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Difference Equation

Difference Equation

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Published by Weijie Chen
Difference equations for economists.
Difference equations for economists.

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Published by: Weijie Chen on Oct 07, 2011
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11/08/2012

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Difference Equations
Weijie ChenDepartment of Political and Economics StudiesUniversity of Helsinki16 Aug, 2011
Contents
1.1 Iterative Method. . . . . . . . . . . . . . . . . . . . . . . . . 21.2 General Method. . . . . . . . . . . . . . . . . . . . . . . . . 41.2.1 One Example. . . . . . . . . . . . . . . . . . . . . . . 6
2.1 Complementary Solution. . . . . . . . . . . . . . . . . . . . . 72.2 Particular Solutions. . . . . . . . . . . . . . . . . . . . . . . 92.3 One Example. . . . . . . . . . . . . . . . . . . . . . . . . . . 9
3
p
3.1 Iterative Method. . . . . . . . . . . . . . . . . . . . . . . . . 113.2 Analytical Solution. . . . . . . . . . . . . . . . . . . . . . . . 133.2.1 Distinct Real Eigenvalues. . . . . . . . . . . . . . . . 143.2.2 Distinct Complex Eigenvalues. . . . . . . . . . . . . . 193.2.3 Repeated Eigenvalues. . . . . . . . . . . . . . . . . . 20
p
5.1 MATLAB code. . . . . . . . . . . . . . . . . . . . . . . . . . 211
 
Abstract
Difference equations are close cousin of differential equations, theyhave remarkable similarity as you will soon find out. So if you havelearned differential equations, you will have a rather nice head start.Conventionally we study differential equations first, then differenceequations, it is not simply because it is better to study them chronolog-ically, it is mainly because diffence equations has a naturally strongerbond with computational science, sometimes we even need to studyhow to make a differential equation into its discrete version-differenceequation-since which can be simulated by MATLAB. Difference equa-tions are always the first lesson of any advanced time series anal-ysis course, difference equation largely overshadows its econometricbrother, lag operation, that is because difference equation can be ex-pressed by matrix, which tremendously increase it power, you will seeits shockingly powerful application of space-state model and Kalmanfilter.
1 First Order Difference Equation
Difference equations emerge because we need to deal with discrete timemodel, which is more realistic when we study econometrics, time seriesdatasets are apparently discrete. First we will discuss about
iterative mathod 
,which is almost the topic of first chapter of every time series textbook. Inpreface of Ender (2004)[5],‘In my experience, this material (difference equa-tion) and a knowledge of regression analysis is sufficient to bring students tothe point where they are able to read the professional journals and embarkon a serious applied study.’ Although I do not full agree with his optimism,I do concur that the knowledge of difference equation is the key to all furtherstudy of time series and advanced macreconomic theory.A simple difference equation is a dynamic model, which describes thetime path of evolution, highly resembles the differential equations, so itssolution should be a function of 
t
, completed free of 
y
t
+1
y
t
, a time instant
t
can exactly locate the position of its variable.
1.1 Iterative Method
This method is also called
recursive substitution 
, basically it means if youknow the
y
0
, you know
y
1
, and rest of 
y
t
can be expressed by a recursiverelation. We start with a simple example which appears in very time seriestextbook,
y
t
=
ay
t
1
+
w
t
(1)2
 
where
w
=
w
0
w
1
...
w
t
.
w
is a determinstic vector, later we will drop this assumption when westudy stochastic difference equations, but for the time being and simplicity,we assume
w
nonstochastic yet.Notice that
y
0
=
ay
1
+
w
0
y
1
=
ay
0
+
w
1
y
2
=
ay
1
+
w
2
...
y
t
=
ay
t
1
+
w
t
Assume that we know
y
1
and
w
. Thus, substitute
y
0
into
y
1
,
y
1
=
a
(
ay
1
+
w
0
) +
w
1
=
a
2
y
1
+
aw
0
+
w
1
Now we have
y
1
, follow this procedure, substitute
y
1
into
y
2
,
y
2
=
a
(
a
2
y
1
+
aw
0
+
w
1
) +
w
2
=
a
3
y
1
+
a
2
w
0
+
aw
1
+
w
2
Again, substitute
y
2
into
y
3
,
y
3
=
a
(
a
3
y
1
+
a
2
w
0
+
aw
1
+
w
2
) +
w
3
=
a
4
y
1
+
a
3
w
0
+
a
2
w
1
+
aw
2
+
w
3
I trust you are able to perceive the pattern of the dynamics,
y
t
=
a
t
+1
y
1
+
t
i
=0
a
i
w
t
i
Actually what we have done is not the simplest version of differenceequation, to show your the outrageously simplest version, let us run throughnext example in a lightning fast speed. A homogeneous difference equation
1
,
my
t
ny
t
1
= 0
1
If this is first time you hear about this, refer to my notes of 
differential equation 
[2].
3

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