-
erences and the appendix are presented.

5
Chapter 2

Stochastic DICE model

In this chapter, the extension of the deterministic DICE model, to a stochastic

variation in which four shocks are integrated, is laid out. First, the model with
uncertainty is given. Then, the stochastic shocks are explained. Lastly, the
welfare function is given.
The model maximizes utility over a finite time horizon of T = 500 years.
Each time period t has a length of ∆ = 5 years, starting from 2015, such
that t = 1 equals to period 2015-2019. We assume a world where everyone
works and maximizes their utility. Then, in period t, gross world product Yt is
determined by labour force Lt and capital stock Kt , through a Cobb-Douglas
function. Given by the following formula:
1−γ
γ Lt
Yt = Z1,t At Kt (2.1)
1000

Where At is the total productivity factor and γ is the elasticity of produc-

tion restricted to 0 < γ < 1. The first log-normally distributed shock, Z1,t ,
with E[Zj,t ] = 1 (j = 1..4) is introduced, which puts uncertainty into the
total productivity factor by changing At into Z1,t At .
Capital Kt is given by the following formula:

Kt+1 = (1 − δ )Kt + ∆It (2.2)

Here, δ is the depreciation rate of capital and policy variable I the investment.

Hereafter, total CO2 emission Et is introduced by:

Et = Z2,t σt (1 − µt ) Yt + Et0 (2.3)

where σt is the CO2 -equivalent-emissions output ratio and we introduce the

policy variable µt , which is the emission control rate and is one of the three
variables used to optimize the model. It has an upper bound of one in the first
twenty periods. This restriction is relaxed to µt < 1.2 after the initial periods
to allow for policies removing emission from the air, instead of only reducing
emission output. The emission from deforestation Et0 is an exogenous variable

6
determined outside of the model. Furthermore, the second shock Z2,t is intro-
duced, which puts uncertainty into the CO2 -equivalent-emissions output ratio
σt . It will become Z2,t σt .

Now, Mt is introduced, which is the increase of the Carbon concentration

in the atmosphere, measured relative to 1750.

Et ∆
Mt+1 = (1 − b0 ) Mt + b1 Mts + (2.4)
3.666
Mts+1 = b0 Mt + (1 − b1 − b3 ) Mts + b2 Mtl (2.5)
Mtl+1 = b3 Mts + (1 − b2 ) Mtl (2.6)

Mts+1 and Mtl+1 are the increases in carbon concentration in shallow and lower
oceans. The values for the constants b0 , b1 , b2 and b3 are given in the appendix.

The increase in temperature of the atmosphere in degrees Celsius since

1900 is called Ht . The formula of Ht is given by:

Ht+1 = (1 − a0 ) Ht + a1 log (Mt+1 ) + a2 Htl + Ft+1 (2.7)

Htl+1 = (1 − a3 ) Htl + a3 Ht (2.8)

Here, Htl is the increase of temperature in lower oceans in degrees Celsius from
1900. Ft is the radiative forcing, i.e. a change in energy caused by natural
processes and climate change. Positive radiative forcing means that the earth
receives more energy from the sun than it sends to space. The constants a1, a2
and a3 are found in the appendix.

For every period Yt is either invested, consumed or spend on abatement.

The fraction spend on the latter is denoted by ωt and specified by

ωt = ϕt µθt (2.9)

with θ > 1 and ϕt the adjusted cost for backstop in period t. With this
fraction we have the following budget constraint, containing policy variables
consumption Ct and investment It :
 
Z3,t 1 − ωt − Z4,t ξHt2 Yt = Ct + It (2.10)

Two shocks are incorporated into the budget constraint, Z3,t , which puts
uncertainty
 into the
 damage-abatement fraction and changes it to
Z3,t 1 − ωt − ξHt2 . The fourth and final shock Z4,t puts uncertainty into the
damage parameter ξ and changes it into Z4,t ξ. These two shocks are then
added to get the above-mentioned budget constraint. All exogenous variables
are determined outside the model and the equations can be found in the ap-
pendix.

7
 In the previous equations, the shocks that put uncertainty into the model
are introduced. The shocks Zj,t (j = 1, ..., 4) are specified as follows:

−τ 2
Zj,t = e 2 eτ ϵj,t (2.11)

with ϵj,t ∼ N (0, 1) and E(Zj,t ) = 1.

If a policy maker wants to change the shocks, for example to increase the
uncertainty of the model, they can change to level of τ , while keeping the
distribution of the error’s the same (Ikefuji et al. 2020). In order to change to
a model with less shocks active, the τ ’s of the inactive shocks are set to zero.
However, in our model all shocks are integrated simultaneously. Therefore, we
fix τ for all shocks.
Furthermore, the utility function U (x) is introduced, with x the per capita
consumption. U (x) is assumed to be existing and strictly concave for all
x > 0. Multiple utility functions are applicable. For example, when dealing
with heavy tailed risk, a Pareto utility function can be used (Ikefuji et al.,
2020). We will focus on the power utility function as in the Nordhaus (2017)
model.
x1−α − 1
U (x) = (2.12)
1−α
Finally, welfare for period t; Wt and total welfare W are introduced.
1000Ct
 
Wt = Lt U (2.13)
Lt
T
X Wt
W = t
(2.14)
t=1 (1 + ρ )

with parameter ρ the discount rate and final period T = 100. Note that the
total welfare is the sum of discounted welfares per period. The discount rate is
set to ρ = 0.015. Therefore at time T, welfare in the final period is discounted
to approximately 22% of it’s original value. Thus, the model takes welfare far
into the future in account. Furthermore, all initial values and parameters can
be found in the appendix.
With these equations the SDICE model can be simulated. The model is
maximized over total discounted welfare, so we need to develop an solution to
this optimization problem. This solution is presented in the next chapter.

