Consider the following model of a closed economy. Y denotes output, C denotes consumption expenditure, and I denotes investment expenditure. The subscripts t and t-1 refer to the respective time periods.
1. Condense the model into a difference equation involving output and comment on its properties. 2. Solve for equilibrium output (assume Y 0 = 4000) and comment on the time path of output.
Solution
1) Substitute equations (6.2) and (6.3) in (6.1) to get the reduced form equation in terms of Y t :
6.4
Conjecture Suppose we are seeking the solution to the first-order difference equation Y t+1 aY t = c where a and c are two constants. The general solution will consist of the sum of two components: a particular integral y p (representing the intertemporal equilibrium level of y), which is any solution of the complete nonhomogeneous equation
(6.4), and a complementary function y c (representing the deviation of the model from equilibrium), which is the general solution of the reduced equation.
yc = A1bt we can write the complementary function for this particular problem as: y c = A 1 (0.9 ) t 2) The intertemporal equilibrium or the particular solution for the model can be computed by setting the characteristic equation to equilibrium (where denotes equilibrium values):
Y 0.9Y = 350 y p = Y = 3500 Thus the general solution for the model can be expressed as:
6.5
Y t = 500(0.9 ) t + 3500 Whether the equilibrium is dynamically stable is a question of whether or not the complementary function will tend to zero as t . The value of b is of crucial importance in this regard. On the other hand the arbitrary constant A only produces a scale effect without changing the configuration of the time path. Since the characteristic root b = 0.9 or |b | 1 the model is convergent. The model is therefore stable as it gradually converges towards 3500 without oscillation over time.
Tutorial 7
Consider the following model (Prof. Paul Samuelsons (1944) classic multiplier-accelerator model) which seeks to explore the dynamic process of income determination. Y denotes output, C, I, and G denote consumption, investment, and government expenditure respectively. The subscript t and t-1 refers to the respective time periods.
Yt = Ct + It + Gt C t = C 0 + cY t1 I t = I 0 + w(C t C t1 ) where 0 c 1, w 0, and G t = G 0 . 1. Condense the model into a difference equation involving output. 2. Solve for equilibrium output. 3. Comment on the time path of output if w = 0.9 and c = 0.5.
Solution
1) In order to condense the model into a difference equation involving output, write down the model in equilibrium form and take deviation of the model from equilibrium (where denotes equilibrium values).
Yt = Ct + It C t = cY t1 I t = w(C t C t1 )
Definition The backward shift or lag operator is defined by LX t = X t1 , L n X t = X tn for n = ..., 2, 1, 0, 1, 2, ..... Formally, the operator L n maps one sequence into another sequence.
I t = w(C t ) = w(1 L )C t
7.10
C t = cY t1 = cLY t
7.11
Y t = cLY t + w(1 L )cLY t Collecting terms in Y t yields (note we are including the C which denotes the constants omitted earlier):
What we have is a second-order nonhomogeneous difference equation in terms of Y t . 2) In order to solve for equilibrium output revert back to equations 7.4,7.5, and 7.6. From 7.6 we get:
7.13
Y = C 0 + cY + I 0 + G 0 Y =
1 (1c )
1 (C + I + G 0 ) (1 c ) 0 0
where
3) Substitute w = 0.9 and c = 0.5 in (7.12) to compute the time path of output.
Y t 0.5(1 + 0.9 )Y t1 + (0.9)(0.5)Y t2 = C Conjecture Suppose we are seeking the solution to the first-order difference equation Y t+1 aY t = c where a and c are two constants. The complementary function of a first-order difference equation y c can be expressed as y c = A 1 b t . Conjecture Trying out a solution of the form y t = Ab t on the second-order difference equation yields Ab t+2 + a 1 Ab t+1 +a 2 Ab t = 0 or, after cancelling out the (nonzero) common factor Ab t , we can express the higher-order difference equation as b 2 + a 1 b + a 2 = 0. This quadratic equation possesses the two characteristic roots b 1 and b 2 .
