Advanced Macroeconomics I

Dynamic Macroeconomic Theory

Dr. Stephen Sacht

University of Kiel
 Dynamic Macroeconomic Theory

Lecture: Monday at 12:00-13:30 & Thursday at 14:15-15:45

[CAP 3, Lecture Hall 2]

Email: sacht@economics.uni-kiel.de
Organization

Room: 308
Visiting Hours: by appointment

Password:

Tutorial (M. Sc. Lutz Honvehlmann; honvehlmann@economics.uni-kiel.de):

Tuesday at 08:15-09:45 [OS40 Room 201] Start: October 24th

Wednesday at 12:15-13:45 [CAP 2 Lecture Hall D] Start: November 1st
Wednesday at 14:15-15:45 [CAP 3 Lecture Hall 2] Start: November 1st

OLAT-Group (Advanced Macroeconomics I WS 2017/2018):

https://lms.uni-iel.de/auth/RepositoryEntry/667582464/CourseNode/92377868517642

Examination(s): tba (check out the EOs homepage) 2

 Dynamic Macroeconomic Theory

Trigger warning:

Macroeconomics is a highly controversial field,

cf. among many others the recent critique of
Main Goal

Blanchard, O., Do DSGE Models Have a Future? Peterson Institute for

International Economics, August 2016

Romer, P., The Trouble With Macroeconomics, New York University, September
2016

P. Krugman: Most macroeconomics of the past 30 years was spectacularly

useless at best, and positively harmful at worst. (Lionel Robbins lectures at LSE)

In light of these controversies what we will do is:

Learning the maths of dynamic systems which is needed to do any macro at all
Review the development of macroeconomic ideas since Keynes General
Theory
3
 Dynamic Macroeconomic Theory

In this lecture: Focus is mainly on deterministic dynamic systems without

stochastic shocks

However: Adding small amounts of noise does mostly not change the qualitative
Course Outline

outcome of the dynamics so that for theoretical purposes the analysis of the
deterministic analogue is appropriate.

To get an idea what we are going to talk about, check out the (although
mathematical) representation of love & hate dynamics by J.C. Sprott
(Dynamical Models of Love, Nonlinear Dynamics, Psychology, and Life Sciences,
Vol. 8, No. 3, July, 2004).
1. Linear Difference equations
1.1. First and Second Order Difference Equations
1.1.1. Mathematical Background
1.1.2. Economic Application: Multiplier-Accelerator Interaction
1.2. Higher-order Difference Equations and Simultaneous Systems of
Difference Equations
1.2.1. Mathematical Background 4
1.2.2. Economic Application: Inventory Cycles
 Dynamic Macroeconomic Theory

2. Linear Differential Equations

2.1. First and Second Order Differential Equations
Course Outline

2.1.1. Mathematical Background

2.1.2. Economic Application: Neoclassical Growth Theory
2.2. Higher-order Differential Equations and Simultaneous Systems of
Differential Equations
2.2.1. Mathematical Background
2.2.2. Economic Application I: Stabilization Policy via Feedback
Control
2.2.3. Economic Application II: The Diamond Search Economy
3. Saddle Path Dynamics and Rational Expectations
3.1. Mathematical Background
3.2. Economic Example: The Dornbusch Model of Exchange Rate
Overshooting
5
 Dynamic Macroeconomic Theory

4. Nonlinear Dynamics
4.1. Limit Cycles and Bifurcations
Course Outline

4.1.1. Mathematical Background

4.1.2. Economic Application: Cycles in Search Equilibrium
4.2. Chaotic Dynamics
4.2.1. Mathematical Background
4.2.2. Economic Application: Chaotic Growth

5. Optimal Control of Dynamic Systems and Saddle Path Dynamics

5.1. Pontryagin's Maximum Principle
5.1.1. Mathematical Background
5.1.2. Economic Application: Optimal Control
5.2. Bellman's Principle of Optimality
5.2.1. Mathematical Background
5.2.2. Economic Application 6
 Dynamic Macroeconomic Theory

Gandolfo, G.: Economic Dynamics. 4th ed., Berlin, 2009

Lorenz, H.-W.: Nonlinear Dynamical Economics and Chaotic

Main Literature

Motion, 2nd ed., Springer-Verlag New York, 1997

Medio, A.: Nonlinear Dynamics: A Primer, Cambridge:

Cambridge University Press (with Marji Lines), 2001

Medio, A.: Chaotic Dynamics. Theory and Applications to

Economics, Cambridge: Cambridge University Press, 1992

Rosser, J. B.: From Catastrophe to Chaos: A General Theory

of Economic Discontinuities, Kluwer Academic Publishers,
1991

Shone, R.: Economic dynamics: phase diagrams and their

economic application, 2nd ed., Cambridge, GB : Cambridge
University Press, 2002
7
Dynamic Macroeconomic Theory

Variants of dynamic equations:

(1) difference equation: y t = a1 y t 1 + a 2 y t 2 + ... + g (t )

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

{
= yt yt 1

dyt
(2) differential equation: = h ( yt , t )
dt
(n )
but there might be also higher derivatives: a0 y + 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

g ( yt , yt 1 ,..., yt n ) =
nonlinear equations:

8
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 : c1 yt + c0 yt 1 = 0
c
or: yt yt 1 = 0 , = 0
c1
y0 = A
Solution via iteration: y1 = y0 = A
y 2 = (y0 ) etc. yt = t y0
= t A
9
1.1 First and Second Order Difference
Equation

yt = t A is a general solution as it satisfies

t t 1

{ A
{ A=0 (irrespective of A)
yt yt 1

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

y*
( y*,t*) y* = t* A A =
t*
Types of dynamic behavior:

0 < < 1: monotonic convergence

1< <0 : oscillatory convergence

> 1: monotonic divergence

< 1 : oscillatory divergence 10

1.1 First and Second Order Difference
Equation

Dynamic evolution of linear first-order difference equation depending on

eigenvalue

11
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 =t A+ y

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

It can be easily checked: if

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

12
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 : const. y

a
c1 y + c0 y = a y =
c1 + c0
c0 t a
General solution: yt = ( ) A +
c1 c0 + c1

13
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 Bd
C= , y= dt
c1d + c0 c1d + c0

14
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:

For example, for:

c0 t
yt = ( ) A+ y
c1
Knowledge of ( y0 , t = 0) leads to: y0 = A + y

c0 t
A = y 0 y yt = ( ) ( y0 y ) + y
c1

15
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: c2 yt + c1 yt 1 + c 0 yt 2 = 0
or: c c
yt + a1 yt 1 + a 2 yt 2 = 0 , a1 = 1 , a2 = 0
c2 c2

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

yt t t + a1 t -1 + a 2 t -2 = 0
t - 2 ( 2 + a1 + a 2 ) = 0
characteristic equation
2
a1 (a 1 4a 2 )1/ 2
1, 2 =
two solutions
2 16
Second-Order Linear Difference Equations

Cases:

(1) Real-valued solutions: = a12 - 4 a2 > 0

Combine both solutions into: yt = A11t + A2 2t
Two constants, because two initial conditions are needed to solve a second-order
equation

Convergence requires: 1 < 1 , 2 < 1

(2) Identical solutions: = 0 1 = 2 = 0.5 a1

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

2 = t t yt = A1t + A2t t
17
Second-Order Linear Difference Equations

(3) Complex numbers with imaginary part: < 0

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

1 1
Try a solution: 1,2 = i = a1 -1 ( 4a2 a12 )1/ 2
2 2
yt would be real-valued if A, A were complex conjugate!

18
Second-Order Linear Difference Equations

Coordinate transformation to polar coordinates:

r cos = , r sin = r2 = 2 + 2
Im() r = ( 2 + 2 )1/ 2
(modulus or absolute value)

r


Re()

We can write: yt = A(r cos + ir sin )t + A(r cos ir sin )t

19
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!

20
Period: 2/ & Amplitude: depends on r
Second-Order Linear Difference Equations

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

explosive >

constant oscillations if a2 = 1
dampened <

Stability condition for the case < 0: a2 < 1 (necessary condition)

General condition: all i < 1

21
 Second-Order Linear Difference Equations

For real roots: consider f ( ) = 2 + a1 + a2

We have: f (1) = 1 + a1 + a2 , f (1) = 1 a1 + a2

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

(serve to exclude all cases of one root larger than 1
in absolute value and the other smaller)

-1 1

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

22
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!