8
Chapter 3

Solving the SDICE model

In this chapter, the solving algorithm and results of the SDICE model will
be discussed, based on the algorithm proposed in Ikefuji et al. (2020). In
this paper, there will be two deviations from the previously mentioned model.
The first difference is the fact that all shocks are incorporated at the same
time. The second difference has to do with the forward simulation of the
final results. In Ikefuji et al. (2020), the results of the model are calculated
without taking the shocks into account. We will also integrate stochasticity
during the forward simulation. In order to prevent distorted results, due to
the uncertainty in the model, Monte-Carlo estimation will be used to calculate
the results. This papers focuses on the time in which the emission control rate
is optimized, i.e. the first 20 time periods (100 years).

3.1 Problem description

SDICE is a stochastic model, which maximizes utility over a finite time horizon.
Therefore, it is as a discrete-time stochastic dynamic programming model. It
optimizes based on the policy variables investment, consumption, and emission
control rate. These policy variables, in combination with the remaining vari-
ables, determine the final output. In order to accurately describe the problem
we are facing, the endogenous variables of the model are grouped into three
clusters.

• The state variables, which consist of capital Kt , temperature increase

Ht , carbon concentration Mt and exogenous variables Mts , Mtl and Htl .
These are clustered into vector Xt .

• The control variables emission control rate µt and consumption Ct , clus-

tered into Rt .

• The stochastic shocks defined by Z1,t , Z2,t , Z3,t and Z4,t , are clustered
into Zt .

The exogenous variables (At , Lt , σt , Et0 , Ft and ϕt ), the parameters (γ, δ, ∆, b0 ,

b1 , b2 , b3 , a0, a1, a2, a3, δ, ξ, α, and ρ), as well as τ and the initial values of the

9
state variables, are determined outside of the model and can be found in the
appendix. The remaining variables in the model, Et , ωt , U (x), Wt , W and It
are the result of the previously mentioned variables and parameters.
Even though investment is a policy variable, we rewrite budget constraint
(2.10) into a formula in which It is determined by our model. Investment is
thus given by:
 
It = Z3,t 1 − ωt − Z4,t ξHt2 Yt − Ct (3.1)

It can readily be seen that the state variables are a Markov process or a
Markov chain, as the value of Xt+1 depends on the value of Xt and not on
any previous states. Since we use time steps of five years, SDICE can be seen
as a discrete-time stochastic controlled Markov process. In this process, the
transition of Xt to Xt+1 depends on the control variables, µt , Ct , and stochastic
shocks of the next period. Now, let us call this transition function f (x). We
have Xt+1 = f (Xt , Rt , Zt+1 ). This signifies that if we know the state variables
at time t, the control variables at time t and the shocks at time t + 1, it is
possible to determine the state variables at time t + 1
As we optimize over welfare, we want this function f to be such that welfare
is maximized in each period. Such a problem can be solved using dynamic
programming. Recursively and backwards in time, a Bellman equation will
be solved. Solving the model like this will break up the programming into
different parts for each period. For each time period the optimal values of
the control variables are calculated and put back into the model to get the
maximum pay-off. In our model, this payoff value is welfare.
As previously mentioned we want to optimize the Bellman equation of this
model with respect to Xt . We take a pay-off value Vt (Xt ) with (1 ≤ t ≤ T ).
Vt being welfare from time t to T . The Bellman equation is derived as follows:
We know that welfare W is maximized in the model. Now, assume we
are in period s, we want to maximize the remaining welfare until final period
T, given current information about the state variables, as these are known at
period t. So at time t, we look at the remaining welfare at [t, T ], adapted
to the filtration Ft , i.e. all information known at time t. Then, we call this
remaining welfare the value function V (X ). If we assume full information
available, Vt (Xt ) is defined as follows:
T
X Ws
Vt ( Xt ) = s
(3.2)
s=t (1 + ρ )

At time t, only the information up until time t is known. Furthermore, we

want to maximize our value function with respect to the state variables and
stochastic shocks, due to the fact that we want to maximize the remaining
welfare. The optimal value function Vt∗ (Xt ) is formulated as:

Vt∗ (Xt ) = max Vt (Xt ) (3.3)

µt ,Ct

Now we combine 3.2 and 3.3. However, we only have information up until time

10
period t, so we take the expectation of Vt∗ (Xt ) and condition on filtration Ft .
  
T
Ws  

Vt∗ (Xt ) = max E 
X
F
s t
(3.4)
µt ,Ct s=t (1 + ρ ) 

As we have the information at time period t, the maximization problem can

be split up in two parts. First of all, welfare at time t. Secondly, the expected
welfare of [t + 1, T ].
  