0.95 (0.95 ) 2 4(1)(0.45) 0.95 0.90 1.8 = b1, b2 = 2 2 Since b 2 4ac we have complex or imaginary roots. In the case of a complex root we can write the solution as:
Y t = Ab t cos(t ) where
cos =
1 a 2
(0.95 ) 1 2
Note: Here a and b denote a 1 and a 2 respectively in Chiangs (1984, pp.513) treatment of higher-order differential equations. ( 360 ( = 44.93 8 quarters. For cycles 2 = 360
Tutorial 8
Consider the following model of a closed economy. The system consists of four equations in four endogenous variables (C t , Y t , T t , and I t ) and one exogenous variable Gt = G0.
Yt = Ct + It + Gt C t = c 0 + c 1 (Y t1 T t1 ) I t = i 0 + i 1 (Y t1 Y t2 ) T t = Y t 1. Condense the model into a difference equation involving output. 2. Solve for equilibrium output and comment on the time path of output if; c 0 = 100 i 0 = 200 c 1 = 0.5 i 1 = 0.5 = 0.2 G 0 = 500
Solution
1) Substituting equations (8.2), (8.3), and (8.4) in (8.1) yields:
Y t = c 0 + i 0 + G 0 + [c 1 (1 ) + i 1 ]Y t1 i 1 Y t2 Y t [c 1 (1 ) + i 1 ]Y t1 + i 1 Y t2 = c 0 + i 0 + G 0 C 8.5
where C denotes all the constants collected together. Equation (8.5) is a second-order nonhomogenous difference equation in output. 2) The particular integral or the intertemporal equilibrium of the model is given by writing (8.5) - the characteristic equation in equilibrium form (where denotes equilibrium values):
As explained in the previous tutorial a second-order difference equation of this form can be expressed as a quadratic equation of the form (ax 2 + bx + c). Hence, the characteristic roots are:
Since b 2 4ac we have complex or imaginary roots. In the case of a complex root we can write the solution as:
Y t = Ab t cos(t ) where
cos =
1 a 2 b
(0.9 ) 1 2 0.5
= cos 1 (0.64 ) = 50.21 Note: Here a and b denote a 1 and a 2 respectively in Chiangs (1984, pp.513) treatment of higher-order differential equations. ( 360 ( = 50.21 7.2 quarters. For cycles 2 = 360
Tutorial 9
Consider the following modified version of Sargent (1987(a)) model of a closed economy. The operator E refers to an expected value based on the information available at time t-1. All other notations have their usual meaning.
Y t = C t + (I t I t1 ) C t = P t I t = (E t1 P t+1 P t ) Y t = E t1 P t + t
where , , and 0. t represents the effects of exogenous variables on supply. Assume perfect foresight so that E t1 P t = P t for all t. 1. Condense the model into a difference equation involving P t and comment on its time path.
Solution
1) Substitute equations (9.2), (9.3), and (9.4) in (9.1) to get the reduced form in terms of Pt:
P t+1 2 +
t P t + P t1 =
Definition A forward lag operator is defined by L 1 X t = X t+1 , L n X t = X t+n for n = ..., 2, 1, 0, 1, 2, ..... Formally, the operator L n maps one sequence into another sequence.
L 1 P t 2 +
t P t + LP t =
1 2+
L + L2 Pt =
t1
Let 2 +
= . Then
[1 L + L 2 ]P t =
t1
9.5
[1 L + L 2 ] = (1 1 L )(1 2 L ) =
1 2L 1L + 12L2
9.6
(1 ( 1 + 2 )L + 1 2 L 2 ) so that we need 1 + 2 = , 1 2 = 1. For the second equality ( 1 2 = 1 ) to hold 2 has to be the inverse of 1 ( 2 =
1 1
).
