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004: Macroeconomic Theory

Lecture 9
Mausumi Das
Lecture Notes, DSE
August 14, 2014
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First Order Linear Non-Autonmous Dierence Equation:
Solution & Stability
In last class we have seem that for a rst order non-autonomous
linear dierence equation of the form
x
t+1
= ax
t
+ b
t
can have two possible solutions:
A Backward Solution that assumes existence of a pre-determined
initial value;
A Forward Solution that assumes existence of a well-dened terminal
value.
The Backward Solution to the above equation is given by:
x
t
= Ca
t
+
t1

i =0
a
i
b
t1i
.
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Backward Solution: Stability
We also know that the backward solution will be globally
asymptotically stable if
1
jaj < 1
2
jb
t
j 5 B for all t, where B is a nite constant.
We now turn to the derivation (and stability) of the corresponding
forward solution.
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First Order Linear Non-Autonmous Dierence Equation:
Forward Solution
Consider the same non-autonomous dierence equation as before:
x
t+1
= ax
t
+ b
t
But instead of an initial condition, suppose we are given a terminal
condition specifying that
lim
t!
x
t
= x,
where x is a nite constant.
Since we have to use a terminal value, we could rewrite the dierence
equation to express the current value of the variable in terms of its
future value as follows:
x
t
=
1
a
x
t+1

1
a
b
t
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Forward Solution: Existence & Stability
Now interating forward,
x
t
=
1
a
x
t+1

1
a
b
t
=
1
a

1
a
x
t+2

1
a
b
t+1

1
a
b
t
=

1
a

2
x
t+2

1
a

2
b
t+1

1
a
b
t
=

1
a

3
x
t+3

1
a

3
b
t+2

1
a

2
b
t+1

1
a
b
t
.............
=

1
a

n
x
t+n

1
a
n

i =0

1
a

i
b
t+i
.
Recall that the terminal value of x
t
is given by x.
Hence allowing n to go to (i.e., iterating innite times forward) and
replacing the corresponding x
t+n
by x, we get the particular solution
for the dierence equation that satisfy the given terminal condition.
Das (Lecture Notes, DSE) Macro August 14, 2014 5 / 18
Forward Solution: Existence & Stability (Contd.)
This particular solution is given by:
x
t
= lim
n!

1
a

n
x
1
a

i =0

1
a

i
b
t+i
.
Notice however that for solution would indeed be consistent with the
given terminal condition if and only if the RHS converges to a nite
value. A sucient condition for that is given by
1
jaj > 1
2
b
t
5 B for all t, where B is a nite constant.
Under these two conditions, the rst term in the RHS above vanishes,
while the last term converges to a nite value, say

B
t
.
Das (Lecture Notes, DSE) Macro August 14, 2014 6 / 18
Forward Solution: Existence & Stability (Contd.)
Thus under these conditions, the forward solution for x
t
is given by:
x
t
=
1
a

i =0

1
a

i
b
t+i
=

B
t
.
Notice that:
The forward solution is well-dened if the above conditions are
satised; a forward solution may not exist otherwise.
When the above sucient conditions are satised, the forward solution
is also stable and converges to its terminal value x. Otherwise, even if
it exists, it explodes to innity.
The terminal value x cannot be just any arbitrary constant. It has to
be the limit point of

B
t
(which in turn depends on the parameter a and
the sequence of the non-autonomous terms fb
t
g

t=0
).
Das (Lecture Notes, DSE) Macro August 14, 2014 7 / 18
System of Simultaneous Dierence Equations:
In our analysis so far we have focussed on a single variable and there
for a single equation of motion capturing the evolution of this variable.
It is concievable that in an economy there are several variables which
change over time simultaneously (e.g., capital stock and population)
such that to analyse the dynamic behaviour of the economy, we have
to look at the evolution of all these state variables together.
If there are N = 2 such state variables, then the dynamical system
will now be represented by N dierent equations of motions and we
have to analyse all these equations simultaneously.
In this course, we shall limit our analysis to a 2 2 autonomous
system, (i.e, 2 autonomous dierence equations in 2 state variables)
as described below:
x
t+1
= f (x
t
, y
t
; )
y
t+1
= g(x
t
, y
t
; )
Das (Lecture Notes, DSE) Macro August 14, 2014 8 / 18
2X2 System of Simultaneous Dierence Equations: Linear
& Autonomous
Consider the following two simultaneous dierence equations:
x
t+1
= a
11
x
t
+ a
12
y
t
+ b
1
y
t+1
= a
21
x
t
+ a
22
y
t
+ b
2
where a
11
, a
12
, a
21
, a
22
, b
1
and b
2
are given parameters of the
dynamical system.
We can write the above system in matrix form as:

x
t+1
y
t+1

=

a
11
a
12
a
21
a
22

x
t
y
t

+

b
1
b
1

or, X
t+1
= AX
t
+ B.
where X
t
represent the time-dependent state vector, A represents
the (time invariant) coecient matrix and B represents the vector
of non-homogenous terms of the system.
Das (Lecture Notes, DSE) Macro August 14, 2014 9 / 18
2X2 System of Linear & Autonomous Simultaneous
Dierence Equations: Solution
One way to solve this system is to iterate the state vector
X
t


