Dynamic Macroeconomic Theory

Thomas Lux
University of Kiel

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

Dynamic Macroeconomic Theory

In this lecture: Focus is mainly a deterministic dynamic system without stochastic

shocks
However: Adding small amounts of noise does mostly not change the qualitative
outcome of the dynamics so that in theoretical purpose the analysis of the deterministic
analogue is appropriate.

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

Dynamic Macroeconomic Theory

Variants of dynamic equations:

1) difference equation: yt = a1 yt 1 + a2 yt 2 + ... + g (t )

y = (a1 1) yt 1 + a2 yt 2 + ... g (t )
equivalently:
t
= yt yt 1

(2) differential equation:

= f ( yt 1 , yt 2 , ... , t )

dyt
= h ( yt , t )
dt

but there might be also higher derivatives: a0 y

(n )

+ a1 y (n 1) + ... + an 1 y + an y = g (t )

(3) mixed difference differential equations: a0 y(t ) + a1 y(t w) + b0 y (t ) + b1 y (t w) = g (t )

higher derivatives, more lags are possible
nonlinear equations: g ( yt , yt 1 ,..., yt n ) =
Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

1.1 First and Second Order Difference

Equation

1.1.1. Mathematical Background

First-order linear difference equation:

c1 yt + c0 yt 1 = g (t )
with time-dependent function g (t ) this is called a non homogenous equation
Homogeneous equation :
or:

c1 yt + c0 yt 1 = 0
yt + byt 1 = 0 , b =

c0
c1

Solution via iteration:

y0 = A
y1 = by0 = bA

y2 = b( by0 ) etc.
Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

yt = ( b ) y0
t

= ( b ) A
t

1.1 First and Second Order Difference

Equation

yt = ( b ) A
t

is a general solution as it satisfies

t
t 1
(
b ) A + b( b ) A = 0

yt

irrespective of A

yt 1

to fix A, any known function value could be used, e.g.

( y*, t*)

y*
y* = (b) A A =
(-b)t*
t*

types of dynamic behavior:

0 < b < 1 :
1 < b < 0 :
b > 1:
b < 1 :

monotonic convergence
oscillatory convergence
monotonic divergence
oscillatory divergence

1.1 First and Second Order Difference

Equation
Gandolfo,1997. Fig.3.1

1.1 First and Second Order Difference

Equation

Solution of the non-homogeneous equation:

General principle: Solution of non-homogeneous equation consists of solution of
homogeneous equation plus so-called particular solution
Hence: solution for

c1 yt + c0 yt 1 = g (t )

yt = (b)t A + y

Particular solution can often be interpreted as a steady state equilibrium in economic

models

c1 y + c0 y = g (t )

It can be easily checked: if

] [

c1 y + (b) t A + c0 y + (b) t 1 A = g (t )
is also a solution!

1.1 First and Second Order Difference

Equation

Determination of particular solutions:

Try a function with the same form of g(t) but with undetermined constants
Substitute into non-homogeneous equation and determine the coefficients
Examples:

(1)

g (t ) = a try : y =
a
c1 + c0 = a y = =
c1 + c0

General solution:

c0 t
a
yt = ( ) A +
c1
c0 + c1

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

1.1 First and Second Order Difference

Equation

(2)

g (t ) = B d t try : y = Cd t
c1Cd t + c0Cd t 1 = Bd t
d t 1 (c1Cd + c0C Bd ) = 0

Bd
,
C=
c1d + c0

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

Bd
y=
dt
c1d + c0

1.1 First and Second Order Difference

Equation

(3) g (t ) = B1 cos t + B2 sin t try : y = cos t + sin t

....
Determination of the constant A:

c0 t
yt = ( ) A + y
c1

for example, for:

Knowledge of

( y0 , t = 0) leads to: y0 = A + y

A = y 0 y yt = (

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

c0 t
) ( y0 y ) + y
c1

1.1 First and Second Order Difference

Equation

Second-Order Linear Difference Equations

General form:

c2 yt + c1 yt 1 + c 0 yt 2 = g (t )