1 t1 t1 = Pt = 2 [1 L + L ] (1 L )(1 1 L )
Thus the general solution (characteristic equation) for this second-order nonhomogeneous difference equation can be expressed as:
Pt =
t1 + A1t + A2 1 1 ) ( )( 1 L 1 L
where A 1 and A 2 are the arbitrary constants and (b 1 ) and roots. Note that = 2+
+
1 + 2 2 since , , and 0.
It follows that one of our roots necessarily exceeds 1, the other necessarily is less than 1. Since, the dominant root | | 1, the price level would follow an explosive nonoscillatory path.
Tutorial 10
Consider the following illustration from Sargent (1987(a)). The operator E refers to an expected value. All other notations have their usual meaning. Let M t be the natural logarithm of the money supply, P t the log of the price level and E t P t+1 the log of the price expected to prevail at time t+1 based on the information available at time t. The model is
M t P t = (E t P t+1 P t ) E t P t+1 P t = (P t P t1 )
10.1 10.2
where 0 and 0. 1. Condense the model into a difference equation involving the price level and determine the long-run equilibrium value of P t once we impose the stability condition 1? 1+ 2. What is the long-run equilibrium value of P t if we assume perfect foresight? What sort of terminal condition is necessary to rule out the occurrence of runaway inflation?
Solution
1) Substitute equation (10.2) in (10.1) to get:
M t P t = P t P t1 P t LP t +P t =M t (1 + L )P t =M t
10.3
Pt
L 1 +
Pt Pt
L 1 +
Mt 1 +
10.4
yt =
1 x = 1 L t
j x tj
j=0
Note
j x tj = x t + x t1 + 2 x t2 + ....
j=0
j x tj = x t + Lx t + 2 L 2 x t + ....
j=0
j x tj = x t (1 + L + 2 L 2 + .... )
j=0
j x tj = x t
j=0
1 1 L
Pt = 1 1 + Pt = 1 1 +
j=0
1 +
j
M tj + Ab t 1 +
j=0
1 +
M tj + A
10.5
where A is the arbitrary constant and b is the characteristic root. Consequently, this is the general solution (characteristic equation) which describes the entire time path of the price level given the time path of M. In order to arrive at the particular solution we must set the model to equilibrium and solve for P which denotes equilibrium price level. So we can write (10.5) as:
= 1 1 +
j=0
1 +
M + A
1 +
Since to infinity.
1+
1, the second term in our particular solution tends to zero as time tends
lim
t
1 +
P =
M 1 +
1+
+ 1 +
1 +
+ ...
P =
M 1 +
1 1
1+
= M
Thus, the long-run effect of a once-and-for-all jump in money supply is to drive the
price level up by an equal amount (provided the above stability condition is met). 2) If we assume perfect foresight then the money demand function becomes:
t 1 + 1 P t = M 1 L 1 L ( 1 ) t1 1 Pt = M 1 L
or
t1 Pt = M
1 1
(1 ) L 1
1 Pt=
j=0
1 M tj + A
10.6
In order to arrive at the particular solution we must set the model to equilibrium and solve for P which denotes equilibrium price level. So we can write (10.6) as:
1 P=
j=0
1 M + A
Note that
j=0
M = M
1 P =M + A
1 1 t However, since ( ) 1 as 0 the second term i.e., A( ) would be explosive. We would therefore require that A = 0 (terminal condition) in order to rule out a bubble.
Tutorial 11
Consider the following model of a closed economy. denotes the inflation rate, u denotes the unemployment rate, and m is the growth of money stock. Treat as exogenous. The superscript e refers to an expected value. The subscripts t and t+1 refers to the respective time periods.
, 0, 0 1 01 0
1. Condense the model into a difference equation involving (i) the inflation rate, (ii) the unemployment rate. 2. Solve for (i) the equilibrium inflation rate, (ii) the unemployment rate. 3. If = 20, = 10, = 1 , = 1 , = 2 3 find the time path of the inflation rate.