T
Wt Ws  

∗
Vt (Xt ) = max E
X
 + Ft (3.5)
µt ,Ct (1 + ρ)t s=t+1 (1 + ρ)s 
"  #
Wt 
Vt∗ (Xt ) = max E + V ∗
( X )  Ft (3.6)

t t + 1 t + 1
µt ,Ct (1 + ρ) 

As previously discussed Xt+1 is rewritten into f (Xt , Rt , Zt+1 ). The Bellman

equation for time t becomes
"  #
Wt 
Vt∗ (Xt ) = max E + V ∗
( f ( X , R , Zt+1  Ft
)) (3.7)

t+1 t t
µt ,Ct (1 + ρ)t

The optimal values (µ∗t , Ct∗ ) for state variables Xt are given by
"  #
Wt 
(µ∗t (Xt ), Ct∗ (Xt )) = arg max E + V ∗
t+1 ( f ( X t , Rt , Zt+1  Ft
)) 
(3.8)
µt ,Ct (1 + ρ)t

With these equations, a policy maker can determine the optimal strategy
for the policy variables. Since the shocks for period t + 1 can be simulated
and all other variables at time t are known, the model can be assessed by
backwards induction. First the optimal control variables in the final period
are calculated. Then, these values are put back to evaluate the value function
at time T − 1, by maximizing over the value function with respect to time t
and the discounted welfare at that time period. These steps are repeated until
time period 1.

3.2 Solution algorithm

Now we will discuss the algorithm that numerically solves the Bellman equa-
tion. It is based on the least squares Monte Carlo approach, used for pricing
American options (Longstaff and Schwartz, 2001). It starts by simulating fu-
ture paths of the state variables and stochastic shocks. With these states, a
regression is run to estimate the value function. The regression is done at the
latest time period and goes back recursively. This value function is then used
in the forward simulation to estimate future values of welfare.
First, we start at time period T . This is the latest period of interest, so it is

11
assumed that welfare in time periods [T + 1, ∞) is zero, giving VT∗+1 (XT +1 ) =
0. Therefore we can rewrite the value function at time T into
"  #
WT  WT
VT∗ (XT ) = max E + V ∗
( X T +1  FT = max
) (3.9)

T T +1
µt ,Ct (1 + ρ) µt ,Ct (1 + ρ)T

From here on, our algorithm works as follows recursively from time period
T to period 1.

• Draw random values for state variables Xt and shocks Zt . The state vari-
ables lie between 0.5 and 2.5 times the optimal state variables from the
deterministic DICE model. The shocks are drawn randomly according
to the errors described in chapter 2.

• For each draw of (Xt , Zt ), a simulation is run. In each simulation Vt is

optimized, given the draw of the state variables and shocks. If (1 ≤ t ≤
20) the optimization is run over both µt and Ct . If (21 ≤ t ≤ 29), we set
µt = 1 and optimize Vt with respect to Ct . In case (t ≥ 30), µt is set to
1.2. These values are in line with the findings of the deterministic DICE
model. A special case is time period T . As this is the final time period,
we set µt and It to zero, since there is no additional welfare gained by
spending on emission control rate or investing.

• Now we use regression to approximate Vt∗ (Xt ). We assume there is a

function ψt (Xt ) and coefficients βj,t (j = 1...J ) such that
J
Vt∗ (Xt ) ≈
X
βj,t ψt (Xt ) (3.10)
j =0

Xt is normalized with respect to the upper and lower bound. We assume

ψt is a polynomial and use the same interaction terms as described by
Ikefuji et al. (2020).

• From the regression of the previous step, we get the least-squares regres-
sion coefficients, which are denoted by β̂i,t . The approximation of the
value function is given by:
J
X
Vbt ( Xt ) = β̂j,t ψt (Xt ) (3.11)
j =0

These steps are then recursively repeated from time period T until time
period 2. Since we know the current state at time period 1, optimization of µt
and Ct is done over the initial state.
With the β̂i,t ’s obtained from the previous steps, it is possible to simulate
the model forward using Monte-Carlo estimation. Stochasticity is accounted
for in the forward simulation by using another set of shocks Zj,t ∗ . The forward

simulation goes as follows:

12
 • Use state XtDET of the deterministic DICE model to calculate bounds.
Obtain a lower bound of 0.5XtDET and upper bound of 2.5XtDET +1 . If t =
1 use XtDET ∗
as our current state, otherwise use Xt , obtained from the
previous loop.

• Obtain optimal control variables µ∗t and Ct∗ by running the model with
state variables Xt∗ . From (3.8) we know that the optimal control variables
are the values for which the value function is maximised. Now use the β̂i,t
for the value function at time t + 1. The solution for time t is (Rt∗ , Xt∗ ).
The optimal control variables are:
  
J
Wt

(µ∗t , Ct∗ ) = arg max E  β̂j,t ψt (f (Xt∗ , Rt , Zt+1 )) Ft 
X 
t
+
µt ,Ct (1 + ρ) j =0 
(3.12)

• Calculate Xt∗+1 by f (Xt∗ , Rt , Zt+1 )

In order to simulate one possible path of the SDICE model, the above-mentioned
steps are executed for all time periods. After the simulations are done, we use
Monte-Carlo to estimate the outcome of the model. If, for example, we want to
look at the temperature increase after 20 time periods H20 . N simulations are
run. In one simulation i (i = 1, ..., N ), we obtain the temperature at t = 20,
H20,i . We are interested in the Monte-Carlo estimator H20 ∗ of all H
20,i .

N
∗ 1 X
H20 = E[H20 ] ≈ H20,i (3.13)
N i=1

This Monte-Carlo approach can be extended to obtain estimates for all vari-
ables of the model.
In this paper, the first part of the algorithm is run for 10000 simulations,
which gives R2 ≈ 0.98 at time period 1 and R2 ≈ 0.999 at time period 20. For
the second part of the algorithm, 1000 simulations of the SDICE model are
obtained from the forward simulation.
The pseudo-code, describing the algorithm, can be found in the appendix.

