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University of Kiel

Dynamic Macroeconomic Theory

[CAP 3, Lecture Hall 2]

Email: sacht@economics.uni-kiel.de

Organization

Room: 308

Visiting Hours: by appointment

Password:

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

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

Dynamic Macroeconomic Theory

Trigger warning:

cf. among many others the recent critique of

Main Goal

International Economics, August 2016

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

2016

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

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

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

2.1. First and Second Order Differential Equations

Course Outline

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

4.1.2. Economic Application: Cycles in Search Equilibrium

4.2. Chaotic Dynamics

4.2.1. Mathematical Background

4.2.2. Economic Application: Chaotic Growth

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

Main Literature

Cambridge University Press (with Marji Lines), 2001

Economics, Cambridge: Cambridge University Press, 1992

of Economic Discontinuities, Kluwer Academic Publishers,

1991

economic application, 2nd ed., Cambridge, GB : Cambridge

University Press, 2002

7

Dynamic Macroeconomic Theory

{

= 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 )

g ( yt , yt 1 ,..., yt n ) =

nonlinear equations:

8

1.1 First and Second Order 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

t t 1

{ A

{ A=0 (irrespective of A)

yt yt 1

y*

( y*,t*) y* = t* A A =

t*

Types of dynamic behavior:

1.1 First and Second Order Difference

Equation

eigenvalue

11

1.1 First and Second Order Difference

Equation

homogeneous equation plus so-called particular solution

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

models.

[ ] [ ]

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

Try a function with the same form of g(t) but with undetermined constants

Substitute into non-homogeneous equation and determine the coefficients

Examples:

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

....

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

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

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:

Combine both solutions into: yt = A11t + A2 2t

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

equation

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

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

r cos = , r sin = r2 = 2 + 2

Im() r = ( 2 + 2 )1/ 2

(modulus or absolute value)

r

Re()

19

Second-Order Linear Difference Equations

= 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

20

Period: 2/ & Amplitude: depends on r

Second-Order Linear Difference Equations

explosive >

constant oscillations if a2 = 1

dampened <

21

Second-Order Linear Difference Equations

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

(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

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

23

Second-Order Linear Difference Equations

depending on eigenvalues

24

Second-Order Linear Difference Equations

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

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

26

1.1.2 Economic Application: Multiplier-

Accelerator Interaction

Model structure:

(multiplier)

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

27

1.1.2 Economic Application: Multiplier

Accelerator Interaction

Yt = bYt-1 + k (Ct Ct 1 ) + G =

= bYt-1 + kb(Yt-1 Yt- 2 ) + G

G

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

1 b

{ =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.

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

30

1.1.2 Economic Application: Multiplier

Accelerator Interaction

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)

exogenous variables.

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

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.

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

( 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

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,

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

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

e

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

(

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

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

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 :

( 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

39

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

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.

of the relevant economic model

40

1.1.3 A First Look at Anticipation:

Backward and Forward Solutions

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

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 )

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)

44

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