Quantitative Methods 3: Dynamic Models

Year 2, Course Period 1
Quantitative Methods 3
Academic year 2017-2018

Course Reader
Mathematics Part
Dynamic models
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Economics (code EBC2011)
School of Business and Economics
Bachelor
© March 2017, Hans de Graaff, Dries Vermeulen

Except as permitted by law, no part of this publication may be reproduced or distributed in any form or by any means,
or stored in a data base or retrieval system, without the prior written permission of the authors.
Dynamic models
So far we have only considered models in which the passing of time was not explicitly modeled.
These models are also called static models. However, in order to describe processes of change,
such as population increase, the development of shares of a number of products, or the growth of
a capital, it is essential to include time in the model. In that case we speak of a dynamic model. In
such a model (some of) the quantities used are time-dependent. For example, in a dynamic
demand-supply model the quantities of demand, supply and price are considered as functions of
time, which is usually indicated by the variable t. We will call these quantities, which are time-
dependent, dynamic quantities or dynamic variables.
We distinguish two ways in which time can be incorporated into a model: discrete and
continuous. In a discrete dynamic model the values of the dynamic quantities are only considered
at consecutive equidistant moments in time, such as days, months, years. We call these discrete
moments. Usually they are moments at which the quantities are recalculated or adjusted. For
example, when a capital K grows by the periodic adding of interest per year, then it is natural to
consider the value of K on an annual basis. Then the model variable or model quantity K can be
seen as a function of time t, where t indicates the number of years that have passed since the
deposit of the capital into the savings account. We indicate this by using the notation Kt for the
value of the capital, t years after its deposit. The consecutive values K0 ,K1,K2,,… thus form a
sequence which represents the growth of capital. Another example: in statistics we are interested
in time series models, actually based on observations at consecutive equidistant moments in time.
In a continuous dynamic model we are interested in the value of the model quantities at all
moments of time in an interval. Such a model is appropriate when adjustment of the model’s
variables takes place continuously or at a large number of moments in time that lie very closely
together. Thus we can speak of continuous (in the sense of: uninterrupted) adding of interest in
the case of the growth of a capital. This means that interest is being added “each moment”. In
practice this will probably come down to adding interest per day. In that case we write K(t) for
the value of the capital t years after the deposit. Since t [0, ) , K is interpreted as a function
defined on the interval [0, ) . Also in the discrete situation Kt can be considered as a function,
but now the domain consists of the set of natural numbers {0,1,2,3,…}.
The equations that arise in discrete dynamic models are called difference equations and those
arising in continuous dynamic models differential equations. In order to find an analytical
solution to these equations we need advanced mathematical techniques. In this course we will
only solve some simple difference and differential equations. As the technique of integration of
functions is useful for solving differential equations, we will deal with this subject as well. We
will use chapter 9 of the book of Sydsæter and Hammond (S&H) for the integration part. Here, in
section 9.8, you will also find a first introduction to differential equations.
Obviously, in a dynamic model it is important to know how the process evolves. Does it
converge to a stable situation? Therefore we are very interested in equilibrium points, actual
candidates for such a stable situation. Fortunately, besides the analytical approach there is a
qualitative approach, which is mainly graphical. In many cases it is possible to get an idea about
the dynamic behavior by just sketching a graph. Spreadsheet software like EXCEL turns out to be
very useful for simulating solutions and plotting graphs, especially in the discrete case. We will
show the use of it in many examples and exercises.
For background reading we refer to the books below:
 Knut Sydsaeter, Peter Hammond and others, Further Mathematics for Economic Analysis,
The book is a continuation on a higher level of the book Essential Mathematics for Economic
Analysis by the same authors.
Chapters 5, 6 and 7 are about differential equations and chapter 11 about difference
equations. This book is available at UM library.
 William E. Boyce and Richard C. DiPrima, Elementary Differential Equations and Boundary
Value Problems.
This is a more advanced mathematics book, available at UM library.
 Morris W. Hirsch, Stephen Smale and Robert L. Devaney, Differential equations, dynamical
systems and an introduction to chaos.
Solid mathematical background at a rather high level that may give you insight in the
arguments behind the theory. This book is available at UM library.
Hans de Graaff, Dries Vermeulen

Maastricht, March 2017
Table of contents
1 Discrete dynamics .................................................................................................................. 2
1.1 Classification of difference equations ............................................................................... 2
1.2 First order linear difference equations ............................................................................. 3
Example 1.1 The growth of a capital .............................................................................. 3
Example 1.2 The growth of a capital with periodic deposits .......................................... 5
Definition 1st order linear difference equation ................................................................... 6
Solution of homogeneous equations ................................................................................... 6
Solution of inhomogeneous equations ................................................................................ 7
Particular solution ............................................................................................................... 9
Examples 1.3 ................................................................................................................... 9
Equilibrium and stability ................................................................................................... 11
An alternative graph .......................................................................................................... 12
Periodic solutions .............................................................................................................. 13
Economic application 1.1 Supply-demand model with price-adjustment ..................... 15
1.3 Second order linear difference equations ....................................................................... 15
Definition 2nd order linear difference equation ................................................................. 16
Solution of homogeneous equations ................................................................................. 16
Examples 1.4 ................................................................................................................. 17
Solution of inhomogeneous equations .............................................................................. 19
Equilibrium and stability ............................................................................................... 19
Examples 1.5 ................................................................................................................. 20
1.4 Systems of difference equations ...................................................................................... 22
Phase diagram ................................................................................................................... 23
1.5 Nonlinear equations ........................................................................................................ 23
Economic application 1.2 .............................................................................................. 27
Application 1.3 Predator-prey model ............................................................................ 28
Application 1.4 The multiplier-accelerator model ........................................................ 29
1 DISCRETE DYNAMICS 2
1 Discrete dynamics
In a discrete dynamic model the development of a quantity, say x, is followed step by step over
the time: we are interested in the sequence x0, x1, x2, …with which we indicate the values of
the quantity at equidistant moments in time t = 0, 1, 2, … (years, months, days, etcetera).
For example let K t be the value of an amount of €10.000,- after t years with a yearly interest
of 5%.
In such a model the development of the quantity is usually described as a relation between the
quantity's value at an arbitrary moment in time is and the quantity's value at earlier moments.
We call this a recursive definition. This dependence can be expressed in an equation for the
variables xt, xt-1, xt-2 etcetera. For example, an equation like xt  12 xt 1  12 xt 2 indicates that at
each moment the value of the quantity x is the average of the values attained by that quantity
at the two preceding moments.
And the equation Kt  1.05Kt 1 informs us that the value of the quantity K is at each moment
five percent more than that quantity's value at the preceding moment.
The two above-mentioned equations are called difference equations (for x), after the
alternative representation by differences xt  xt 1  xt , the difference between two subsequent
values. For example, the equation Kt  1.05Kt 1 can also be written as Kt 1  0.05Kt 1 .
In this chapter we will give a classification of different types of difference equations. For
example, in the second equation above, the value at time t is only expressed in terms of the
value at time t-1, so one period earlier. Therefore we call them equations of the first order. If
the value at time t is expressed in terms of values at time t-2 and maybe t-1, then the equation
is of the second order, and so on. The variable t is the time variable and the variable
depending on t, here xt, is often called (dynamic) state variable. The central issue will be how
to investigate the behavior of the dynamic model. In some simple cases we will solve the
equations analytically, hence solve for xt as a function of t, defining the complete sequence x0,
x1, x2, …. A solution of a difference equation is simply a sequence, or function, xt that satisfies
the equation. We are especially interested in the behavior in the long run and the question
whether there exists an equilibrium value. You will experience, that often it is not necessary to
solve the difference equation analytically in order to know the long run behavior. A graphical
approach can help to see the development of the sequence. We will show how you can use
EXCEL to calculate and graph an initial run x1,x2,x3,…,xn of the sequence.
1.1 Classification of difference equations

We already saw the distinction between first and second order difference equations. The order
of a difference equation is the number of periods back in time needed to define the current
state: hence xt  3xt 2  xt 4 is an example of a 4th order difference equation.
A general first order difference equation can be described by xt  f ( xt 1 ) . If the function f is
linear, then we say the difference equation is linear, otherwise nonlinear. The definition of
higher order (non)linear equations is an obvious generalization. Even 1st order nonlinear
difference equations can reveal surprisingly complex behavior. For instance,
1.3 SECOND ORDER LINEAR DIFFERENCE EQUATIONS 3
xt  3.7 xt 1 (1  xt 1 ) describes a nonlinear equation (we will later see, that it generates
complex, even so-called chaotic behavior).
A difference equation like xt  3xt 2  xt 4 is said to be autonomous, if time t does not occur
explicitly in the equation, but only as an index of the state variable. So, the equation xt  t 2 xt 1
is nonautonomous.
A final characteristic has to do with the occurrence of terms that do not contain the state
variable at all. If each term in the difference equation contains the state variable, as in
xt  3xt 2  xt 4 , then we say, that the equation is homogeneous, otherwise inhomogeneous, as
for example xt  3xt 2  xt 4  4 .
Being aware of the characteristics of an equation is especially important when you are solving
the equation analytically.
A dynamic model may consist of one difference equation or more than one. In the latter case
several state variables play a role and the equations may be coupled, which means that
equations may contain more than one state variable. Consider for example the equations
 xt  0.8 yt 1

 yt  0.9 xt 1  0.6 yt 1
We call this a system of difference equations. In general a dynamic model, consisting of one or
more difference equations, is also called a dynamic system.
EXERCISES 1.1
Classify the following difference equations. Give all the characteristics.
a) xt  4 xt 2
b) Kt  0.3tKt21
c) Kt  Kt21  t
d) Yt  Yt 1 (t  Yt 3 )  1
Check that the sequence, or function, xt  10  2t is a solution of the difference equation in part
a).
1.2 First order linear difference equations

In this section we will investigate a dynamic model of the 1st order linear type in both the
analytical and the graphical way. First let’s consider some examples.
Example 1.1 The growth of a capital

Assume that an amount of €10.000,- is deposited in a savings account, say at time 0, with an
interest of 5%, added annually. In order to give an adequate description of the growth of the
capital, we write Kt for the value of the capital in euros, t years after time t = 0. Now the
starting or initial capital can be represented by K0. After one year interest is added for the first
time, namely 5% of K0, or 0.05K0. This increases the capital to K1  K0  0.05K0  1.05K0 , so
K0  0.05K0 .
For the next years, capital will grow in a similar way. This gives rise to the sequence
K1  1.05 K 0
K 2  1.05 K1
K 3  1.05 K 2
M
This growth process can easily be summarized in a single equation:
Kt  1.05Kt 1 with t  1,2,3,...
Here we see a 1st order difference equation, which is also linear and homogeneous. We have
seen capital growth models in the first year, see chapter 4 of QM2. Actually this is an example
of exponential growth and the analytical solution is well-known: Kt  K01.05t . The analytical
solution is an exponential function of t. As we know the initial value K0, we can easily
determine Kt at each moment in time t, so at the end of year t.
It is easy to use EXCEL to calculate an initial run of the sequence. See the printout in figure
1.1 below in which you can read off the values for the first ten years. The first table shows the
calculated outcomes and the second one the cell formulas. In the graph the exponential
behavior of the process is clearly visible.
Kt
80000
60000
40000
20000
0
0 20 40 60 t
FIGURE 1.1 The growth of capital Kt with K0 = €10.000,-.
Example 1.2 The growth of a capital with periodic deposits