3.3 Results
As we are interested in the validity of our model, we will review final results,
obtained from running the model in Matlab. These results are then compared
to the deterministic model and the model from Ikefuji et al. (2020). We start
by analyzing the policy variables, followed by the temperature increase. Lastly,
we look at the welfare. The model is simulated for 100 time periods. However,
we are interested in the part of the model in which µ is optimized. Therefore,
the focus of our results will be from time period 2 up to time period 20. In
order to obtain the results, 1000 sample paths of the model are simulated.

13
3.3.1 Emission control rate µt
In figure 3.1a, the simulations of µt are plotted. The initial starting values
of µ2 are between [0.25,0.39]. Most sample paths end at values in the range
of [0.7,1]. In time period 16 and 18 there are sample paths with low outliers.
It can readily be seen that some sample paths converge to the same solution
for certain time periods. An example of this can be seen at time period 12:
approximately at µ12 = 0.65, multiple sample paths flock at the same point.
More about this can be found in the discussion of the results.
By using the Monte-Carlo estimation, explained at the end of section 3.2,
the estimates of µt are calculated. These can be found in figure 3.1b, indicated
by the orange line. In addition to the the Monte-Carlo estimator, the 95%
confidence interval of the estimates along with the emission control rates of
the deterministic model (yellow line) are plotted. We find that the confidence
interval and thus the inaccuracy of our estimates increases over time, but only
with a small amount. The emission control rates of our SDICE model are
substantially larger than in the deterministic model. Thus, according to these
results, more money should be spent on fighting climate change than in the
deterministic model.
In table 3.1 the values from four different time periods of Ikefuji et al.
(2020) and the Monte-Carlo estimation are found. Our model has a higher µ
for all shown periods. It can easily be assumed that for all 20 time periods,
this observation holds, since µ is increasing over time.

Figure 3.1: Simulations and Monte-Carlo estimation of µt

time period µt Ikefuji et al. µt

1 0.030 0.030
6 0.351 0.441
11 0.506 0.664
16 0.711 0.888

Table 3.1: Comparison of µt between Ikefuji et al. (2020) and this paper’s
model

14
3.3.2 Consumption Ct
The trajectories of Ct are found in figure 3.2a. All sample paths follow an
upward trend. There is a substantial difference between all the values at
time period 20. The 2.5% quantile and 97.5% quantile are [519.52,831.04].
Therefore, 95% of the sample paths lie within this interval. On the upper and
lower ends of the sample paths a triangle shaped shape can be found. This
means that if consumption in a period is high or very low, it will be "corrected"
to a more average value next period.
The Monte-Carlo estimator of consumption is plotted in blue in figure 3.2b
and the consumption per period from the Nordhaus model is plotted in orange.
We observe that the values for consumption are very close to each other. From
period 4 up to period 19, the Nordhaus model has a higher consumption. After
period 19, the consumption in our model is higher.
From figure 3.2 it can readily be seen that the consumption in the Ikefuji
et al. (2020) model is higher than in our model. However, the difference is
very small.

Figure 3.2: Simulations and Monte-Carlo estimation of Ct

time period Ct Ikefuji et al. Ct

1 80.18 80.39
6 169.00 165.63
11 306.44 304.91
16 491.41 489.88

Table 3.2: Comparison of Ct between Ikefuji et al. (2020) and our model

3.3.3 Temperature Ht
In figure 3.3a, the sample paths of the temperature are found. 95% of the
paths end up in the interval [3.21,3.34] at time period 20.In the first periods
the difference between simulations is very small, contrary to the later periods,
in which there is more variance between the sample paths.

15
 The Monte-Carlo estimator of temperature is plotted in orange in figure
3.3b. The yellow line is the temperature from the Nordhaus model. The grey
area around the Monte-Carlo estimator is the 95% CI of this estimator. There
is a substantial difference between the two results. In the deterministic model
the temperature after 100 years is almost 4.5 ◦ C, while the temperature in
the stochastic model is approximately 3.3 ◦ C. In addition, the increase of
temperature in the former model is not slowing down, contrary to the latter
model, in which the temperature curve flattens.
The temperature in our model is lower than in the model from Ikefuji et
al. (2020). At time period 16 (after 80 years) the difference is almost 0.2 ◦ C.

Figure 3.3: Simulations and Monte-Carlo estimation of Ht

time period Ht Ikefuji et al. Ht

1 0.850 0.850
6 1.673 1.654
11 2.460 2.379
16 3.148 2.963

Table 3.3: Comparison of Ht between Ikefuji et al. (2020) and this papers
model

3.3.4 Welfare Wt
In figure 3.4, the welfare at period t from this papers model is plotted as the
blue line. The welfare of the Nordhaus model is the orange line. Evidently,
the welfare of the deterministic model is higher in the first 14 time periods.
From period 18 forth, the welfare of the stochastic model is higher.
Unfortunately, there is not enough data known from Ikefuji et al. (2020)
to compare the welfare from their model to the welfare of this papers model.