Homogeneous equation:
or:

c2 yt + c1 yt 1 + c 0 yt 2 = 0
yt + a1 yt 1 + a 2 yt 2 = 0, a1 =

In analogy to first-order equations: try a function like:

c1
c2

, a2 =

yt t

t + a1 t -1 + a 2 t -2 = 0

t - 2 ( 2 + a1 + a 2 ) = 0
1, 2

a1 (a 1 4a 2 )1/ 2
=
2

characteristic equation

two solutions

c0
c2

Second-Order Linear Difference Equations

Cases:
(1) real-valued solutions:

= a12 - 4a2 > 0

Combine both solution into:

yt = A11t + A2 2t

two constants, because two initial conditions are needed to solve a second-order
equation

Convergence requires:

(2) identical solutions:

1 < 1 , 2 < 1
= 0 1 = 2 =

a1
2

Since one only has one solution, one tests as a second solution

2 = t t yt = A1t + A2t t

Second-Order Linear Difference Equations

(3) complex numbers with imaginary part: < 0

1
1
1,2 = i = a1 -1 ( 4a2 a12 )1 / 2
2
2
Try a solution:

yt

yt = A ( + i )t + A( i )t

would be real-value if A, A were complex conjugate!

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

Second-Order Linear Difference Equations

Coordinate transformation to polar coordinates:

r cos = , r sin =

r 2 = 2 + 2

r = ( 2 + 2 )1 / 2

Im()

modulus or absolute value

r

Re()

we can write:

yt = A(r cos + ir sin )t + A(r cos ir sin )t

Prof. Dr. Thomas Luxlux@bwl.uni-kiel.de

Second-Order Linear Difference Equations

Using de Moivres theorem:

( cos i sin )n = cos(n) i sin( n )

yt = Ar t (cos(t ) + i sin(t)) + Ar t (cos(t ) i sin(t )
= r t [( A + A) cos(t ) + ( A A)i sin(t )]
= r t [( A1 cos(t ) + A2 sin(t )]
A1 A + A, A2 = ( A A)i

assume:

A = a + ib, A = a ib
A + A = 2a, ( A A)i = 2b

real numbers

Potential for true oscillatory motion already with two lags!

period: 2/ , amplitude: depends on r

Second-Order Linear Difference Equations

since:

r 2 = ( 2 + 2 )1/ 2 = (0.5a1 ) 2 + (0.5(4a2 a12 )1/ 2 ) 2

r 2 = a2

explosive
constant
dampened

oscillations if a2

>
=
<

Stability condition for the case : a2 < 1 (necessary condition)

General condition: all

i < 1

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

Second-Order Linear Difference Equations

For real roots: consider

f ( ) = 2 + a1 + a2

f (1) = 1 + a1 + a2 , f (1) = 1 a1 + a2

we have:

f (1) > 0, f (1) > 0

f()

serve to exclude all cases of one root larger than 1

in absolute value and the other smaller

-1

Additionally, cases with both 1,2 < -1 or > 1 can be excluded by the condition: 1,2 < 1

Second-Order Linear Difference Equations

Stability Conditions (sufficient and necessary):

(1)

f (1) = 1 + a1 + a2 > 0

( 2)

12 = a2 < 1 1 a2 > 0

(3)

f ( 1) = 1 a1 + a2 > 0

Stability can be checked without explicit solution of difference equation!

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

Second-Order Linear Difference Equations

Solution of non-homogeneous equation: add particular solution like before

example:

c2 yt + c1 yt 1 + c0 yt 2 = g
y = b : c2b + c1b + c0b = g
yt = A11t + A2 t2 + c + cg + c
0
1

2
y

Determination of constants
via two initial conditions
example: (t

= 0, y0 ) (t = 1, y1 )

lead to

y0 = A1 + A2 + y , y1 = A11 + A2 2 + y
A1 , A2

1.1.2 Economic Application: Multiplier

Accelerator Interaction

If

< 0 : second-order difference equation potentially generates sinusoidal fluctuations

business cycle explanation
Two lagged adjustment are in principle sufficient to generate economic
fluctuation