Now assume that we have decided to annually deposit an amount of €1000,- in a savings
account, from say time 0 onward, with an interest of 5%, added annually. Now after one year
interest is added, 0.05K0, but an additional amount of €1000,- will be added as well. This
increases the capital to K1  1.05K0  1000 . Hence we get the sequence
K1  1.05K 0  1000
K 2  1.05K1  1000
K 3  1.05K 2  1000
M
Again this process can easily be summarized in a single equation:
Kt  1.05Kt 1 +1000 with t  1,2,3,...
st
This is a linear 1 order difference equation, which is however not homogeneous. It turns out
to be much more difficult to analytically solve this inhomogeneous equation than the
homogeneous counterpart. In EXCEL things are equally easy: see Figure 1.2.
FIGURE 1.2 The growth of capital Kt with periodic deposits.
In both examples the difference equation describes the growth of capital. By giving an initial
value, a value at t = 0, the model quantity Kt will be uniquely determined at all times by the
first order linear difference equation.
Definition 1st order linear difference equation
A first order linear difference equation for x with constant coefficients is an expression of the
form
xt  a xt 1  bt (t  1,2,3,...)
where the coefficient a  0 does not depend on t.
We definitely do not exclude the possibility of dependence on t for the so-called free
coefficient bt.
If bt = 0 for all t = 1, 2, 3, …, then the equation is homogeneous, otherwise inhomogeneous.
Solution of homogeneous equations

The analytical solution of a general 1st order homogeneous linear difference equation can be
found in the same way as in example 1.1, so
The solution of the 1st order linear difference equation xt  axt 1 is

xt  x0 at for t  1,2,3,...
If we know the initial value x0 then the solution is uniquely determined.
If the initial value is not given, then this solution representation is called the general solution,
where x0 is actually a parameter.
Notice that xt  0 (for all values of t) is always a solution of a homogeneous equation, namely
the solution with x0  0 . We call this the zero solution.
The general solution actually is a collection of all possible solutions to the equation if no
initial value has been given. The behavior of this dynamic process, i.e. the behavior of the
solutions to the equation, depends on the value of the coefficient a. If this value is between 0
and 1, then the value of the state variable xt will get smaller and smaller over time and finally
converge to 0 in the limit. Also for –1 < a < 0 the solution sequence will converge to 0, but
now the values will alternately be positive and negative, so we have an oscillatory or
alternating sequence. In both cases we call this limit 0 a stable equilibrium, as it is a limit
point towards which each solution converges. If a > 1, then the sequence will get larger and
larger and tend to infinity in the limit. Also for a < -1 it will not converge, but explode over
time in an alternating way. Finally, for a = 0 or a = 1 it is constant over time, 0 and x0
respectively, and for a = -1 it is alternately x0 and –x0.
Besides the analytical solution it is often clarifying to use pictures in order to get an idea of the
behavior of the dynamic system. A graphical presentation of the various situations is shown in
figure 1.3. These graphs show initial runs of the solution sequences depending on time t and
are called time paths. Also the solution sequences, or functions, are sometimes called time
paths. They can be generated immediately, if we put the value of the parameter a in a separate
cell for reference. We took x0 = 15 and t from 0 to 10.
FIGURE 1.3 Solutions of xt  a xt 1 , with x0 = 15.
EXERCISES 1.2
Give the general solution of the following difference equations:
1
a) yt   yt 1 b) yt  yt 1  0 c) a xt  xt 1  0 with a  0
3
Solution of inhomogeneous equations

Consider again example 1.2 about the annual deposit of an amount of money on an account.
Here Kt is the total amount at the end of year t of yearly deposits of €1000,- at an interest rate
of 5%. It turns out to be possible to give a formula for Kt at each t using the summation
formula for a finite geometric series. See also Chapter 4 of QM2.
In general this is known as the formula for the future value of an annuity immediately after the
last deposit:
a
Ft  [(1  r )t  1] ,
r
where the amount a is the annual deposit, r is the interest rate and t the number of years,
assuming the amount a is deposited at the end of each year.
1000
In this case we have a = 1000 and r = 0.05, so we get: (1.05t  1)  20000(1.05t  1) for
0.05
the future value of the amounts deposited at the end of each year. As we had already a deposit
of €1000 at the start of year 1, we have to add the future value 1000(1.05) t of this amount, so
the result is
Kt  21000(1.05)t  20000 (t = 0, 1, 2, …)
As you can easily check the first part of this solution is a solution of the corresponding
homogeneous equation Kt  1.05Kt 1 and the 2nd part, the constant number -20000, is itself a
solution of the inhomogeneous equation Kt  1.05Kt 1 +1000 . This is a general rule:
The general solution of an inhomogeneous difference equation can be written as the sum of
the general solution of the corresponding homogeneous equation and a solution of the
inhomogeneous equation. The latter is often called a particular solution.
Shorthand notation:
GIS = GHS + PS
(General Inhomogeneous Solution = General Homogeneous Solution + Particluar Solution)
Don't misunderstand: a particular solution is just a solution of the inhomogeneous equation, in

fact nothing particular.
From this general rule we can deduce the following result:
The general solution of the 1st order linear difference equation xt  axt 1  bt is
xt  c at  pt for t  1,2,3,...
where c is an arbitrary number and pt a particular solution of the inhomogeneous equation
itself. If the initial value x0 is given, then the constant c is uniquely determined.
Graphs of solution sequences for inhomogeneous difference equations can be obtained in the
same way as before.
Theoretical background. Why GIS = GHS + PS.

For those who are interested in the arguments why this rule is true we will try to explain it for
the 1st order linear case. Other cases can be motivated in the same way.
(This is an example of rather abstract mathematical reasoning which may be strange and
confusing to you. If you do not understand it, don’t worry about QM3, but if you feel “wow,
this is what I always wanted to do”, then ask your teacher for more.)
Consider the difference equation
xt  a xt 1  bt
Suppose that pt is a particular solution, so pt  a pt 1  bt .
We want to show that
(i) each solution is the sum of a solution of the corresponding homogeneous equation
xt  a xt 1 (we call this a homogeneous solution) and pt , and that
(ii) the sum of a homogeneous solution and pt is a solution.
Let us first motivate the first statement:

(i) Suppose that st is a solution to the difference equation, so st  a st 1  bt .
We have to show that st  (some homogeneous solution)  pt , or that
st  pt  (some homogeneous solution) .
Because pt  a pt 1  bt and st  a st 1  bt , we see immediately that
(st  pt )  a st 1  bt  (a pt 1  bt )  a(st 1  pt 1 ) , so st  pt is a homogeneous
solution.
Now the proof of the second statement:
(ii) Suppose that ht is a homogeneous solution. This means that ht satisfies the
homogeneous equation xt  a xt 1 , so ht  a ht 1 .
Now we have to show that ht  pt is a solution of xt  a xt 1  bt . This follows
directly from ht  a ht 1 and pt  a pt 1  bt , because
ht  pt  a ht 1  a pt 1  bt  a(ht 1  pt 1 )  bt .
Particular solution
We know how to find solutions to a homogeneous equation. But what can we say about a
particular solution pt ? Unfortunately this is not so simple and straightforward. It is only by
trial and error that we can hope to find it. But we have an important indicator, namely the free
coefficient bt in the difference equation. It will turn out that the form of bt can be used as a
handhold for finding a particular solution:
General rule of thumb for finding PS:

Always try a solution that has the same form as bt, so:
if bt is a constant, then try a constant for pt,
if it is a linear or quadratic function of t, then try a linear or quadratic function,
if it is an exponential function of t, then try an exponential function.
In most cases this will work! But:
if it does not work, then multiply your provisional solution by t and try it again.
We will only provide some simple examples and not go deeper into this issue.
Examples 1.3
 Constant free coefficient.
Consider again the equation Kt  1.05Kt 1 +1000 Applying the general rule we first solve
the homogeneous equation Kt  1.05Kt 1 , with general solution c1.05t and then try the
provisional solution pt, which in this case must be a constant, say pt = d. After substitution
in the inhomogeneous equation we get d  1.05 d  1000 , which has solution d = -20000.
So the general solution is Kt  c1.05t  20000 . The value of c depends on the initial value
K0. If e.g. K0 = 1000, as before, than we find after substitution
1000  c1.050  20000  c  20000 , so c = 21000 and the unique solution is,
Kt  21000(1.05)t  20000 , as before. With K0 = 0 we find Kt  20000(1.05)t  20000
and with K0 = 2000 we will find Kt  22000(1.05)t  20000 .
 Linear free coefficient.
A slightly different situation is described by Kt  1.05Kt 1 +100  5t , where the amount
added to the account yearly increases linearly, i.e. by a linear increasing function of t. The
general solution of the corresponding homogeneous equation will not differ from the one
before, but now it is not so easy to find a particular solution. Following the recipe for
finding a particular solution we will now try a linear function of t. A linear function of t
has the form a + b t. Substitution in the equation yields
a  bt  1.05[a  b(t  1)]  100  5t , with t  1,2,3,... , after some rearranging:
a  bt  1.05a  1.05b  100  (1.05b  5)t . As this equation should hold for all t, this
means that the linear functions on both sides must be equal, hence intercept and slope of
the left-hand side must be equal to those of the right-hand side. This will give two
equations for a and b:
a  1.05 a  1.05b  100


 b  1.05b  5
with solution a = -4100 and b = -100, as can easily be checked. So the general solution is
now Kt  c (1.05)t  4100  100t . If we take K0 = 100, then the unique solution is
Kt  4200(1.05)t  4100  100t
 Exponential free coefficient: simple case.
The equation xt  2 xt 1  3t 1 has c2t as general solution for the corresponding
homogeneous equation. According to the structure of the free coefficient we try k  3 as a
t
t 1 t 1
particular solution. Substitution gives k  3  2  k  3  3 . After dividing both sides by
t
3t we get k  2  k  31  3 , so k  9 . Hence the complete general solution is

xt  c 2t  9  3t  c 2t  3t  2 .
 Exponential free coefficient: more complicated case.
The equation xt  2 xt 1  2t 1 has c2t as general solution for the corresponding
homogeneous equation. According to the structure of the free coefficient we are inclined
to try k  2t as a particular solution, but substitution gives
t 1 t 1 t 1
k  2  2 k  2  2
t
 k  2  2 , simplified 0  2 , which is obviously impossible.
t t1
Now, according to the recipe for finding a particular solution, we try pt  t k 2t and
substitution gives t  k  2t  2(t  1)(k  2t 1 )  2t 1  t  k  2t  k  2t  2t 1 , simplified
k  2t  2t 1 . So k  2 and pt   t 2t 1 . Hence the complete general solution is
xt  c 2t  t 2t 1 .
 Constant free coefficient: more complicated case.
Consider the equation xt  xt 1 +10 . The corresponding homogeneous equation xt  xt 1

has the easy general solution xt = c, where c is an arbitrary constant (this is the special
situation that in the equation xt  a xt 1 the coefficient a has the value 1). Now it is
obvious, that a particular solution cannot be a constant. So according to the recipe for
finding particular solutions we do not try pt = d, but pt = t d. After substitution:
t d  (t  1)d  10 , so d = 10 and the general solution is xt = c + 10t. If the initial value is
known to be x0, then c = x0.
EXERCISES 1.3
Give the general solution of the following difference equations and the unique solution
corresponding to the initial value that is given, if so:
1
a) yt  yt 1  20 and y0  100 d) Kt  1.05Kt 1  10(1.1)t
3
b) yt  yt 1  2 and y0  5 e) Kt  1.05Kt 1  100  5t
c) xt  xt 1  t  1 and x0  1 f) Kt  1.05Kt 1  21(1.05)t
Equilibrium and stability