16
 Figure 3.4: Welfare per time period

3.3.5 SDICE with DICE controls

Now we consider the results of our SDICE model, with the control variables
from the deterministic model instead of the variables from the solution algo-
rithm. We are interested if our algorithmically determined control variables
give better results than the control variables from the Nordhaus model. An-
other 1000 simulations of the model are run and Monte-Carlo estimation is
applied to get estimates. Since µ and consumption are the same for all simu-
lations, we compare welfare and temperature of both models.
The temperature, obtained from the model with deterministic control vari-
ables is approximately 4◦ C at time period 20. Our model’s temperature is
lower at roughly 3.25◦ C. The welfare of the alternative model is higher in the
earlier periods than the model from this paper. However, after 13 periods, the
welfare of both models is similar. From period 18, the welfare of our model is
larger.

Figure 3.5: Temperature and welfare from control variables algorithmically

determined vs Nordhaus’ control variables

17
Chapter 4

Model Risk

This chapter describes the model risk of our SDICE model. First of all, a
conceptual framework of worst-case model risk will be laid out. Secondly,
this framework will be applied to compare the worst-case scenarios between
our model with optimized control variables and our model with the Nordhaus
control variables. Thereafter, the results of other worst-case comparisons will
be shown. Finally, the results will be discussed.

4.1 Worst-case framework

We start by introducing model risk as the distance between two models. We
consider our "true" model P and an alternative model Q. We are interested
in the difference between Q and P. For example, we have our SDICE model
which measures temperature after 20 time periods as our true model P. Then,
we are interested in an alternative model Q that also measures this tempera-
ture increase.
We start with the distance or difference between two probability distribu-
tions, which is called "relative entropy", or Kullback-Leibler divergence, in-
troduced by Kullback and Leibler (1951). In literature this distance is either
called η or DKL (P ||Q). In this paper we call it η. Glasserman and Xu (2014),
laid out the framework for a worst-case model assessment. They apply rela-
tive entropy to measure the plausibility of an alternative model. Model risk
is expressed by the worst-case scenario, from all models given a constrained
relative entropy, for a predetermined payoff value.
˜
Glasserman and Xu (2014) start by defining likelihood ratio m = ff , with
f the density of the true model P and f˜ the density of alternative model Q.
Now relative entropy is defined as

f˜(x) f˜(x)
Z !
E[m ln(m)] = ln f (x)dx. (4.1)
f (x) f (x)

The model risk is quantified by considering alternative models Pη , such that

E[m ln(m)] < η. Meaning that we look at all other models, within the relative
entropy constraint η.

18
 Now, consider a value function V(X), which measures some aspect of a
model. for example, in our SDICE model it can be the temperature increase,
welfare or one of the policy variables. We want to find the bounds of this value
function, with respect to the relative entropy constraint.

inf E[m(X )V (X )|m ∈ Pη ] (4.2)

sup E[m(X )V (X )|m ∈ Pη ] (4.3)

These bounds are the range of values E[V (X )] can have within the relative
entropy constraint. Glasserman and Xu (2014), proceed to argue that the
upper bound is defined by
1
inf sup[mV (x) − (m ln(m) − η )] (4.4)
θ>0 m θ
and the lower bound accordingly, with the only difference θ < 0. For the inner
supremum, the optimal m(X ) is given by

exp(θV (X ))
m∗θ (X ) = (4.5)
E[exp(θV (X ))]

This theoretical framework can be used in practice using Monte-Carlo.

A standard Monte-Carlo estimator for E[V (X )] is N1 N i=1 V (Xi ), with Xi
P

i.i.d. This property is used to get the Monte-Carlo estimator of the likelihood
ratio m̂i (X, θ ). With this estimator, it is possible to approximate the relative
entropy evaluated at θ. Using Monte-Carlo, we get the following equations for
the likelihood ratio and relative entropy:

exp(θV (Xi ))
m̂i (X, θ ) = 1 PN
(4.6)
N j =1 exp(θV (Xj ))
N
1 X
η̂ (θ ) = m̂i (X, θ ) ln (m̂i (X, θ )) (4.7)
N i=1

4.2 Implementation
Now, an example of the worst-case framework will be applied to our SDICE
model. For this implementation, the model risk between our model, with
optimized control variables, will be compared to our model with the control
variables from the Nordhaus model. The quantity of interest for this example
is the temperature at t = 20. Note that this implementation can be extended
to implement other quantities of interest or different models.
We will evaluate model risk based on the simulations from subsection 3.3.5,
in which a Monte-Carlo evaluation is described of the sample paths for the de-
terministic control variables, and the simulations of our model. As said before
we are interested in the temperature at period 20. Thus, the value function,
as described in 4.1, becomes V (X ) = H20 . Note that V(X) is a general value
function and not necessarily the same as the value function used in SDICE.

19
 Define H20,i as the temperature at period 20 from the i-th forward simula-
tion of the SDICE model. Then, the likelihood ratio of simulation i, dependant
on θ, is given by:

exp(θH20,i )
m̂i (θ ) = 1 PN
(4.8)
N j =1 exp(θH20,j )

From 4.8, N likelihood ratios are acquired for a specific θ. These likeli-
hood ratios are put into the formula of (4.7) and the relative entropy η̂ (θ ) is
obtained. In addition to the relative entropy, we are interested in the bounds
of the value function. Therefore, the expectation of the value function un-
der another model, is calculated by Monte-Carlo estimation: E[m(θ )H20 ] =
1 PN
N i=1 m̂i (θ )H20,i .
Combining the results of the previous paragraphs, we find the relative en-
tropy necessary to move from the original result H20 , to the result under
the alternative model (m(θ )H20 ). However, in order to assess the worst-case
model, we need to evaluate for multiple θ’s. For this specific example we let
θ ∈ [−150, 150].
As we are interested in the model risk between two models, the previous
steps are also done for the simulations of the SDICE model with the Nord-
haus control variables. Both results are plotted and we get the following figure:

Figure 4.1: Expected temperature at t = 20 vs relative entropy

The blue line shows the worst-case scenario performance of the SDICE
model with the control variables from the deterministic model. The red line
shows the worst-case scenario performance of our model with optimized control
variables. If θ = 0, there is no relative entropy and the expected temperature
is the Monte-Carlo estimate as discussed in section 3.3. The dotted lines are
the corresponding Monte-Carlo estimator values.