x
t
y
t

backward and express it in terms of its initial value X


0
(as we did in the single variable case).
This yields:
X
t
= A
t
X
0
+
t1

i =0
A
i
B.
Once again we can write the general solution to this 2 2 system by
replacing X
0
with some arbitrary matrix C.
The only problem is that it is not so easy to comment on the stability
property of the system because that would involve calculating a
powered matrix and a geometric series on matrices!!
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2X2 System of Linear & Autonomous Simultaneous
Dierence Equations: Solution (Contd.)
So we shall use the alternative method of Superposition Principle,
which requires nding
a genreral solution to the homogenous part of the system (which is
called the complementary function);
then locating one particular solution to the entire (non-homogenous)
system,
and then adding the complementary function and the particular
solution together to arrive at the general solution to the entire
non-homogenous system.
The homogenous part of the system is given by:

x
t+1
y
t+1

=

a
11
a
12
a
21
a
22

x
t
y
t

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2X2 System of Linear & Autonomous Simultaneous
Dierence Equations: Solution (Contd.)
Notice that if the coecient matrix was diagonal (such that
a
12
= a
21
= 0), then nding the general solution to the above
homogenous system would have been very very easy!!
Suppose A is a diagonal matrix given by

a
11
0
0 a
22

. Then the
above homogenous system collapses into two independent
single-variable dierence equations, given by:
x
t+1
= a
11
x
t
;
y
t+1
= a
22
y
t
.
The general solution to the above homogenous dierence equations
are given respectively by:

x
t
y
t

=

C
1
(a
11
)
t
C
2
(a
22
)
t

; C
1
, C
2
arbitary constants.
Das (Lecture Notes, DSE) Macro August 14, 2014 12 / 18
2X2 System of Linear & Autonomous Simultaneous
Dierence Equations: Solution (Contd.)
Having found the complementary functions, the Superposition
Principle now requires identication of a particular solution to the
general (nonhomogenous) system.
Since we are looking only at non-autonomous systems, the equations
would always permit existence of some steady state.
So the easiest way to locate a particular solution is to identify a
steady state of the correponding non-homogenous system.
Notice that when A is a diagonal the non-homogenous system is given
by:
x
t+1
= a
11
x
t
+ b
1
;
y
t+1
= a
22
y
t
+ b
2
.
Das (Lecture Notes, DSE) Macro August 14, 2014 13 / 18
2X2 System of Linear & Autonomous Simultaneous
Dierence Equations: Solution (Contd.)
We can easily calculate the corresponding steady states as follows
(provided a
11
, a
22
6= 1):
x =
b
1
1 a
11
;
y =
b
2
1 a
22
.
Thus we can now write the general solution to the non-homogenous
system of equations (with a diagonal coecient matrix) as:

x
t
y
t

=

C
1
(a
11
)
t
C
2
(a
22
)
t

+

x
y

; C
1
, C
2
arbitary constants.
The stability of the system will of course depend on the values of a
11
and a
22
.
But this is only a special case where the coecient matrix is diagonal.
Das (Lecture Notes, DSE) Macro August 14, 2014 14 / 18
2X2 System of Linear & Autonomous Simultaneous
Dierence Equations: Solution (Contd.)
What about a more general case when the coecient matrix A is
non-diagonal?!
It turns out that a square matrix A can be transformed into a
diagonal matrix by applying a procedure called Diagonalization.
To apply this procedure we need a little knowledge of Matrix algebra,
in particular, the concepts of eigen values and eigen vectors.
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A Digression: Eigen Values & Eigen Vectors of a Square
Matrix
Consider a square matrix A
nn
.
If there exists a scaler and a non-zero vector X such that
AX = X,
then the scaler is called an eigen value of the Matrix A, and the
vector X is called the eigen vector associated with .
Thus, to nd an eigen value of the matrix A, we have to nd a
non-zero solution to the equation:
[A I ] X = 0,
where I in a n n identity matrix.
The above equation will have a non-zero solution if and only if the
matrix [A I ] is singular or degenerate, i.e., its determinant is zero:
det [A I ] = 0
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Eigen Values & Eigen Vectors of a Square Matrix: (Contd.)
The above equation is called the characteristic equation of matrix
A.
If A is a n n square matrix, then the LHS of above equation will be
a n-th order polynomial of , and its solution will give us all the eigen
values of matrix A.
For the 2 2 coecient matrix A

a
11
a
12
a
21
a
22

, the characteristic
equation is given by:
det

a
11
a
12
a
21
a
22

= 0
i.e.,
2
(a
11
+ a
22
) + (a
11
a
22
a
12
a
21
) = 0
This is a quadratic equation in , which we can now solve to derive
two eigen values and the corresponding eigen vectors of matrix A.
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Eigen Values & Eigen Vectors of a Square Matrix: (Contd.)
Using the eigen vectors, one can then construct an invertible matrix
P, which can be used to to transform the original coecient matrix A
into a diagonal (or, in some cases, almost diagonal) form such that
P
1
AP = D,
where D is a diagonal (or, in some cases, almost diagonal) matrix.
This way, one can transform the given system of dierence equations
into a new system, where the coecient matrix of the new system is
none-other-than the diagonal matrix D (and therefore we can solve
the new system very easily).
We shall discuss this transformation mechanism in the next class.
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