The long run behavior can be investigated as before. If you have an analytical solution, then
you may immediately observe what happens. Again the value of a in the general solution
xt  c at  pt plays a crucial role. For example, let’s consider the equation xt  0.5xt 1  3 ,
then the general solution will be xt  c(0.5)t  2 and it is easy to observe, that in the long run
the value of the state variable will approach 2. This is also the particular solution of the
system, which has been found by trying a constant solution. Such a constant solution is called
an equilibrium solution or equilibrium point or a fixed point of the difference equation and the
way to find such a point is substituting a constant x* into the equation and trying to solve it. In
our example we will find x* = 2 from x*  0.5x * 3 . If, as in this example, all solutions
converge to this point, then it is called a stable equilibrium and the solutions are called
convergent.
In order to describe what we exactly mean by equilibrium we will use the more general
representation of a 1st order difference equation xt  f ( xt 1 ) , where f is a function of one
variable. If f is a linear function, then it is a linear difference equation.
We call x* an equilibrium point or fixed point of the system xt  f ( xt 1 ) , if the constant

sequence x(t) = x* is a solution, hence if x* = f(x*).
If every solution, regardless of the initial value, converges to x*, then it is called a (globally)
stable equilibrium. The constant solution xt = x* is called an equilibrium solution, and a stable
solution, if stable.
Now we can easily check, that the linear 1st order equation xt  f ( xt 1 ) with f ( x)  ax  b
b
has the equilibrium point x*  , which is stable if a  1 .
1 a
An alternative graph
Besides the time path we may use another way to picture a 1st order dynamic system, namely a
plot of the relation between xt and xt-1. Such a graph is sometimes called a phase diagram of
the difference equation. It differs essentially from a time path graph, because there is no t-axis.
This graph turns out to be very useful for the analysis of equilibrium points. Take again our
example xt  f ( xt 1 )  0.5xt 1  3 . In the picture below you see the graph of the function
f ( x)  0.5x  3 , as well as the graph of the auxiliary function g ( x)  x (‘the line y = x’).
Suppose, that the initial value is x0 = 4. Then starting at this value we find x1 by drawing a
vertical line (arrow) until we cross the graph at xt-value 1. Now we take this value as our new
xt-1-value. In the graph this point on the xt-1-axis can be found by drawing a horizontal line
until we intersect the line y = x. The corresponding value on the horizontal axis is x1 = 1. The
next value can be found in the same way: draw vertical line until the function value
f ( x1 )  0.5x0  3  2.5 , then horizontal line until y = x and so on. You see immediately in
the picture, that the sequence is converging to a fixed point (in the neighborhood of) 2. As you
can see the convergence does not depend on the initial value: If we had taken x0 = 5, then we
could expect the same long-run behavior. The fixed equilibrium point attracts all the solutions.
That's why it is sometimes called an attractor.
3
xt
1 2 3 4 5 6
x1 x3 x4 x 2 x0
xt 1
1
FIGURE 1.4 Phase diagram of xt  0.5xt 1  3 with x0 = 4.
Also in the time path picture in figure 1.5 the converging property can quickly be read off.
4,50
4,00
3,50
3,00
2,50
2,00
1,50
1,00
0,50
0,00
0 1 2 3 4 5 6 7 8 9 10
FIGURE 1.5 Time path of xt  0.5xt 1  3 with x0 = 4.
As we saw before, crucial for the convergence of the system xt  f ( xt 1 )  axt 1  b is the
value of a: if a  1 , then the system will converge. Notice that a is the slope of the linear
function f.
In the xt 1 vs. xt graph in figure 1.6 you see what happens, if a = -1.5. No matter what the
initial value is, the solution will diverge away from the fixed point x* = 1.2. Such a fixed point
is often called a repellor. Of course, if the initial value is equal to the fixed-point value, x0 =
1.2, then the sequence 'converges', it sticks to the value 1.2. Now it is easy to understand, that
for a  1 the system will not converge (except for the initial value being equal to the fixed-
point value).
We saw an example for a = 1 before: xt  xt 1 +10 has the general solution xt = x0 + 10t.
3
xt
1 1 2 3
x3 x1 x0 x2 x4
xt 1
1
FIGURE 1.6 Phase diagram of xt  1.5xt 1  3 with x0 = 1.5.
Periodic solutions
A special situation arises, when a = -1. Consider for example the equation xt   xt 1  4 . As
can easily be found, the equilibrium point is x* = 2 and the general solution is xt  c (1)t  2 .
This solution does not converge (except for x0 = 2, for then c =0). If we take x0 = 3, then the
solution function is xt  (1)t  2 , so the solution sequence is 3, 1, 3, 1, 3, … It is a so-called
periodic or cyclic solution, as after some fixed number of time periods the sequence repeats
Here this number is equal to two and the solution is called a two-cycle or a two-period limit
cycle. See the figures below.
xt
3,50
3,00
2,50
2,00
1,50
1,00
0,50
0,00
0 1 2 3 4 5 6 7 8 9 10 11 t
FIGURE 1.7 Time path of xt   xt 1  4 with x0 = 3.
xt 4
1 1 2 3 4 5
xt 1
1
FIGURE 1.8 Phase diagram of xt   xt 1  4 with x0 = 3.
Summarizing
Suppose that xt  f ( xt 1 )  axt 1  b has solution xt  c at  p .
If  1  a  1, then xt converges to p (p is stable equilibrium)
(if  1  a  0, then xt is oscillating but converging to p)
If a  1, then xt is divergent
If a  1, then xt is oscillating and divergent
If a  1, then xt is constant if b  0, else divergent
If a  1, then xt is alternating ( periodic solution, period 2)
b
Note 1: x* is solution of x*  f ( x*)  a x * b , so x*  (only if a  1 )
1 a
Note 2: x* = 0 is always an equilibrium of the homogeneous system! (the case b = 0)
EXERCISES 1.4
Determine the long run behavior of the equilibrium points, if they exist, of the dynamic
systems in exercises 1.3.
Economic application 1.1 Supply-demand model with price-adjustment

Consider the static market model
 D  12 P  160

 S  aP  40
D  S

where D is demand, S is supply and P is the price. a is a parameter. It seems reasonable to

transform this model into a dynamic one, as we may assume, that supply reacts to price with a
certain delay (adaptation time of the production). Suppose that S reacts with a one period delay
to P and that demand reacts immediately to the price level. We also assume that the total
supply will be sold.
Hence, suppose that we have at a certain moment, say time t-1, price Pt 1 . Then in the next
period supply will be St  aPt 1  40 . Total supply will be sold, so the price will be adjusted to
Pt , so that St  Dt .
a) Give the corresponding dynamic model.
Assume initial values D0 = 16 and P0 = 12.
b) Calculate initial runs of the sequences for Dt, St and Pt with the help of EXCEL. Take
several values for a, for example a  8, 12, 16 .
c) Use the graphing option in EXCEL to get an idea of the long run behavior of these
sequences for the different values of a.
Now take a  8 .
d) Deduce from the dynamic model a 1st order linear difference equation for Pt, the price-
adjustment equation.
e) Give the general solution of this equation and the unique solution when starting at P0
= 12.
f) What is the long run behavior of the solution sub e)?
1.3 Second order linear difference equations

In the section before we saw how complex behavior can arise from a simple first order
difference equation. In this section we get back to the linear situation, but now we allow for
2nd lags in the equation, so that we get 2nd order difference equations.
Definition 2nd order linear difference equation
A second order linear difference equation for x with constant coefficients is an expression of
the form
xt  c xt 1  d xt 2  bt (t  2,3,4,...)
where the coefficients c and d  0 do not depend on t.
The free coefficient bt may depend on t.

If bt = 0 for all t = 2, 3, 4, …, then the equation is homogeneous, otherwise inhomogeneous.
An initial run of a 2nd order system can be generated easily with the help of EXCEL, as soon
as two initial values x0 and x1 are known.
Like in the 1st order case the following general rule holds (repeat):
The general solution of an inhomogeneous difference equation can be written as the sum of the
general solution of the corresponding homogeneous equation and a particular solution, i.e. a
solution of the inhomogeneous equation. In short:
GIS = GHS + PS
That's why we will again split up the work in solving the homogeneous equation and finding a
particular solution.
Solution of homogeneous equations

It is not so easy to find the analytical solution of a general 2nd order homogeneous linear
difference equation as it was in the 1st order case. We will suppose however, that analytical
solutions are of the same exponential nature. In the 1st order case we saw that xt  x0 at was
the general form of a homogeneous solution. Hence we will try as a solution a function of the
same form, but in stead of the symbol a as the base for the exponential expression we will use
the symbol  ("lambda") . So try xt   t . Substitution in the homogeneous equation
xt  c xt 1  d xt 2 yields
 t  c  t 1  d  t 2
Assuming   0 we can simplify to
2  c   d  0 ,
which is a quadratic equation in . This equation is called the characteristic equation of the
system and can have two, one or no so-called real solutions, or roots. As you know these roots
can be found with the help of the "abc-formula", which here gives the result
c  c 2  4d
1,2 
2
(see the first one of examples 1.4 below)
The number of real roots depends on the sign of the discriminant   c  4d , so two real
2
roots if   0 , one if   0 and zero if   0 . If it has only one real root, then actually the
equation has two identical roots. If there are no real roots, mathematicians say, that properly
two roots exist and they call them complex roots. We will not further deal with the subject of
complex numbers during this course.
We will see, that for every value of  two essentially different solutions for the difference
equation can be found, called basic solutions. This means that these solutions cannot be
written as a multiple of each other. Solutions with this property are often called independent
solutions. An important property, which we will not prove here as it comes from “higher
mathematics”, says:
Every solution of a homogeneous 2nd order linear difference equation can be written as a linear
combination of two basic, independent solutions.
A linear combination of basic solutions is a sum of multiples of these solutions.