20
 Model risk is defined as the distance between the worst-case scenario line
and the dotted line. Even though the starting point of the two models is not
the same, it is obvious that the worst-case scenario of the deterministic control
variables performs worse than the optimized control variables.

4.3 Results
In this section, we will describe several evaluations of model risk. First of all,
we introduce four models in which only one shock is active. These models
are called SDICE1 , SDICE2 , SDICE3 and SDICE4 , in which the subscript
refers to the shock integrated in the model (e.g. SDICE1 refers to SDICE with
only shock Z1 active). These alternative models are the same as our SDICE
model, except for the amount of shocks used.
In the SDICE models, total discounted welfare is maximized. We will
compare the worst-case scenarios of this welfare, in order to assess the model
risk. In order to compare the model risk between all models, the techniques of
the previous chapter are used.

4.3.1 SDICE compared to SDICE1

In figure 4.2a the worst-case scenario of SDICE and SDICE1 are plotted. The
blue line represents the worst-case scenario of SDICE1 and the red line the
worst-case scenario of our SDICE model. Since both models look very similar,
it is hard to determine which of the two models has more model risk. For this
reason, the worst-case scenarios are overlapped, which is shown in figure 4.2b.
There is a substantial difference between model risk in SDICE and SDICE1,
as the distance to the dotted line is less for the DICE1 model.

Figure 4.2: Worst-case evaluation of SDICE vs. SDICE1

21
4.3.2 SDICE compared to SDICE2
The worst-case scenario’s for SDICE and SDICE2 are plotted in figure 4.3a,
using the same notation as in 4.3.1. The difference in total welfare between
the simulations of SDICE2 is very small. Therefore, figure 4.3a does not give
easily interpretable results. In order to compare the model risk between the
two models, they are laid over each other in figure 4.3b. We observe that
model risk for the SDICE2 model is very small, compared to the model risk
of SDICE.

Figure 4.3: Worst-case evaluation of SDICE vs. SDICE2

4.3.3 SDICE compared to SDICE3

The red line in figure 4.4a shows the worst-case scenario performance of SDICE.
The blue line represents the performance of SDICE3 . The distance of the blue
line to the dotted line is less than the distance of the red line to the dotted line.
Therefore, we conclude that the model risk of the SDICE3 model is less than
that of our SDICE model. The difference in model risk between SDICE and
SDICE3 is smaller than in the other deviations from SDICE, as the worst-case
scenario curves lie close together.
Furthermore, in figure 4.4a, we see that the SDICE model at zero relative
entropy has a higher total welfare than the SDICE3 model.

22
 Figure 4.4: Worst-case evaluation of SDICE vs. SDICE3

4.3.4 SDICE compared to SDICE4

In figure 4.5a, the worst-case scenarios for SDICE4 and SDICE are plotted.
In line with the previous results, we find that DICE4 , having less uncertainty
than DICE, has a higher welfare at t = 20. Additionally, the model risk of
our model is higher than the model risk of the alternative model, which can
be derived from figure 4.5b.

Figure 4.5: Worst-case evaluation of SDICE vs. SDICE4

23
Chapter 5

Discussion

In this chapter, we will discuss the results of our model and the model risk
assessment. First, we examine the SDICE analysis, then we discuss possible
shortcomings of the model. Next, the model risk results are reviewed. Lastly,
we discuss the flaws of our model risk analysis and propose possible future
research.

5.1 SDICE results

Since our model applies shocks Z1 , ..., Z4 simultaneously, we are interested
whether the results from the model are plausible, not only absolutely, but also
compared to the model from Nordhaus (2017) and Ikefuji et al. (2020), the
latter in which only shock Z3 is investigated extensively.
The first result that stands out, is the difference in emission control rate
between the models. In our model it is substantially larger than in the Nord-
haus model. However, there is less difference between the results from Ikefuji
et al. (2020) and our model. A possible explanation is the solution method
used. In both this paper and the Ikefuji et al. (2020) paper, the algorithm
from section 3.2 is applied. Unlike the Nordhaus model, which is solved as a
deterministic optimization problem.
A high emission control rate implies more money spent on climate change
reduction policies. Therefore, a reduction in temperature should be observed
if the emission control rate is higher. From figure 3.3 and table 3.3, we find
that this decrease in temperature is indeed observed in our model. Thus, it
can be concluded that temperature decreases by spending more on emission
reductions, even though there is uncertainty in emissions from shock Z2 .
Looking at 2.9 and budget constraint 2.10, it can readily be seen that an
increased µ also implies lower consumption. Since the fraction of Y spent
on abatement and damages is larger, less money is available for consumption.
In this model shock Z3 puts uncertainty into the damage-abatement fraction.
Therefore, it can distort our results. However, we find that consumption is
lower, albeit only a small amount.
Figure 3.4 and figure 3.5b show that welfare is higher in the Nordhaus
model than in the SDICE model for the first periods, even if non-optimal con-