First model of the business cycle: Samuelson, 1939

Prof. Dr. Thomas Lux, lux@bwl.uni-kiel.de

1.1.2 Economic Application: MultiplierAccelerator Interaction

Model structure:

(1)

Ct = bYt-1

(2)

I t = I t + I t

investment

(3)

I t = G

constant part: public expenditures

(4)

I t = k (Ct Ct 1 )

induce investment: accelerator

(5)

Yt = Ct + I t

goods market equilibrium

consumption function with time lag, 0 < b < 1

(multiplier)

1.1.2 Economic Application: Multiplier

Accelerator Interaction

Combine the equations:

Yt = bYt-1 + k (Ct Ct 1 ) + G =
= bYt-1 + kb(Yt-1 Yt- 2 ) + G
Yt b(1 + k )Yt-1 + bkYt- 2 = G

particular solution: try

Yt = Y Y b(1 + k )Y + bkY
Y =

stability: characteristic equation:

G
1 b

2
b(1 + k ) + bk
=0

"a1 "

"a2 "

1.1.2 Economic Application: MultiplierAccelerator Interaction

Stability conditions:

1 b(1 + k ) + bk > 0 1 b > 0

1 bk > 0 (?)
1 + b(1 + k ) + bk > 0
Goods market equilibrium is stable, if

b k < 1 b < 1/ k
Oscillations:

= b 2 (1 + k ) 2 4bk
>
= 0 if
<

> 4k
b=
2
+
k
(
1
)
<

o.k.
product of the roots
o.k.

1.1

First and Second Order Difference

Equation

Gandolfo,1997. Fig.6.1

Prof. Dr. Thomas Lux, WSP1 Room 507, lux@bwl.uni-kiel.de, +49 431 880-3661

1.1.2 Economic Application: Multiplier

Accelerator Interaction

fluctuations around growth path: assume

G = G0 (1 + g )t

for particular solution: try

y = A(1 + g )t
A(1 + g )t b(1 + k )(1 + g )t 1 + bkA(1 + g )t 2 = G0 (1 + g )t

{[

(1 + g )t 2 A (1 + g ) 2 b(1 + k )(1 + g ) + bk G0 (1 + g ) 2 = 0

y=

G0 (1 + g ) 2
(1 + g ) 2 b(1 + k )(1 + g ) + bk

(1 + g )t > 0

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

Assume g(t) is not a known function, but a sequence of (stochastic) realizations of

exogenous variables
different approach for determination of particular solution: operational method
use lag operator

Lyt = yt 1 , Ln yt = yt n , L1 yt = yt +1

Application to first-order equation:

yt + byt-1 = xt
(1 + bL) yt = xt
yt = (1 + bL) 1 xt

One finds that

y t = (b) L xt = (b) i xt i
i

i =0

it satisfies the difference equation

i =0

is valid particular solution since

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

This holds because:

( 1- ) L = 1 + L + L + ... = i Li
1

2 2

i =0

Operator expansion like Taylor-series expansion about 0!

Note: these sequences converge only if |b| < 1 or || < 1, i.e. if the system is stable
If |b| > 1, consider:

i =1

i =1

yt = ( b1 )i Li xt = ( b1 )i xt +i
which also fulfills the difference equation and is bounded since |1/b| < 1.

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

Particular solution here = geometrically declining sum of all past or future values of x0
depending on whether the equation is stable or unstable
alternative expansion:

( 1 L) = ( 1 ) i Li
1

i =1

Derivation, reformulate and develop the second term in a Taylor series of

( 1 L) 1 = 1 L1 (1 L1 ) 1
Application: forward looking models are typically mathematically unstable, but can be
represented via second type of solution concept for particular solution.