We will see in some examples what all this means in practice.
Examples 1.4
   0 . The difference equation xt  5 xt 1  6 xt 2 has characteristic equation
 2  5   6  0 with   1 and roots 1  2 and 2  3 . As the characteristic equation
arose from trying t as a solution, it is immediately clear that 1t  2t and 2t  3t are
solutions of the difference equation. So they are the basic solutions and because of the
aforementioned property we know that every solution is a linear combination of these
basic solutions. Hence the general solution can be written as
xt  k1 1t  k2 2t  k1 2t  k2 3t , with k1 and k2 arbitrary real numbers (parameters of
the solution).
1
   0 . The difference equation xt  xt 1  xt  2 has characteristic equation
4

t
 2    14  0 with   0 and root   12 . It is clear that  t  1
is a solution of the
2
difference equation. But the property says that there are two basic solutions. Now the

t
other basic solution turns out to be t  t  t 1
(this can easily be checked by
2
substitution into the equation). Hence the general solution can be written as
t t
xt  k1  t  k2 t  t  k1  1   k2 t  1  , with parameters k1 and k2.
2  2
   0 . The difference equation xt  c xt 1  d xt 2  4 xt 2 , with c  0 and d  4 has

characteristic equation   4  0 with   16 , so there are no real roots. Yet it is
2
possible to give two basic solutions to the equation. These solutions turn out to have
the form r t sin  t and r t cos  t , so the trigonometric functions sin and cos play a
role here. We will give no explanation of the origin of these solutions, but they can be
easily verified to be so (if you know your trigonometric rules). The most important
thing to notice is, that solutions show periodic behavior, and that r  d  2 . Hence
the general solution can be written as
xt  k1 r t sin  t  k2 r t cos t  k1 2t sin  t  k2 2t cos t
with parameters k1 and k2.
Summarizing:
The general solution of the homogeneous 2nd order linear difference equation
xt  c xt 1  d xt 2 is determined by the solutions of the characteristic equation
2  c   d  0
If   c  4d  0 , then the characteristic equation has two solutions 1 and 2 and the general
2
solution is
xt  k1 1t  k2 2t
If   0 , then the characteristic equation has one solution  and the general solution is
xt  k1  t  k2 t  t
If   0 , then the characteristic equation has no real solutions and the general solution will
contain sin and cos functions:
xt  k1 r t sin  t  k2 r t cos t , with r  d
If we know the initial values x0 and x1 then the solution is uniquely determined.
The  in case   0 is no simple and obvious expression and will not be given here. It can be
found in most literature about this subject. Besides, for the convergence of solutions, which is
a main issue in this course, the value of r turns out to be decisive.
Notice that we need two initial values to single out a unique solution, as the general solution
contains two parameters.
EXERCISES 1.5
Give the general solution of the following difference equations:
a) yt  3 yt 1  yt 2 b) yt  12 yt 1  36 yt 2 c) xt  2 xt 1  xt 2
EXERCISES 1.6
Give an indication of the form of the general solution of the difference equation
Kt  4Kt 1  8Kt 2
Solution of inhomogeneous equations

We know more or less how to find solutions to a homogeneous equation. In order to find
solutions to an inhomogeneous equation xt  c xt 1  d xt 2  bt we need again a particular
solution of this equation. Fortunately the way find such a particular solution is the same as in
the 1st order case: take the free coefficient bt as an indicator, so always try a solution that has
the same form as bt, so if bt is a constant, then try a constant for pt, if it is a linear or quadratic
function of t, then try a linear or quadratic function, and so on. And if it does not work, then
multiply your provisional solution by t and try it again.

The long run behavior can be investigated as before. You may use a spreadsheet (e.g. EXCEL)
in order to get an idea, and if you have an analytical solution, then you may immediately
observe what happens. We will only consider cases for which the free coefficient is a constant,
so the difference equation looks like
xt  c xt 1  d xt 2  b
The equilibrium point can be found directly from the equation
x*  c x * d x * b
b
which gives x*  (if 1  c  d  0 ). Looking at the summary for a general solution of
1 c  d
a homogeneous equation we see that for   0 the values of the roots of the characteristic
equation are crucial, whereas for   0 the value of r  d is important. An obvious,
general rule is the following (no further explanation):
Consider the 2nd order difference equation with constant free coefficient xt  c xt 1  d xt 2  b .
Let  be the discriminant of the characteristic equation of the corresponding homogeneous
equation.
If for   0 both 1  1 and 2  1 , then solutions converge to the equilibrium point.
If for   0 we have   1 , then solutions converge to the equilibrium point.
If for   0 we have r  1 , then solutions converge to the equilibrium point.
In all cases we call the equilibrium point (globally) stable.
Examples 1.5
 Consider the difference equation xt  5 xt 1  6 xt 2  8 . As we saw before, the
corresponding homogeneous equation has the characteristic equation  2  5   6  0 ,
with roots 1  2 and 2  3 , and the general solution xt  k1 2t  k2 3t , with k1 and k2
arbitrary real numbers. Now try a constant s as particular solution. Substituting and
solving gives: s  5 s  6 s  8 , so s  4 , which is also the equilibrium point. Hence,
the general solution is xt  4  k1 2t  k2 3t , which is clearly not converging, as
1  2  1 and 2  3  1 . The equilibrium is unstable. A last remark: if initial values
were given, then there was only one unique solution. For example, if x0  3 and
x1  3 , then substitution gives two equations for k1 and k2
3  4  k1  k2
3  4  2k1  3k2
with solutions k1  2 and k2  1 and the unique solution of the system is
xt  4  2t 1  3t .
 Consider the difference equation xt  5 xt 1  6 xt 2  2t . As we saw before, the general
solution of the homogeneous equation is xt  k1 2t  k2 3t , with parameters k1 and k2.
Because the free coefficient is an exponential function, at first sight we will be
tempted to try as a particular solution pt  c  2t . But, you will see that this will not
work (actually because it is a solution of the homogeneous equation), so multiply by t
and try pt  c  t  2t . Substitution gives: c  t  2t  5c(t  1)2t 1  6c(t  2)2t 2  2t .
5 6
Deviding this whole equation by 2t gives c  t  c(t  1)  c(t  2)  1 with solution
2 4
t 1
c  2 . Hence, the general solution is xt  t  2  k1 2  k2 3 , which is clearly not
t t
converging. Notice that no equilibrium point exists in this case.

1
 The difference equation xt  xt 1  xt 2  2 has the general solution
4
t t
xt  k1  1   k2 t  1  for the corresponding homogeneous equation and it can easily be
2  2
verified, that pt  8 is a particular solution. So the general solution is

t t
xt  8  k1  1   k2 t  1  , which clearly converges to the particular solution 8. This
2 2
can also be observed in the EXCEL output below, where we took x0  4 and x1  10
t 2 t 3
(verify that this will give the solution xt  8   1   t  1  ).
2  2
xt
12,00
10,00
8,00
6,00
4,00
2,00
0,00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 t
1
FIGURE 1.9 Table and time-path for xt  xt 1  xt 2  2 .
4
 Consider the difference equation xt  xt 1  0.81 xt 2  2 . The corresponding

homogeneous equation has the characteristic equation     0.81  0 with
2
discriminant   2.24 . Now we know, that the general solution looks like
xk  k1 r t sin  t  k2 r t cos t with r  d  0.9 . A particular solution can be found
to be pt  2.46914 . Hence the general solution can be written as
xk  k1 (0.9)t sin  t  k2 (0.9)t cos t  2.46914 . Below you can see that this
converges to the equilibrium point 2.46914 as a dampening wave.
xt
5,00
4,00
3,00
2,00
1,00
0,00
0 1 2 3 4 5 6 7 8 9 101112131415161718192021222324252627
t
FIGURE 1.10 Time-path for xt  xt 1  0.81 xt 2  2 .
EXERCISES 1.7
Give the general solution of the following difference equations, and, in a) and b), the solutions
corresponding to the initial values.
a) yt  12 yt 1  36 yt 2  50, y0  3, y1  20 c) Kt  2Kt 1  Kt 2  1
b) xt  5xt 1  6 xt 2  2  3t 1 , x0  2, x1  48 d) xt  3xt 1  xt 2  t  4
In a) and b), determine the first 10 values of the solution sequences with the help of EXCEL.
1.4 Systems of difference equations

If two or more dynamic variables play a role in a dynamic model, then the model may be described
by more than one difference equation. In this case we talk of a system of difference equations. The
equations may be coupled, which means that different dynamic variables occur in one equation
Consider for example a transition model that describes the transition within a population from one
state to another. Assume that in a given market there is a supply of two brands of coffee, A and B,
and that buying behavior of a customers population is monitored from month to month. Suppose
further, that after each month 5% switches from A to B and 10% from B to A. This switching
behavior can be represented by a system of difference equations for the dynamic variables xt and
yt, being the number of customers in the population preferring A and B respectively at the end of
month t. Verify that this is given by the system:
 xt  0.95 xt 1  0.10 yt 1

 yt  0.05 xt 1  0.90 yt 1
This is clearly a linear system, consisting of two 1st order linear difference equations with two
dynamic variables. Generally linear systems are presented in a short matrix and vector notation. If
we describe the situation at the end of month t by the state vector
x 
st   t  ,
 yt 
then the system can be described by
st  M st 1 ,
0.95 0.10 
where the matrix M    is called the transition matrix.
0.05 0.90 
How to analytically solve linear systems in general is beyond the scope of this course. In the
theory of difference and differential equations so-called eigenvalues and eigenvectors are generally
used to solve these systems, which belong to the mathematics field of Linear Algebra.
In simple cases like our example the system can also be transformed into one difference equation
for one of the dynamic variables.
EXERCISE 1.8
Transform the transition model into one difference equation for xt , by a suitable substitution, and
determine the general solution for xt .
Also derive the general solution for yt . What is the long run behavior?
Of course, if you want to get a quick idea of the model’s behavior, you may again invoke EXCEL.
1.5 NONLINEAR EQUATIONS 23
EXERCISE 1.9
Make a table in an EXCEL worksheet of the first 25 values of the sequences for xt and yt. Also
plot both time paths. Use x0 = 500 and y0 = 2000.
Phase diagram
In the case of systems of difference equations we have, besides time paths and xt-1 vs. xt phase
diagrams, the option to plot xt against yt. These plots are also called phase diagrams, as they do not
contain a t-axis, and they can easily be produced by EXCEL (choose select scatter plot). After
some formatting the result for our transition model may look like this:
2500
yt
2000
1500
1000
500
0
0 500 1000 1500 2000
xt
FIGURE 1.11 Phase diagram for the xt, yt system.
1.5 Nonlinear equations

In section 1.2 we dealt with 1st order linear difference equations where the dynamic variable xt at
time t was a linear function of xt-1. These were easy to solve analytically. In a more general 1st
order difference equation xt can be considered as a general function of xt-1:
xt  f ( xt 1 ) (t  1,2,3,...)
Notice, that this equation is autonomous. We will confine ourselves to this kind of problems
because of their simplicity. An equation of this kind is therefore sometimes called simple equation.
Although, if the function f is simple but nonlinear, then solutions may exhibit complex behavior
and an analytical solution can rarely be found. Of course, in a spreadsheet we can get an idea of
solutions in the same easy way as before. Even in the case of a simple quadratic function we may
observe fascinating behavior. Some special cases are known to display so-called chaotic behavior.
We will demonstrate nonlinear behavior in an example where f is the quadratic hill-shaped
function
f ( x)  r x(1  x)
with parameter r. The corresponding nonlinear 1st order difference equation is
xt  r xt 1 (1  xt 1 )
We will experience, that long run behavior depends heavily on the parameter r and the initial
value.
Let us first have a look at an example where r = 1.8 and x0 = 0.9. See figure 1.12.
0.6 xt
xt
1,00
0.4
0,80
0,60
0.2 0,40
0,20
0,00
0.2 0.2 0.4 0.6 0.8 1 1.2
xt
0 1 2 3 4 5 6 7 8 9 10 11
0.2
1 t
FIGURE 1.12 Phase diagram and time-path for r = 1.8 and x0 = 0.9.
4
The solution clearly converges to the equilibrium point x*  , which is a solution of
9
x  f ( x)  1.8 x(1  x)
What can generally be said about the behavior of the system at an equilibrium point?
If we try to solve x  f ( x)  r x(1  x) , then we will find two solutions (if r  0 ), namely x*  0
1
and x*  1  . Hence there is only a positive equilibrium point, if r > 1.
r
Recall from the linear case, that an equilibrium point turned out to be stable if the slope of the line
was between –1 and 1, with oscillating solutions for a negative slope. In the nonlinear case the
function f does not have a fixed slope, but it seems obvious, that here the relevant slope is the slope
4
of the tangent line at the equilibrium point. In our example with r = 1.8 we find f '( )  0.2 , nicely
9
corresponding to the non-oscillatory convergence of the solution. See figure 1.13.
0.6
xt
0.4
0.2
0.2 0.2 0.4 0.6 0.8 1 1.2