23
Second-Order Linear Difference Equations

Dynamic evolution of linear second-order difference equation

depending on eigenvalues

24
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 : c2 y + c1 y + c0 y = g
yt = A11t + A2 t2 + c +cg + c
0 1
1 2 32
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

25
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)

26
1.1.2 Economic Application: Multiplier-
Accelerator Interaction

Model structure:

(1) Ct = bYt-1 consumption function with time lag, 0 < b < 1

(multiplier)

( 2) I t = I t + I t investment

(3) I t = G constant part: public expenditures

( 4) I t = k (Ct Ct 1 ) induced investment: accelerator

(5) Yt = Ct + I t goods market equilibrium

27
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

G
Particular solution: try Yt = Y Y b(1 + k )Y + bkY = G Y =
1 b

Stability: characteristic equation: 2 b(1 + k ) + bk

{ =0
1424 3 "a "
"a1 " 2

28
1.1.2 Economic Application: Multiplier-
Accelerator Interaction

Stability conditions:
1 b(1 + k ) + bk > 0 1 b > 0 o.k.
1 bk > 0 (?) product of the roots
1 + b(1 + k ) + bk > 0 o.k.

Goods market equilibrium is stable, if

b k < 1 b < 1/ k

Oscillations:
= b 2 (1 + k ) 2 4bk

> > 4k
= 0 if b= 2
< < (1 + k ) 29
1.1 First and Second Order Difference
Equation

Gandolfo (1997), Figure 6.1

30
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 ) A( 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

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

31
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions
(for PhD students)

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
We know:

( 1- ) = 1 + L + L + ... = i Li
1 2 2

i =0

(operator expansion like Taylor-series expansion around 0!)

32
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

Hence, one finds that y t = (b) L xt = (b)i xt i
i i
is the valid particular
i =0 i =0
solution since it satisfies the difference equation.
Note: these sequences converge only if |b| < 1 or || < 1, i.e. if the system is stable.

If |b| > 1, consider:

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

33
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 xt
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.

34
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

Illustration via Cobweb model:

Dt = a + bpt , St = a1 + b1 pt 1

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

Equilibrium price is particular solution,

since b < 0: improper oscillations

b1
stable if <1
supply should have smaller slope than demand
b
35
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 = pt 1 + c( p N pt 1 )
e

D = S a + bpt = a1 + b1{pt 1 + c( p N pt 1 )}
a1 a
Assume:
p N = p* =
b b1
t
b1 (1 c)
Then: pt = A + p*
b
Stable if b1 (1 c) < b
more stable than naive expectations if c<1 36

faster convergence or switch from instability to stability
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

(2) Adaptive expectations: e e

(
pt pt 1 = pt 1 pt 1
e
)
Can be written as: e e
pt (1 ) pt 1 = pt 1

e
Solution of homogeneous equation for pte: pt = A(1 )t

which is stable if 0 < < 1.

Particular solution: e
pt = (1 ) L pt 1 = (1 )i pt 1i
i i

i =0 i =0

37
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

General solution:

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

i =0

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

past prices.

e St a1

Solution for pt: pt =
b1
St a1 S a
= (1 ) t 1 1 + Pt 1
b1 b1
St = (1 ) St 1 + a1 + b1 Pt 1

38
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

( a1 a )
pt [( b1
b
)
1 + 1 pt 1 =] b

Stability condition:
( b1
b
)
1 +1 < 1 1 2
{
< b1
b
<1
< 1 for 0< <1

Again: more stable than naive cobweb

39
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
e
production: Pt = pt + xt
inventory: I t = ( pte+1 pt )

equilibrium: Ct + I t I t 1 = Pt
with xt as exogenous factors.

rational expectations: correct expectations, expectations under complete knowledge

of the relevant economic model

40
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

In a deterministic context we observe perfect foresight:

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

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

Homogeneous part leads to characteristic equation:
2 + +
2 +1 = 0

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

1
Since a2=1
stability conditions are violated; note: 1 2 = 1 1 =

one stable, one unstable 2 41
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

Particular solution: Operational method for known sequence of X t 1 xt 1

For second-order equations:

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

2 2
1 + a1 L + a2 L2 = L2 ( F 2 + a1 F + a2 )
14 4244 3
=( F F1 )( F F2 )

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

42
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

1 + a1 L + a2 L2 = L2 ( F 1 )( F 2 )
Hence:
= ( LF 1 L)( LF 2 L)
= (1 1 L)(1 2 L)

and 1
(1 1L )(1 2 L )
= 111L + 122 L , 1 = 1
1 2
, 2 = 2
1 2

yt = 111L X t + 122 L X t
Hence:

= 1 X t i + 2 i2 X t i
i
1
(backward solution)
i =0 i =0

43
1.1.3 A First Look at Anticipation:
Backward and Forward Solutions

i i
Or:
yt = 1 1 X t +i 2
i =1 1 i =1
( )X1
2 t +i

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


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

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

Particular solution is geometrically weighted average of all past, present and (known)

future shocks: pt = A11t + A2 t2 + pt

44