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

Illustration: Cobweb model

Dt = a + bpt , St = a1 + b1 pt 1
Dt = St bpt b1 pt 1 = a1 a
b1
a a
pt 1 = 1
b
b
b1 t a1 a
pt = A( ) +
b
b b1
pt

equilibrium price is particular solution,

since b < 0:
stable if

improper oscillations

b1
< 1 supply should have smaller slope than demand
b

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

Cobweb model with expectations

Dt = a + bpt , St = a1 + b1 pt e
(1) Normal price expectations: orientation at benchmark pN with short-run deviations

pt e = pt 1 + c( p N pt 1 )
D = S a + bpt = a1 + b1{pt 1 + c( p N pt 1 )}
Assume:
a a
p N = p* = 1
b b1
t

then:

stable if

b (1 c)
pt = A 1
+ p*

b
b1 (1 c) < b

more stable than naive expectations if c<1 faster convergence or switch from
instability to stability

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

(2) Adaptive expectations

pt pt 1 = pt pt 1
e

pt (1 ) pt 1 = pt 1
e

Can be written as:

Solution of homogeneous equation for pte:

pt = A(1 ) t
e

which is stable if 0 < < 1.

Particular solution:

pt = (1 ) L pt 1 = (1 ) i pt 1i
e

i =0

i =0

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

General solution:

pt = A(1 ) + (1 )i pt 1i
e

i =0

adaptive expectations are (roughly) equivalent to a geometric weighted average of all

past prices.
Solution for pt:

S a
pt e = t 1
b1

St a1
S a
= (1 ) t 1 1 + Pt 1
b1
b1
St = (1 ) St 1 + a1 + b1 Pt 1

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

Since

Dt = St , t :
a + bpt = (1 )a + (1 )bpt 1 + a1 + b1pt 1
pt =
stability condition:

[(

b1
b

1 + 1 pt 1 =
b1
b

( a1 a )

1 +1 < 1

1 2

< 1 for 0< <1

Again: more stable than naive cobweb

<

b1
b

<1

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

(3) Rational Expectations la Muth (1961)

Variables now are deviations from equilibrium, demand consists of consumption and
inventory component
consumption:

Ct = pt

production:

Pt = pt + xt

inventory:

I t = ( pte+1 pt )

equilibrium:

Ct + I t I t 1 = Pt

xt: exogenous factors

rational expectations: correct expectations, expectations under complete knowledge of
the relevant economic model

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

in a deterministic context: perfect foresight:

pt = pt , pt +1 = pt +1
e

pt +1 (2 + + ) pt + pt 1 = xt
pt

2 + +

pt 1 + pt 2 =

xt 1

homogeneous part leads to characteristic equation:

Discriminant:

2 + +

+1 = 0

(2 + + ) 2 4 2
=
>0
2

Since a2=1 stability conditions are violated; note:

one stable, one unstable

1 2 = 1 1 =

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

Particular solution: Operational method for known sequence of

for second-order equations:

yt + a1 yt 1 + a2 yt 2 = X t
(1 + a1 L + a2 L2 ) yt = X t
1
yt =
Xt
2
1 + a1 L + a2 L
Denote by F = L-1 the forward operator:

1 + a1 L + a2 L2 = L2 ( F 2 + a1 F + a2 )

= ( F F1 )( F F2 )

with F1, F2 roots of the polynomial which coincide with 1, 2

X t 1 xt 1

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

Hence:

1 + a1L + a2 L = L2 ( F 1 )( F 2 ) =
= ( LF 1L)( LF 2 L) =
= (1 1L)(1 2 L)

and

1
= 1 + 2
(1 1L )(1 2 L ) 1 1L 1 2 L

hence:

, 1 =

1
1 2

2
2 =
1 2

yt =

Xt + 2 Xt
1 1L
1 2 L

= 1

i =0

1i X t 1 + 2

i =0

i2 X t i

backward solution

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

or

i

1
1
yt = 1 X t + i 2

i =1 2
i =1 i

X t +i

In the RE cobweb case: backward solution for stable root, forward solution for unstable
root.
i

1
pt = 1 1i X t i 2 X t + i

i =0
i =1 i

= 1 1i X t i 2 1i X t + i
i =0

i =1

1 < 1

particular solution is geometrically weighted average of all past, present and (known)
future shocks.

pt = A11t + A2t2 + pt