xt 1
0.2
FIGURE 1.13 Tangent line at the fixed point of f ( x)  1.8 x(1  x) .
Actually, in the nonlinear case we are investigating the linear approximation of the difference
equation around an equilibrium point x*. As you may remember the linear approximation of f
around x* is the linear function g ( x)  f ( x*)  f '( x*)( x  x*) with slope f '( x*) (see Section
7.4 of the S&H book).
For f ( x)  r x(1  x) the slope at x* is f '( x*)  r  2r x * , so at x*  0 it is f '(0)  r and at
1 1
x*  1  it is f '(1  )  2  r .
r r
However, as the slope is not constant, it may also depend on the initial value what the eventual
behavior will be. But for the smooth (differentiable) function f we may expect the obvious
behavior if the initial value x0 is close enough to the equilibrium point. As the behavior depends on
the initial value, we are talking of local properties:
If solutions, starting close to the equilibrium point x*, converge to it, then we call x* a locally
stable equilibrium point. If solutions, irrespective the initial value (excluding x*) diverge from x*,
then it is called unstable.
As we assumed f to be differentiable, we have the following condition for local stability:
An equilibrium point x* of the difference equation xt  f ( xt 1 ) , where f is a differentiable

function, is locally stable if f '( x*)  1 and unstable if f '( x*)  1 .
We cannot formulate a general statement for points that satisfy f '( x*)  1 . These points need
further investigation, which, however, is beyond the scope of this course.
For a linear function f, yielding a linear difference equation, stability of x* does not depend on the
initial value. If in this case x* is stable, it is sometimes called globally stable.
1
If f ( x)  r x(1  x) , then we can discern the following cases for the equilibrium point x*  1  :
r
if 0  r  1 then 2  r  1, so x * is unstable
if 1  r  2 then 0  2  r  1, so x * is locally stable (no oscillation)
if 2  r  3 then  1  2  r  0, so x * is locally stable (oscillatory)
if r  3 then 2  r  1, so x * is unstable
The other equilibrium point x*  0 is obviously locally stable if 0  r  1 , as can be seen in the
following picture with r = 0.8 and x0 = 0.6.
xt
xt
0.2
0,80
0.1 0,60
0,40
0.25 0.25 0.5 0.75 1 0,20
0.1 0,00
xt 1 0 1 2 3 4 5 6 7 8 9 10 11
0.2 t
An example with 2  r  3 with clear oscillatory convergence is given in the next figure.
0.8
xt
0.6 0,80
xt
0.4 0,60
0,40
0.2
0,20
0,00
0.2 0.2 0.4 0.6 0.8 1 1.2 0 1 2 3 4 5 6 7 8 9 10 11
0.2
xt 1 t
The last case, with r  3 , turns out to demonstrate very interesting behavior. Look for example at
the following example, with r  3.7 and x0  0.2 .
1
1,00
0.8 0,90
0,80
0.6 0,70
xt 0,60
0,50
0.4
0,40
0,30
0.2 0,20
0,10
0,00
0.2 0.2 0.4 0.6 0.8 1 1.2
xt 1
0.2
There seems to be a repeating pattern in the time-path pointing to a periodic solution, but a closer
look contradicts periodic behavior (nevertheless it may be periodic with a large number of
periods). However, periodic solutions may very well be possible. Look for example at the
following pictures, with r  3.1 and r  3.55 respectively.
1
0,90
0.8 0,80
0,70
0.6 0,60
xt
0,50
0.4 0,40
0,30
0.2 0,20
0,10
0,00
0.2 0.2 0.4 0.6 0.8 1 1.2
xt 1
0.2
1
1,00
0.8 0,90
0,80
xt 0.6
0,70
0,60
0,50
0.4
0,40
0,30
0.2 0,20
0,10
0,00
0.2 0.2 0.4 0.6 0.8 1 1.2
xt 1
0.2
In both cases a periodic pattern can clearly be observed: a two-period limit cycle and a four-period
limit cycle. Hence, although solutions are not converging, they may show interesting periodic
characteristics.
If, for r  3 , solutions do not have periodic patterns, then we talk of chaos. This seems to occur for
r  3.7 , as we saw before. One final example of chaos shows that chaotic patterns may be very
strange:
1
1,20
0.8
1,00
xt 0.6 0,80
0.4 0,60
0,40
0.2
0,20
0,00
0.2 0.2 0.4 0.6 0.8 1 1.2
t
2
5
8
11
14
17
20
23
26
29
32
35
38
41
44
47
xt 1
0.2
There is a lot of mathematical literature about nonlinear dynamics, especially about these kinds of
hill-shaped relations between xt and xt-1. Also in economic theory concerning dynamic models
chaotic behavior has become popular.
Economic application 1.2

The relationship between a firm’s profits Pt in period t and its advertising budget xt is traditionally
hill-shaped, first increasing until its optimum and then decreasing. Such a relation can very well be
described by:
Pt  a xt (1  xt )
If we suppose, that for the next period the firm devotes a fixed proportion b of its profit to
advertising, so xt 1  b Pt , then we will get exactly the nonlinear model described above:
Pt  b Pt 1 (1  Pt 1 )
EXERCISE 1.10
Try to reproduce some of the time-path pictures in EXCEL and play around a little with the
parameter and initial values. Especially try some different initial values in a chaos situation and
experience that small differences in the initial values may have huge consequences.
EXERCISE 1.11
In a former example (see figure 1.14) we saw that a 2-cycle arises for xt  f ( xt 1 )  r xt 1 (1  xt 1 ) ,
when r = 3.1. So in the long run solutions jump up and down between two values, say z1 and z2, so
that z2  f ( z1 ) and z1  f ( z 2 ) . Actually these two values are fixed points of the repeated
function h( x)  f ( f ( x)) , so solutions of the equation x  f ( f ( x)) . Calculate these two values.
Hint: if 𝑥 ∗ is a solution of 𝑓(𝑥) = 𝑥, then it is also a solution of 𝑓(𝑓(𝑥)) = 𝑥.
The following application is an example of a nonlinear system of difference equations, which

nevertheless can be simulated straightforwardly in EXCEL.
Application 1.3 Predator-prey model

Assume that two populations of animals live together, one of which can be consider as predator
and the other as prey. Let xt be the number of animals of the predator type and yt the number of
animals of the prey type at time t, let's say at the end of month t. Suppose that both populations on
their own have a constant natural growth rate, say -a and b respectively, so
xt  xt 1  a xt 1
yt  yt 1  b yt 1
with a  0 (lack of prey) and b  0 (herbivorous animals). The living together influences the
population growth in an obvious way, xt will go up due to the presence of prey and yt will go down
due to the presence of predators. Suppose, that the changes are proportional to the other
population's size, so that the final model is:
xt  xt 1  (a  c yt 1 ) xt 1
yt  yt 1  (b  d xt 1 ) yt 1
with c  0 and d  0 .
EXERCISE 1.12
Investigate this model with the help of EXCEL. For example make time path plots for xt and yt and
a phase diagram (xt vs. yt) for a  0.06, b  0.18, c  0.0006 and d  0.003 , with initial values
x0  65 and y0  120 . In order to get nice pictures calculate a large run of values, e.g. over 250
months. Can you determine an equilibrium point, and , if so, does it seem stable?
Application 1.4 The multiplier-accelerator model

Introduction: A dynamic macro-economic model
A consumption economy in a closed economy without government can be described by means of
the following static, macro-economic model:
Y  C  I

C  cY  A
Here the model quantities Y, C, I and A, expressed for example in billions of euros, have the
following meaning:
Y is national income,
C is total consumption,
I is total investment and
A is autonomous consumption (not depending on income).
Furthermore, c is a measure for the change of C resulting from a change in Y, and it is called
marginal consumption quota.
We now wish to devise a dynamic model that is based on the assumption that total consumption
reacts by a one year's delay to changes in national income. This means that we must devise a
dynamic model in which time t is measured in years from a certain initial moment t = 0.
In addition, we will assume that total investment I depends on t and that the autonomous
consumption A is constant over time.
a) Formulate the dynamic model and show that from this model a first order linear difference
equation can be derived, namely
𝑌𝑡 = 𝑐𝑌𝑡−1 + 𝐼𝑡 + 𝐴
Now suppose that the marginal consumption quota c is equal to 0.7, the yearly investment is
constant 𝐼𝑡 = 𝐼 = 60 and 𝐴 = 90. Further, take as an initial value Y0 = 600.
b) Calculate the first 20 values of Yt and Ct in an EXCEL spreadsheet. Use reference cells for
Y0 and c, so that you can directly re-use your spreadsheet later on. Make plots (time paths)
of these sequences. Do they tend to stabilize (converge)? If so, around which values they
do so? What is the influence of the initial value Y0 on the behavior of the sequences (you
may play around somewhat with the initial value).
Now take Y0 = 1600 and c = 0.9, but keep 𝐼𝑡 = 60 and 𝐴 = 90.

c) Compare the behavior of an initial run of the solution sequence to the original one with Y0
= 600 and c = 0.7.
Again let Y0 = 600 and c = 0.7, keeping 𝐼𝑡 = 60 and 𝐴 = 90.

d) Solve the difference equation in a).
Now suppose that investment is not a constant anymore but a function It of t increasing linearly
with time t according to the equation It  60  9t , keeping 𝑐 = 0.7, 𝐴 = 90 and 𝑌0 = 600.
e) Solve the difference equation in a). Describe the behavior of the solution with words.
The accelerator-multiplier model

Above you studied a dynamic closed macro-economic model, without government expenditure,
where investment It was constant or a linear function of time t. In the following dynamic model,
which you are going to study again with the help of both EXCEL and analytical tools, investment
It depends on the increase of consumption. If consumption rises, as compared to the previous year,
entrepreneurs feel stimulated to make new investments, for they notice that customers spend more
money. In this accelerator-multiplier model, investment in year t is proportional to Ct – Ct-1 which
represents the increase of consumption as compared to the previous year. The complete model now
has the following form (we use some other parameter names):
Yt  C t  I t

C t   Yt 1  A (0    1)
 I   (C  C ) ( > 0)
 t t t 1
Here A is again the autonomous consumption,  the marginal consumption quota, and  the so-
called accelerator.
.
4
f) Take 𝐴 = 100, 𝛾 = 0.9, 𝛿 = 9, I 0  20 and C0  10 . Use EXCEL to calculate values for
Yt, Ct and It for t = 0, 1, 2, 3, …, 40. Reserve separate cells for the model parameters , 
and A. Plot the sequence for Yt in a time path graph. What is the behavior of the sequence?
What happens if you take a higher value for  ?
g) Show that from the accelerator-multiplier model the following 2nd order difference
equation for national income Yt can be derived:
𝑌𝑡 = 𝛾(1 + 𝛿)𝑌𝑡−1 − 𝛿𝛾𝑌𝑡−2 + 𝐴
4
Take 𝐴 = 100, 𝛾 = 0.9 and 𝛿 = 9, and as initial values Y0  1300 and Y1  1300 .
h) Determine the analytical solution of the equation at g) and check the long run behavior.
Use EXCEL to calculate the values of Yt for t = 2, 3, 4, …, 40 and plot the time path graph
for this sequence and compare to the analytical solution.
Take 𝐴 = 100,   0.75 and   3 , and initial values Y0  200 and Y1  250 .
i) Redo h) for this case. Consider only t = 2, 3, 4, …, 10 in the EXCEL calculations.
Now take 𝐴 = 100,   0.8 and   0.5 , and initial values Y0  200 and Y1  250 .
j) Repeat h) for this case, as far as possible. Consider only t = 2, 3, 4, …, 10 in the EXCEL
calculations.
Set   0.5 and leave  as an unknown parameter in the model. Keep 𝐴 = 100.
k) What is the equilibrium point of the equation? For which values of  do you expect the
general solution to contain trigonometric functions (sin and cos)? Do you think the
equilibrium point is stable in this case? Determine the form of the general solution of
the difference equation at g), if we take   0.8 (see the 4th one of Examples 1.5).
We now extend the model with a role for the government. We consider a closed macro-economic
model with constant government expenditure and a tax on national income. The model equations
are as follows:
Yt  Ct  I t  Gt