24
trol variables are put into the model, as described in 3.3.5. This seemed counter
intuitive at first, since welfare is optimized and thus expected to be higher.
However, the solution algorithm optimizes Vt in a way, such that the welfare
at final time period T , is maximized and not the welfare per time period. This
effect can be seen in the model, as welfare of our model is higher after 18
periods. To extend this, in figure 5.1 the welfare per time period from period
20 up to period 40 is plotted for the original Nordhaus model and our SDICE
model. It is apparent that welfare in the SDICE model is higher. Thus we can
conclude that our model performs better than the deterministic model after
20 periods. Since the deterministic DICE model and the alternative SDICE
model are optimized over 500 years, our model is also optimized over the same
time period. If a policy maker wants to apply optimal policies for the short
term, they should rerun the model with a lower final time period.

Figure 5.1: Welfare Nordhaus vs SDICE from t = 21 : 40

5.2 SDICE comments

There is a difference in temperatures between the Ikefuji et al. (2020) model
and ours, indicating possible errors. After 16 time periods, the temperature
in our model is almost 0.2 ◦ C lower, which is a significant amount. Since
the only difference between the two models is the amount of shocks used,
this result could imply that more uncertainty in the model leads to lower
temperatures, which seems very unlikely. A possible explanation is the higher
µt in all time periods in our model. As more money is spent on emission
control, the temperature will be lower. Due to the missing welfare data from
the Ikefuji et al. (2020) model, it is not possible to conclude whether this
increase in spending on emission control leads to higher welfare.
Another indication of possible errors is the fact that some sample paths
of µt converge to exactly the same values at different time periods. This is
especially visible at period 12 and 16. It is obviously not true that one value of
µt is optimal for multiple states of the model at time t. This error is a result of
the optimization function used in the Matlab code. In order to optimize C and
µ, the f mincon optimization function is used. This function utilizes a gradient
based method to find the minimum of a given optimization problem. The exact
workings of this function are beyond the scope of this paper. Nonetheless, it

25
gives inaccurate results for some sample paths. However, the effects of this
inaccuracy are reduced by the Monte-Carlo estimation, which averages over
all simulations. Therefore, the results are still applicable. In future research,
it is recommended to utilize another optimization method.
Taking another look at the simulations of µt , the assumption that it is
always 1 after 20 time periods, can be seen as invalid, as a lot of sample paths
seem to not end up around 1 at period 20. However, from the distribution of
µ20 in figure 5.2, it is obvious that this assumption is plausible. Most sample
paths end up around 1. Furthermore, the model is stochastic, therefore there
will always be sample paths which have outliers.

Figure 5.2: Distribution of µ20

The simulations of both µt and Ct at upper and lower bounds of the sam-
ple paths in figure 3.1a and figure 3.2a have a triangular shape. At first sight
this can seem wrong. However, the triangular shape can be explained by the
stochasticity of the model. If a shock becomes very large or small, the corre-
sponding optimal control variables can deviate substantially from most other
simulation outcomes in that period. Consider for example shock Z3,t large.
Then, there is an increase in output able to be spent on consumption. As a
result, consumption will increase for that time period. However, in time period
t + 1 this shock is very different and the spendable output is expected to be
lower. Therefore, consumption will be lower in period t + 1 and this specific
sample path will have a triangular shape at time t.

5.3 Model risk results

We find that in all four models, the model risk is less than in our SDICE model.
However, the level of model risk varies per model. Compared to SDICE2 , we
find that the model risk in our model is much higher. Contrary to SDICE3 ,
as we find that the model risk of this model is only a fraction smaller compared
to SDICE. The results for SDICE1 and SDICE4 are similar; in both models,
model risk is smaller, albeit not to the same extend as the other two models.
To explain the differences in model risk, we look at the research of Ikefuji et
al. (2020), whom investigated the amount of uncertainty these shocks put into

26
the model. They found that applying shock Z3 , corresponding to SDICE3 ,
has almost no impact, meaning that the results are close to the deterministic
results. Furthermore, shocks Z1 and Z4 have a moderate impact. Lastly, they
found that shock Z4 has substantial impact on the model, especially if shocks
become large or small. These results relate closely to our findings about model
risk. In the models with more uncertainty, the model risk is higher.
An interesting result is that of SDICE3 . Namely, the model risk is almost
the same as in our model. Therefore, if a policy maker wants to put uncer-
tainty into the model trough the damage-abatement fraction (i.e. shock Z3 ),
they can choose to incorporate all shocks simultaneously, without increasing
model risk substantially.