1 2
Solution
1) Expressing the model in equilibrium (where denotes equilibrium value):
= u + e e = e + ( e ) u = u + (m )
t = u t + e t
e e e t+1 = t + ( t t )
u t+1 = u t + t+1 Using the lag operator we can simplify equations (11.5) and (11.6) as follows:
e e L 1 e t = t + t t
L 1 1 + e t = t e t = t 1+ L t [1 L(1 )] 11.7
L 1 u t = u t + L 1 t (L 1 1 )u t = L 1 t
ut =
L 1 t t (1 L ) (L 1 1 )
11.8
t =
t (1 L )
L t [1 L(1 )]
(1 + ) + (1 + 1 + )L + (1 + )L 2
=0
(1 + ) t + (2 + + ) t1 + (1 + ) t2 = 0
Note that by writing down the model in deviation form we have successfully omitted the constants i.e., and m. We can now add the constants to the second-order difference equation in .
(1 + ) t + (2 + + ) t1 + (1 + ) t2 = C
11.9
where C denotes the omitted constants. For a second-order difference equation the solution for the complementary function can be written as c = A 1 (b 1 ) t + A 2 (b 2 ) t where A 1 and A 2 are the arbitrary constants and b 1 and b 2 are the characteristic roots. As we have seen already, a second-order difference equation can be represented as a quadratic equation and its roots can be computed by applying the quadratic formula,
b1, b2 =
b b 2 4ac 2a
If (b 2 4ac) we have real roots. On the otherhand if (b 2 4ac) we have complex roots. In the case of complex roots we can write the solution simply as
t = A t cos(t )
where cos =
a 1 2 b =
= cos 1
1 a 2 b =
In order to obtain a difference equation in terms of the unemployment rate go back to equation (11.8):
ut = or t =
t (1 L ) u t (1 L )
11.10
Substitute (11.10) in (11.9) for t , t1 etc to obtain a second-order nonhomogenous difference equation in terms of the unemployment rate. 2(i) For equilibrium inflation rate go back to equation (11.3). Note that m = 0 that is, equilibrium inflation is equal to the growth in money supply. 2(ii) For equilibrium unemployment rate go to equation (11.2). From equation (11.2) we know that e = . Substituting this in equation (11.1) yields:
u =
(1 )
3. Substituting the given values in equation (11.9) (ignoring the constant term for simplicity) yields:
1 + 10 1 t + 2 + 1 10 1 + 10 1 1 1 1 t1 3 2 2 3 2 3 2
+ 1 1 1 1 3 2 or
t2 = 0
6 t 31 t1 + 5 t2 = 0 6 6
t 0.86 t1 + 0.14 t2 = 0
b1, b2 =
Since, (b 2 4ac) we have real roots. Thus the complementary function is given by c = A 1 (0.22 ) t + A 2 (0.64 ) t where b 2 is the dominant root. As t this model converges in the form of a step function. 4. Substituting the given values in equation (11.9) (ignoring the constant term for simplicity) yields:
6 t 2 t1 + t2 = 0
Since, (b 2 4ac) we have complex roots. In the case of complex roots we can write the solution simply as:
t = A t cos(t )
where cos =
(0.33 ) 1 2 0.17
= 0.42
Note: Here a and b denote a 1 and a 2 respectively in Chiangs (1984, pp.513) treatment of higher-order differential equations.
For cycles
360 ( 65.17
Tutorial 12
Consider the following model of a closed economy. p denotes the price level, x denotes output, and m is the growth of money stock. The superscript e refers to an expected value. The subscripts t and t-1 refers to the respective time periods.
p t = ax t1 + p e t1
e p e t = p t + (1 )p t1
x t = (m p t ) 1. Condense the model into a difference equation involving (i) the price level, (ii) full-employment output. 2. Solve for (i) the equilibrium price level, (ii) the equilibrium output. 3. If a = 0.2, = 0.2, = 0.1; find the time path of the price level. 4. Comment on the time path of the price level if = 1.