Ct  A  c Yt 1 (0  c  1)
b
Y b  Y  T

t t t
 t
T   Y t (0    1)
G  G
 t
 I t  I
Here Y represents national income, Yb spendable income, I investment, G government expenditure
and T tax. The model parameters A, c and  respectively represent autonomous consumption,
marginal consumption and marginal tax quota.
l) Deduce a (1st order) difference equation for Yt.

m) Prove that, regardless of the values of the model parameters c and , with 0  c  1 and
0    1 , the solutions are always convergent. Give the equilibrium solution Y*, as well as
the general solution Yt of this difference equation in terms of A, I, G, c and .
2.1 INTRODUCTION 1
Table of contents
2 Continuous dynamics ....................................................................................................................2
2.1 Introduction ........................................................................................................................... 2
The basic model .........................................................................................................................2
Classification of differential equations.......................................................................................5
Examples 2.1 ..........................................................................................................................5
Time paths, solutions and equilibria...........................................................................................6
Example 2.2............................................................................................................................6
Example 2.3............................................................................................................................7
2.2 First order linear differential equations ............................................................................... 9
2.3 Second order linear differential equations ............................................................................ 9
Example 2.4..........................................................................................................................10
General solution homogeneous equation .................................................................................10
What happens when D < 0?......................................................................................................11
Example 2.5..........................................................................................................................13
Inhomogeneous equations ........................................................................................................13
Example 2.6..........................................................................................................................14
Extra conditions........................................................................................................................17
Example 2.7..........................................................................................................................17
Equilibrium and stability ..........................................................................................................18
2.4 Nonlinear differential equations. ........................................................................................ 19
Simple differential equations ...................................................................................................20
Equilibria ..................................................................................................................................20
Phase diagrams and stability ....................................................................................................20
Example 2.8..........................................................................................................................20
Application 2.1 In-population dynamics .............................................................................22
Example 2.9 Linear simple differential equations ................................................................24
Application 2.2 The Solow model .......................................................................................24
Application 2.3 Logistic growth...........................................................................................27
2.5 Systems of differential equations ......................................................................................... 27
Example 2.10........................................................................................................................27
Equilibria ..................................................................................................................................28
Phase diagrams .........................................................................................................................30
2.6 Linear systems ..................................................................................................................... 32
Example 2.11........................................................................................................................33
Phase diagrams revisited ..........................................................................................................33
Convergence and stability ........................................................................................................34
The associated 2nd order equation in one variable. ...................................................................37
Example 2.12........................................................................................................................37
Application 2.4 The tâtonnement process ............................................................................39
2 2 CONTINUOUS DYNAMICS
2 Continuous dynamics
2.1 Introduction
This part on Continuous dynamics connects the part on Integration and the part on Discrete
dynamics. In this introduction, we will first have a look at the basic continuous dynamic model, the
natural growth model. We will see that a solution is easy to find, using our knowledge of
integration. Also some more realistic growth models will be solved, the limited growth model and
the logistic growth model. This is done by a clever substitution that makes it again a simple natural
growth model.
Whereas a discrete dynamic model is described by difference equations, a continuous dynamic
model is described by differential equations. Also differential equations can be divided into
different groups, a classification that is similar to the discrete case. And again we will study
solutions as well as equilibrium points.
In sections 2.2 and 2.3 we will deal with first and second order linear differential equations of one
dynamic variable. In section 2.4 we also consider nonlinear models for one variable.
In sections 2.5 and 2.6 systems of differential equations with two dynamic variables will be
studied.
The basic model

An example of the basic model is the growth of a capital K where interest is accrued continuously,
based on a constant interest rate r. This growth can be described by the equation
𝐾 ′ (𝑡) = 𝑟 𝐾(𝑡)
Here 𝐾′(𝑡), growth of capital, is proportional to the magnitude 𝐾(𝑡) of the capital, with growth
rate r. The variable t denotes time. Time could be measured in years, hours or whatever time units,
starting from an initial time moment 𝑡 = 0, the moment that an initial amount 𝐾0 has been
deposited at a savings account.
Natural growth
The basic model is also used for a constantly growing population, and is generally referred to as
the natural growth model. Usually derivatives with regard to time are denoted with a “dot” instead
of a “prime”, so we get as the general model
Natural growth model with constant growth rate r
𝑥̇ (𝑡) = 𝑟 𝑥(𝑡)
𝑥̇ (𝑡)
The growth rate 𝑟 = is also called relative rate of change.
𝑥(𝑡)
2.1 INTRODUCTION 3
We use our knowledge of integrals to solve this equation. We are going to take the antiderivative
of the relative rate of change on both sides of the definition.
𝑥̇ (𝑡)
∫ 𝑟 𝑑𝑡 = ∫ 𝑑𝑡
𝑥(𝑡)
Now the left hand side (LHS) is easy to find if we assume that r is a constant: ∫ 𝑟 𝑑𝑡 = 𝑟 𝑡 + 𝑐1 .
To the right hand side (RHS) we apply integration by substitution of 𝑦 = 𝑥(𝑡). Then 𝑑𝑦 = 𝑥̇ 𝑑𝑡
𝑥̇ (𝑡) 1
and the RHS is transformed into ∫ 𝑑𝑡 = ∫ 𝑑𝑦 = ln|𝑦| + 𝑐2 = ln|𝑥(𝑡)| + 𝑐2 . Here 𝑐1 and 𝑐2
𝑥(𝑡) 𝑦
are constants of integration. So we get
ln|𝑥(𝑡)| = 𝑟 𝑡 + 𝑐
Here we combined the constants of integration into c. Taking the exponential function on both
sides gives the result
|𝑥(𝑡)| = 𝑒 𝑟𝑡+𝑐 = 𝑒 𝑐 𝑒 𝑟𝑡
We observe that |𝑥(𝑡)| is a positive constant times 𝑒 𝑟𝑡 . But, then we can also write a general
constant A times 𝑒 𝑟𝑡 for 𝑥(𝑡):
𝑥(𝑡) = 𝐴 𝑒 𝑟𝑡
So we did not find one unique solution but a set of solutions. Similar to the discrete case we call
this the general solution.
The basic model of natural growth is also referred to as the exponential growth model.
The graph of a solution is given below:
Here the horizontal axis is the t-axis and the curve represents the corresponding values 𝑥(𝑡). Here
we took 𝐴 > 0 and 𝑟 > 0. Because 𝑥(𝑡) is a function of time, we call this function, and also its
graph, a time path.
Limited growth
With a positive growth rate a population that behaves according to the natural growth model will
grow exponentially to infinity. However, often we assume that there is an upper limit for the
population size, called the carrying capacity K. This can be modeled as follows:
𝑥̇ (𝑡) = 𝑎(𝐾 − 𝑥(𝑡))
This is called the limited growth model. The closer the population size 𝑥(𝑡) is to K, the slower is
the growth. Actually the population growth is proportional to the deviation from the carrying
capacity. Now the general solution to this model can be found by transforming the model into a
natural growth model by the smart substitution 𝑢(𝑡) = 𝐾 − 𝑥(𝑡). Then 𝑢̇ (𝑡) = −𝑥̇ (𝑡) and we have
the following equation for 𝑢(𝑡):
𝑢̇ (𝑡) = −𝑎 𝑢(𝑡)
with general solution 𝑢(𝑡) = 𝐴 𝑒 −𝑎𝑡 , so the general solution for 𝑥(𝑡) is
𝑥(𝑡) = 𝐾 − 𝐴 𝑒 −𝑎𝑡
where A is the constant of integration and K the carrying capacity.

The graph of a solution, with positive A, K and a, is given below:
Logistic growth
A next step in refining the growth model could be the combination of exponential growth and
limited growth. We want growth to be exponential if the population is small, and limited if the
population approaches a carrying capacity K. Consider the following dynamic model:
𝑥(𝑡)
𝑥̇ (𝑡) = 𝑟 𝑥(𝑡) (1 − )
𝐾
This model is referred to as the logistic growth model. Also this model can be transformed into a
𝐾
natural growth model by the clever substitution 𝑢(𝑡) = −1 + 𝑥(𝑡). Applying the chain rule makes
2.1 INTRODUCTION 5
𝐾
𝑢̇ (𝑡) = − 2 𝑥̇ (𝑡). From our dynamic model we know what 𝑥̇ (𝑡) is in terms of 𝑥(𝑡). So we
(𝑥(𝑡))
𝐾 𝑥(𝑡)
can rewrite 𝑢̇ (𝑡) = − 2 𝑟 𝑥(𝑡) (1 − 𝐾
), which can be simplified to 𝑢̇ (𝑡) = −𝑟 (−1 +
(𝑥(𝑡))
𝐾
𝑥(𝑡)
) = −𝑟 𝑢(𝑡), with general solution 𝑢(𝑡) = 𝐴 𝑒 −𝑟𝑡 . Finally, for 𝑥(𝑡) we find
𝐾
𝑥(𝑡) =
1 + 𝐴 𝑒 −𝑟𝑡
This is the logistic function. Parameters are the carrying capacity K, the constant of integration A
and the growth rate r. The graph for positive values of the parameters looks as follows:
Classification of differential equations

Just like in the case of difference equations (see Section 1 Discrete dynamics) differential
equations can be categorized into different groups, each group having its own distinct features. For
example, the basic natural growth model is described by the differential equation
x(t )  rx(t ) for all t
st
This differential equation is called a homogeneous 1 order linear differential equation. It is called
linear, because the equation is linear in the derivatives
x, x, x,x,
of x . It is said to be of 1st order because, besides x itself, it only involves the 1st order derivative x&
of x. And it is called homogeneous because it does not contain any expressions besides multiples
of x and its derivatives. Besides, we may observe the equation to be autonomous, as x&is given as
a function of x only: x  f ( x )  r x . The time-variable t does not occur explicitly in the
differential equation, but only as an argument of the (dynamic) state variable x and its derivatives.
Examples 2.1
 The differential equation
x(t )  x(t )  2 x(t )  5

is for example a 3rd order linear differential equation. It is not homogeneous because of the
expression –5 in the equation.
 The logistic equation
 x (t ) 
x (t )  rx(t )1  
 K 
is a 1st order homogeneous equation. The equation is not linear though because it contains a
r 2
quadratic term x (t ) as you can see when you expand the right-hand side of the equation.
K
Time paths, solutions and equilibria