5.4 Model risk comments

Our worst-case analysis does have shortcomings. First of all, the alternative
models make use of the same least-squares regression coefficients β̂ to approx-
imate the value function in the Bellman equation. Since these coefficients are
used in the forward simulation of the alternative models, the results for the
alternative models are non-optimal. The solution algorithm should be run for
all four models, in order to give more precise results.
Furthermore, during the evaluation of SDICE2 , multiple problems came
to light. First of all, the calculations of m̂(X, θ ) returned NaN as output in
the beginning. Since our expected discounted total welfare is approximately
28000, the calculation of exp(θ )V (X ) was not possible. To prevent these
errors, very small θ’s should be used to evaluate model risk. For example,
exp(−100) ≈ 3.7 × 10−44 , which shows that large negative numbers result to
very small answers. Therefore, with regard to our welfare, if θV (X ) < −1,
the code gives Not a Number as output, since it can not calculate a number
that small. Secondly, the relative entropy is very small. Due to the small dif-
ferences between simulation outcomes, m̂(X, θ ) is close to one in simulations
of SDICE2 . Thus, the relative entropy became very small. The original eval-
uation of all four models, was done for a relative entropy up to 0.5. However,
this is not possible due to the small relative entropy in SDICE2 . The first
plots made seemed to not contain worst-case scenarios for SDICE2 , however
after investigating the relative entropy, the values are only visible when the
plot is zoomed in.
Additionally, the current analysis of SDICE gives a limited overview of
model risk. Further research into the initial parameters of the model could be
done. For example by drawing the initial parameters from a predetermined
distribution and applying our model risk approach on these models. Future
research can also assess the model risk between stochastic implementations of
the three IAM models used by the US government.

27
Chapter 6

Conclusion

We have extended a stochastic implementation of the DICE model by adding

more uncertainty into the model. The implementation is build upon the model
from Ikefuji et al. (2020), combining the shocks used, to put uncertainty into
the deterministic DICE model.
The solution method to solve such models, is extended to take uncertainty
in account during a forward simulation, by incorporating Monte-Carlo simu-
lation techniques. We have found that solving the model as a discrete-time
stochastic dynamic programming model, using our simulation method, results
in a higher amount of money spent on emission reductions and thus slowing
down the temperature increase.
Furthermore, our model is compared to the model of Ikefuji et al. (2020).
This examination found that the models are very similar, but the added un-
certainty in our model leads to less welfare. Additionally, our model results in
lower temperatures.
Lastly, we assess the model risk of our model, using a worst-case scenario
approach. From this approach, we determined that our model has more model
risk than alternative models, in which only one shock is active.
All things considered, our changes to the SDICE model have impact on the
results. However, the impact is limited and does not make the new model in-
valid. If a policy maker wants to incorporate more uncertainty in his analysis,
in an effort to obtain a better representation of the real world, the new SDICE
model is a viable option to consider.

28
Chapter 7

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29
Chapter 8

Appendix

Equations of exogenous variables:

L(t) = L(t − 1)(popasym/L(t − 1))popadj

ga(t) = ga0exp(−dela∆(t − 1))
A(t) = A(t − 1)/(1 − ga(t − 1))
gSigma(t) = gSigma(t − 1)(1 + dSigma)∆
σ (t) = σ (t − 1)exp(gSigma(t − 1)∆)
pbacktime(t) = pback (1 − gback )t−1
ϕt = pbacktime(t)σ (t)/θ/1000;
Et0 = E00 (1 − deland)t−1
f orcoth(t) = f ex0 + (1/17)(f ex1 − f ex0)(t + 1)1t∈[1,17] +
(f ex1 − f ex0)1t∈[18,100]
F (t) = −a1log (588) + c1f orcoth(t)

Parameter values:

T = 100, ∆ = 5, γ = 0.3, δ = 0.1, τ = 0.06

b0 = 0.12, b1 = 0.196, b2 = 0.001465, b3 = 0.007
a0 = 0.128189, a1 = 0.533755, a2 = 0.008844, a3 = 0.025
δ = 2.6, ξ = 0.00236, α = 1.45, ρ = 0.015
popasym = 11500, popadj = 0.134, ga0 = 0.076
dela = 0.005, pback = 550, gback = 0.025
deland = 0.115, f ex0 = 0.5, f ex1 = 1
c1 = 0.1005

30
Initial values at t=1:

A1 = 5.115, K1 = 223, L1 = 7.403, E1 = 35.85

σ1 = 0.3503, E10 = 2.6
M1 = 851, M1s = 460, M1l = 1740
H1 = 0.85, H1l = 0.0068
µ1 = 0.03, gSigma1 = −0.0152

Algorithm 1 Algorithm for solving the SDICE model

Input Initialize final time period T, amount of backward simulations S,
amount of forward simulations N, τ , Shocks Z & deterministic state variables
X DET . Also set VcT (Xj ) = 0, for j = 0,...,J
for t = T − 1 to 1 do ▷ Backwards Simulation
Set lower and upper bounds
for s = 1 to S do
obtain Xs randomly between 0.5Xt−1DET and 2.5X DET
h t i
Vbt (Xs ) = maxCt ,µt E (1W t
+ρ)t + β V
b
t+1 ( f ( X s , R t , Z s,t+1 )
end for
yt = Vbt (Xs ) ▷ y is a matrix of all values of all Vbt (Xs )
xt = X s ▷ x is a matrix of all Xs
xt = xt (relevant) ▷ relevant state variables are: K, M , M s &H
ψt = Quartic polynomial of x, normalized by upper and lower bound.
βbt = (ψt′ ψt /ψt′ )yt
end for
for n = 1 to N do ▷ Forward Simulation
Xn,1 = X1DET
for t = 1 to T do h i
µn,t , Cn,t = arg maxµ,C E (1W
PJ
t
+ρ)t + β̂
j =0 j,t t ψ ( f ( X n,t , Rt , Zn,t+1 ))
s , M l , H , Hl ]
Solutionn,t = [Cn,t , µn,t , Kn,t , Mn,t , Mn,t n,t n,t n,t
end for
end for
FinalSolution = N1 Ni=1 Solution(i)
P

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