Solution
1) Expressing the model in equilibrium (where denotes equilibrium value);
p t = ax t1 + p e t1
e p e t = p t + (1 )p t1
x t = p t Using the lag operator we can simplify equations (12.5) and (12.6) as follows:
e (1 L )p e t = (1 L )p t + (1 )Lp t (1 L )
pe t [1 (1 )L ] = p t pe t = p t [1 (1 )L ] 12.7
(1 L )x t = (1 L )p t
x t = p t
12.8
(1 L )p t = aL(p t ) + L
p t [1 (1 )L ]
(1 L )
(1 L + L L + L 2 L 2 )p t = ap t L + aL 2 p t ap t L 2 + Lp t p t L 2
pt
1 L + L L + L 2 L 2 + aL aL 2 + aL 2 L + L 2 p t [2 a ]p t1 + [1 a(1 )]p t2 = C
=C
12.9
x t = p t or
pt = 1 xt
12.10
Substitute (12.10) in (12.9) for p t , p t1 etc to obtain a second-order nonhomogenous difference equation in terms of output. 2) In order to compute equilibrium output go to equation (12.2);
p e = p + (1 )p e p e [1 (1 )] = p
x = 0
Substitute the value of equilibrium output in (12.3) to get equilibrium price level:
m = p
3. Substituting the given values in equation (12.9) (ignoring the constant term for simplicity) yields:
or p t 1.98p t1 + 0.984p t2 = 0
b1, b2 =
Since (b 2 4ac) we have complex roots. In the case of complex roots we can write the solution simply as:
= 0.998
For cycles
360 ( 3.62
4. Substituting the given values in equation (12.9) (ignoring the constant term for simplicity) yields:
Since (b 2 4ac) we have complex roots. In the case of complex roots we can write the solution simply as
p t = A t cos(t )
where cos =
(1.98 ) 1 2 1
= 0.99
For cycles
360 ( 8.11
Tutorial 13
Consider the following Neo-Classical/Keynesian Synthesis model where notations have their usual meaning.
y t = r t + d m = p t + y t R t
e p t = p t + (y t y ) e p t
(p t1
e p t1 )
Rt = rt +
e p t+1
where x t = x t = x t x t1 . 1.Condense the model into a difference equation involving the price level. 2. If = 0.5, = 3, = 0.2, = 1, and = 0.1; find the time path of the price level.
Solution
1) Expressing the model in equilibrium (where denotes equilibrium value):
y = r + d m = p + y R p = p e + (y y ) p e = p p e R = r + p e
y t = r t 0 = p t + y t R t
e p t = p t + y t e e p t = (p t1 p t1 )
Rt = rt +
e p t+1
e e (1 L )p t = Lp t Lp t
e p t =
Lp Lp t t (1 L + L ) (1 (1 )L )
13.16
p t =
Lp t + y t (1 (1 )L )
p t [1 L ] = y t [1 (1 )L ] yt = p t [1 L ] [1 (1 )L ] 13.17
13.18
y R t = t + L 1
Lp t (1 (1 )L )
13.19
y 0 = p t + y t t + L 1 0 = pt + + 0 = pt + + yt
Lp t (1 (1 )L )
p t (1 (1 )L ) p t (1 (1 )L )
p t [1 L ] [1 (1 )L ]
Note that p t = p t p t1 = (1 L )p t :
0 = pt + +
[1 L ] 2 p t [1 (1 )L ]
(1 L )p t (1 (1 )L )
0 = p t (1 (1 )L ) + [1 L ] 2
p t p t (1 L )
1+
+ + p t + 1 + 2
+ p t1
p t2 = C
where C denotes the omitted constants. 2) Substituting the given values above ( ignoring the constant term for simplicity) yields:
p t 1.978p t1 + 0.98p t2 = 0
b1, b2 =
Since, (b 2 4ac) we have complex roots. In the case of complex roots we can write the solution simply as
= 0.999
For cycles
360 ( 2.56