Like in the discrete counterpart, also in the case of differential equations we would like to find as
many solutions as we can, preferably all solutions (also called the general solution) of the
differential equation.
A solution to a differential equation is a function x(t ) for t  0 that satisfies the differential
equation at every moment t in time.
The function x(t ) for t  0 is usually called a time path because of the interpretation of the
parameter t as being time. Also the graph is often called a time path.
Example 2.2
Consider the differential equation
2 x  t x  2 x.
(We will often suppress the time parameter in our equations and write e.g. x instead of x(t ) ).
The time path x(t )  t 2  4t is a solution to this differential equation, since x (t )  2t  4 and
x(t )  2 , and indeed substitution shows that
2x  2t 2  4t   2t 2  8t
t x  2 x  t 2t  4  2  2  2t 2  8t
EXERCISE 2.1
In the following exercises show that the given time path
a) x(t )  t 2  3 is a solution to the differential equation 2 x  tx  3x .
b) x(t )  t 3  4t  5 is not a solution to the differential equation 3x  tx  x  2x .
c)  
x(t )  t  1 is a solution to the differential equation x  1x  1  t 2  2t x .
d) x(t )  1  Ae at is a solution to the equation x  ax  a for each value of A.
Also classify all the differential equations mentioned in a) to d).
2.1 INTRODUCTION 7
Now we will turn to the notion of equilibrium of a differential equation. An equilibrium is

basically a point for which, once you are there, the differential equation tells you to stay there. A
formalization of this idea is
An equilibrium of a differential equation is a point x * such that the constant time path x(t )  x *
is a solution to the differential equation.
Hence, an equilibrium is a constant solution. See also the section Discrete dynamics.
Example 2.3
We already saw in exercise 2.1c) that the time path x(t )  t  1 is a solution to the differential
 
equation x  1x  1  t 2  2t x . But this differential equation has more solutions. Take for
example the constant time path x(t )  1 . Since x (t )  0 (and all its other derivatives are equal to
zero as well by the way) it is easy to check that this is indeed a solution to the differential equation.
And more can be done with this observation. If you think about it for a moment it is clear that any
constant time path will have all its derivatives equal to zero. Which automatically implies that a
 
point x * is an equilibrium of the differential equation x  1x  1  t 2  2t x precisely when it
satisfies the equation
x * 1x * 1  0.
The reason for this is that the right-hand side of the differential equation must necessarily be equal
to zero in an equilibrium because x  0 in such a point. So, the points x*  1 and x*  1 are the
only two equilibria of this differential equation.
Of course this insight gives us a way to find (all) equilibria of other differential equations as well,
as you will see in the next exercise.
EXERCISE 2.2
Compute all equilibria of the following differential equations.
a) x 2  xx3  2 x  tx .
b) x  tx  x .
c) x 2  tx  x .
d) x 2  xx 3  2 x  t .
e) x  0 .
....
f) xx  xx  xx  5xx  x .
Finally we briefly discuss the notion of global stability of an equilibrium.

An equilibrium x * of a differential equation is globally stable if for every solution x(t ) of that
differential equation we have that
lim x(t )  x *.
t 
The intuition behind this definition is clear: no matter where you start, if you follow the movement
prescribed by the differential equation you will always move closer and closer towards the
equilibrium. In the figure below several time paths are shown of x(t )  1  Aet , solutions of the
differential equation x   x  1 (see also exercise 2.1 c). The convergence of these time paths can
clearly be observed.
Note: give yourself some time to have a look at this figure. It may clarify your understanding of
differential equations and their solutions, the corresponding time paths. For example the upper
time path starts at x(0)  2 , so this solution has A  1 and the time path is x(t )  1  et . The slope
of the graph at t  0 can immediately be read from the equation: x (0)   x(0)  1  1 .
2
x(t)
1.5
0.5
 0.5 0.5 1 1.5 2 2.5 3

 0.5 t
FIGURE 2.1 Time paths of x(t )  1  Aet for several values of A, converging to x(t )  1 .
EXERCISE 2.3
Suppose that a given differential equation turns out to have two equilibria. Explain why neither of
these equilibria is globally stable.
So you see that global stability is a very rare property of an equilibrium. A less ambitious notion,
and usually sufficient for such equilibria to be observed in real-life dynamical systems is the notion
of local stability.
Let x * be an equilibrium of a differential equation. We say that the equilibrium x * is locally

stable when for every solution x(t ) of the differential equation with the initial value x(0)
sufficiently close to x * we have that
lim x(t )  x *.
t 
2.1 INTRODUCTION 9
We will not discuss the (lack of) stability any further here in this general context, but restrict the
elaborated analyses of equilibria to the several special cases that we will present in the remaining
sections.
2.2 First order linear differential equations

In the introduction it has already been explained how the general solution to a 1st order
homogeneous linear differential equation can be determined. We will give a brief recap.
The general solution to the 1st order linear differential equation
x (t )  rx(t )
is given by the formula
x(t )  Ae rt
The specific value of A is determined by a specification of the initial value x(0)  A.
Now notice that the specific choice A  0 yields the constant time path x(t )  0 . In other words,
x*  0 is an equilibrium of this differential equation.
EXERCISE 2.4
Show that the equilibrium x*  0 is globally stable if and only if r  0 .
2.3 Second order linear differential equations

In this section we will systematically analyze the solutions to 2nd order linear differential equations
as well as their behavior, just like we did before for discrete time difference equations. We will
start with the homogeneous equation
x  ax  bx.
Now, with the solution x(t )  Aert of the 1st order equation in mind, we could try to see what
happens if we try this function as a solution for the above equation. We might get lucky and find a
solution after all. Since x (t )  Arert and x(t )  Ar 2 e rt in this case, we see that x will be a
solution to the differential equation precisely when we have that
Ar 2ert  aArert  bAert .
Dividing both sides by Aert we see that this is equivalent to the requirement that
r 2  ar  b.
This equation, completely analogous to the discrete time model terminology, is called the
characteristic equation of the differential equation. And because it is simply a quadratic equation
in r we may be able to find the solutions to this equation if we are lucky enough.
Example 2.4
Consider the 2nd order differential equation
x  x  2x.
Its characteristic equation is
r2  r  2
whose solutions are r = -1 and r = 2. Now recall what we were doing. We were simply trying to
see which functions of the form x(t )  Aert are solutions to our differential equation, and
apparently the answer is that it is a solution precisely when r = -1 or r = 2. In other words, both
x(t )  Aet and x(t )  Ae2t are solutions to the equation. But, again just like in the discrete time
situation, also in this case linear combinations of solutions will again be solutions. A little thinking
leads us to conclude that all functions of the form
x(t )  Aet  Be2t
are solutions to the differential equation, where A and B can be chosen arbitrarily. It can be shown
that these are also all solutions to the differential equation in question. Again we sometimes refer
to the solutions x(t )  et and x(t )  e2t as the basic solutions. We call the expression
x(t )  Aet  Be2t a linear combination of the basic solutions.
General solution homogeneous equation

The recipe we used in the above example to find all solutions to the differential equation is a
general principle. We will explain here how you can use the trick we just showed you to find all
solutions to the homogeneous differential equation x  ax  bx. Consider its characteristic
equation
 2  a  b  0.
As you know, as soon as the discriminant   a 2  4b is strictly smaller than zero, we cannot
solve this equation. But suppose we can. In other words, suppose that D  a2  4b  0. Then the
roots of the characteristic equation are
a  a 
1  and 2  .
2 2
2.3 SECOND ORDER LINEAR DIFFERENTIAL EQUATIONS 11
Now, like in the example, the general solution to the differential equation can be expressed in
terms of the roots 1 and 2 as follows.
Suppose that 1  2 . (In other words,   0. ) In this case the general solution to the 2nd order
linear differential equation x  ax  bx is given by
x(t )  Ae1t  Be2t .
If 1  2   (in other words   0 ), the general solution to the differential equation
x  ax  bx is given by
x(t )  Aet  Btet .
Again, like in the example, each specific choice of the coefficients A and B yields one specific
solution and by varying A and B we find all solutions to the differential equation.
EXERCISE 2.5
Give, if possible, the general solution of the following differential equations:
a) x  4 x  4 x  0 .
b) x   x .
c) x  3x  10 x  0 .
d) x   x .
e) 2 x  2 x  3x.
What happens when D < 0?

Consider the differential equation x   x from the last exercise part b). Those of you who are
familiar with classical mechanics may recognize this equation as the one that governs the
frictionless (undamped) motion of a weight on a spring. The general solution to this equation is
x(t )  A cos t  B sin t
and all these solutions are periodic.
1 1.5
x(t) 1
x(t)
0.5
0.5
2 4 6 8 10
2 4 6 8 10
 0.5 t  0.5 t
1 1
 1.5
FIGURE 2.2 Time paths of x(t )  cos t and x(t )  cos t  sin t .
EXERCISE 2.6
Check that all functions of the form x(t )  A cos t  B sin t are indeed solutions to the differential
equation x   x .
Solutions to other differential equations for which   0 will in general typically involve a
combination of periodicity and exponential growth (or decline), such as a damped periodic motion
1
x(t)
0.5
2 4 6 8 10 12 14
 0.5 t
1
FIGURE 2.3 A damped periodic time path: x(t )  et / 5 cos t  et / 5 sin t .
or an “exploding” periodic motion.
4
3
x(t)
2
1
2 4 6 8 10 12 t 14
1
2
3
FIGURE 2.4 An exploding periodic time path: x(t )  et /15 cos t  et /15 sin t .
However, in general the situation is still completely analogous to the discrete time case as you can
see in the next statement.
Every solution of a homogeneous 2nd order linear differential equation can be written as a linear
combination of two basic (independent) solutions.
Now, even in the case that   0 , we are able to formulate the general solution, if only two
independent basic solutions are given.
Remark: you do not need to be able to find the basic solutions yourself in the case that   0 !
Example 2.5
Consider the differential equation
x  2 x  5x  0
Observe that D  0 . Now we can easily check, that x1 (t )  et sin 2t and x2 (t )  et cos 2t are
solutions of the equation. As you should know, sin' t  cos t and cos' t   sin t , so
x1  et sin 2t x2  et cos 2t
x1  et sin 2t  2et cos 2t x2  et cos 2t  2et sin 2t
x1  3et sin 2t  4et cos 2t x2  3et cos 2t  4et sin 2t
It follows immediately, that both x1 and x2 satisfy the differential equation. And they are
independent, as one is not a multiple of the other.
Hence, the general solution to the differential equation is
x(t )  Aet sin 2t  Bet cos 2t
EXERCISE 2.7
Check in same way that the general solution to the equation x  3x  0 is
x(t )  Asin 3 t  B cos 3 t
Inhomogeneous equations
Let us denote a 2nd order linear inhomogeneous differential equation by
x(t )  c x (t )  d x(t )  b(t )
where b(t ) is called the free coefficient.

The following general property that we know from the discrete case holds here as well:
The general solution of an inhomogeneous differential equation can be written as the sum of the
general solution of the corresponding homogeneous equation and a solution of the inhomogeneous
equation. The latter is often called a particular solution. In short:
GIS = GHS + PS
Just like in the discrete case also in the continuous case a particular solution p(t ) can be found
by trying a function that looks like the free coefficient b(t ) .
Let us repeat the rule of thumb as mentioned in the section Discrete dynamics (slightly adapted):
General rule of thumb for finding PS:

Always try a solution that has the same form as b(t ) , so:
if b(t ) is a constant, then try a constant for p(t ) ,
if it is a linear or quadratic function of t, then try a linear or quadratic function,
if it is an exponential function of t, then try an exponential function.
In most cases this will work! But:
if it does not work, then multiply your provisional solution by t and try it again.
Example 2.6
 Let us try to find all solutions to the differential equation
x  3x  2 x  2
First we solve the corresponding homogeneous equation
x  3x  2 x  0
As you can check for yourself, its characteristic equation is  2  3  2  0 with roots 1  1
and 2  2. So, the general solution of the homogeneous equation is
x(t )  Aet  Be2t
Now we only have to find one single solution of the inhomogeneous equation and combine it
with the above solutions. In order to find a particular solution, let us try a constant, as the free
coefficient is also a constant. So, we try p(t )  k .
The aim is to find a value for k such that the above time path is a solution Substitute this into
the differential equation
x  3x  2 x  2
This gives 2k  2 , so k  1 .
Thus we find that the general solution to the differential equation x  3x  2 x  2 is
x(t )  1  Aet  Be2t

 Now consider the differential equation
x  3x  2 x  2t
The corresponding homogeneous equation is the same has before, so the general solution is
Again we have to find one single solution of the inhomogeneous equation and combine it with
the above solutions. In order to find a particular solution, let us try a linear function of t, as the
free coefficient is also a linear function of t. So, we try p(t )  k t  l . The aim is to find values
for the parameters k and l such that the above time path is a solution to the equation. Now,
since p (t )  k and p(t )  0 , we need to solve
3k  2  kt  l   2t

(2k  2)t  3k  2l  0
Since this should hold for all t, we can find solutions for k and l by equating the coefficients of
t and the constant parts to zero.
k  1
 2k  2
  0 
  3
 
 3k  2l  0 l
 2
So the general solution to the differential equation x  3x  2 x  2t is
3
x(t )  t   Aet  Be2t
2
 Next consider the differential equation
x  3x  2 x  2t 2
As before the general solution to the homogeneous equation is
In order to find a particular solution, let us try to fit a quadratic function of a general form, as
the free coefficient is a quadratic function of the time variable t. So, we try
p(t )  kt 2  lt  m
The aim is to find values for the parameters k, l and m such that the above time path is a
solution to the equation. Now, since p (t )  2kt  l and p(t )  2k , we need to solve
2k  3  (2kt  l )  2   kt 2  lt  m   2t 2

(2k  2)t  (2l  6k )t  2k  3l  2m  0
2
Since this should hold for all t, we can find solutions for k, l and m by equating the coefficients
of t 2 , t and the constant parts to zero.

 2 k  2  0 k  1
 
 2l  6k  0l  3
2k  3l  2m  0 
 m  3
1
 2
Thus we find that the general solution to the differential equation x  3x  2 x  t 2 is
1
x(t )  t 2  3t  3  Aet  Be2t
2
(where A and B are arbitrary)

Warning! It may be tempting to try p(t )  kt 2 as a format for the particular solution. But
see what happens when you do that: p (t )  2kt and p(t )  2k , so we need to solve
2k  6kt  2kt 2  2t 2
This yields the system
 2k  2
 k 1
6k  0  
 2k  0 k  0

Apparently we do not find a solution to the differential equation this way. So you see that
it is really essential to include the lower order terms lt and m as well.
 Finally consider the differential equation
x  3x  2 x  e2t
The general solution to the homogeneous equation is
In order to find a particular solution, we may try an exponential function of the form
p(t )  k e2t , but this will not work, because this function is itself a solution to the
homogeneous equation, so plugging it in into the equation will give right hand side 0 and
certainly not e 2t . According to our rule of thumb we “multiply by t and try it again” .So, we
try
p(t )  kt e2t
Now we try to find a value for the parameter k such that the above time path is a solution to the
equation. Now, since p (t )  k e2t  2kt e2t and p(t )  4k e2t  4kt e2t (product rule), we
need to solve
4k e2t  4kt e 2t  3k e 2t  6kt e 2t  2kt e 2t  e 2t


k e  e 2t
2t
So k  1 and the general solution to the differential equation x  3x  2 x  e2t is
x(t )  t e2t  Aet  Be2t
(where A and B are arbitrary)
EXERCISE 2.8
Find all solutions to the following differential equations (it is of course allowed to use your results
from exercise 2.5 whenever you can):
a) x  4 x  4 x  4t .
b) x  4 x  4 x  t  1 .
c) x  4 x  4 x  et .
d) x  x  2 .
Extra conditions.
Just as in the discrete time case, also for the continuous time case, adding extra conditions for the
solution can single out a particular solution out of all the possibilities in the general solution. In
other words, these extra conditions determine the specific values of A and B for the particular
solution that satisfies the extra conditions. The extra conditions usually take the form of what are
called “initial” conditions, or “initial values”, meaning that they specify the value of the solution x
or its derivatives on time t  0.
Of course we will need two of these initial values in the 2nd order case to single out a unique
solution, because a general solution contains two parameters.
We will give an example.
Example 2.7
Determine the solution x(t ) of the differential equation
x  3x  2 x  0
such that x(0)  5 and x (0)  7.

If you want to solve this problem you first need to determine the general solution. As we saw
above, in this case the general solution is
x(t )  Aet  Be2t .
Taking the derivative to t yields
x (t )  Ae t  2 Be 2t .
So, from the initial conditions x(0)  5 and x&(0)  7 we get that
A  B  5 A  3
 
 A  2B  7  B  2
So, we find that the (only) solution to the equation that satisfies the initial conditions is
x(t )  3et  2e2t .
EXERCISE 2.9
Determine in each case the solution to the differential equation that satisfies the initial conditions.
(It is of course allowed to use your results from exercise 2.8.)
a) x  4 x  4 x  4t such that x(0)  0 and x (0)  3 .
b) x  4 x  4 x  et such that x(0)  1 and x (0)  0 .
c) x  3x  2 x  et such that x(0)  2 and x (0)  3 .

As it turns out, a 2nd order homogeneous linear differential equation has a unique equilibrium. We
will identify the conditions under which this equilibrium is stable, and discuss how this result is
linked to the existence of a trend in the general solution for inhomogeneous 2nd order equations.
Consider the 2nd order homogeneous linear differential equation
x  ax  bx.
First observe that any equilibrium x * necessarily satisfies the equation bx*  0 , because in
equilibrium we have that x  0 and x  0 . So, obviously x*  0 is the unique equilibrium of the
homogeneous equation x  ax  bx as soon as b  0 .
EXERCISE 2.10
What are the equilibria when b  0 ? What can you say about the stability of these equilibria,
directly from the definition of stability of an equilibrium?
The question that remains is: given that b  0 , under which conditions will the equilibrium x*  0
be (globally) stable.
In order to get a feeling for the answer to this question, suppose that the characteristic equation has
two roots 1 and 2 , and that 1  2 . So, the general solution to the differential equation is
x(t )  Ae1t  Be2t .
Now, if you recall how the graph of the function t a et looks like when   0 ,
x(t)
FIGURE 2.5 The graph of t a et for   0 .

you can easily see that such a solution converges to zero precisely when both 1  0 and 2  0 .
This is a general fact, even when 1 happens to be equal to 2 .
If 1  2 and both 1  0 and 2  0 , or if 1  2    0 , then

x*  0
& ax& bx.
is the unique globally stable equilibrium of the 2nd order differential equation x&
Furthermore, if at least one of the roots roots 1 and 2 is larger or equal to zero, the equilibrium
x*  0 is not stable.
EXERCISE 2.11
Check whether or not x*  0 is a stable equilibrium of the following 2nd order homogeneous linear
differential equations.
a) x  3x  2 x  0 .
b) x  3x  4 x  0 .
c) x  5x  6 x  0 .
d) x  4 x  0 .
EXERCISE 2.12
Show that the equilibrium x*  0 of the differential equation x  x  0 is not globally stable.
(Hint: see exercise 2.5.)
2.4 Nonlinear differential equations.

Again in analogy with the discrete situation, nonlinear equations are usually very difficult, if not
impossible, to solve. Sometimes you can get lucky though and do something.
Simple differential equations

In this section we will discuss a fairly interesting class of differential equations, namely equations
of the form
x  f (x).
In this reader such equations are dubbed simple differential equations by us. Simple differential
equations feature, among other properties, autonomy (i.e., the time variable t is not an explicit part
of the equation). They are also non-implicit (simply meaning that x&is a function of x) and of the
1st order. All these properties facilitate the analysis of such differential equations considerably.
Equilibria
For example, the search for equilibria now becomes very straightforward. Since we know that in
an equilibrium it holds that x  0 , we immediately get the following fact.
A point x * is an equilibrium of the simple differential equation x  f (x ) if and only if it holds

that
f ( x*)  0.
EXERCISE 2.13
Compute all equilibria of the following simple differential equations.
a) x  2 x 2  3x  2 .
b) x  (2 x  3)3x  6x  56 x  1( x  100) .
c) x  e5 x  2 .
d) x  2 x 2  1 .
x  x  1 x  2 .
2
e)
Phase diagrams and stability

However, the main advantage of simplicity of a differential equation is the direct connection
between phase diagrams and (lack of) stability of the equilibria of the equation. We will explain
this in the following example.
Example 2.8
Consider the simple differential equation
x  x  1x  3.
Its equilibria are obviously x*  1 and x*  3 . This can also easily be seen when we draw the
graph of the function f ( x)   x  1 x  3 .
21
2.4 NONLINEAR DIFFERENTIAL equations.
1 2 3 4
x
-1
FIGURE 2.6 The graph of f ( x)   x  1 x  3 .
The equilibria of the differential equation are simply the intersection points of the graph of f with
the horizontal axis.
However, the graph of f also tells us something about the (lack of) stability of the equilibria x*  1
and x*  3 . In order to see what we are talking about, notice that we can interpret the variable on
the vertical axis as the derivative x of x . In other words, the value of the function f in a point x
tells us something about the velocity of change in x. In particular, if f ( x)  0 , the derivative of x is
positive and x will be increasing, and conversely if f ( x)  0 , the derivative of x is negative and x
will be decreasing.
4
x
3
1 2 3 4
x
-1
FIGURE 2.7 Direction of movement of x(t ) .
In other words, the graph of f plays a double role in this story because it also enables us to
determine the phase diagram of the associated differential equation.
Actually the phase diagram consists only of the x-axis together with the arrows indicating in which
direction a solution moves when it arrives at the point in question, the so-called arrows of
movement.
FIGURE 2.8 The phase diagram of x&  x  1 x  3 .

Now it is clear that the equilibrium x*  3 cannot be locally stable: if we move a little to the left
or to the right when starting in x*  3 we will immediately move away from the equilibrium. So,
x*  3 is a repellent equilibrium. The equilibrium x*  1 on the other hand is locally stable,
although not globally. (Why not?)
Hence, notice that, as we just observed, local stability of an equilibrium x * of the simple
differential equation x  f (x ) can be checked by looking at the behavior of f in the vicinity of
x*.
The equilibrium x * of the simple differential equation x  f (x ) is locally stable whenever

f ( x)  0 for values of x  x * close to x * and f ( x)  0 for values of x  x * close to x * .
When f ( x)  0 for values of x  x * close to x * and f ( x)  0 for values of x  x * close to x *
the equilibrium is repellent.
So, this is how the phase diagram should look like locally:
FIGURE 2.9 A locally stable and a repellent equilibrium.
EXERCISE 2.14
Check for the differential equations from exercise 2.13 which of the equilibria you found are
locally stable, and which ones are repellent.
Application 2.1 In-population dynamics

In game theory differential equations are used to model the change over time of a population of
individuals (e.g. animals in biology or traders in a market in economic applications). Consider for
example a population of birds that are competing for territory (notice the economics-flavored
terminology here, we might as well tell you a story about firms competing for customers in a
market). Each bird within the population is either aggressive (a Hawk) or acquiescent (a Dove).
This choice is made once and for all (you might think of each specific individual being born either
as a Hawk-type or a Dove-type bird without the option to change its own type). The table below
shows how well each type of bird performs when it encounters another bird. The rows represent
the active type and the columns the type that will be encountered.
H D
H 0 3 
 2 
D  
As you can see, a Hawk performs very well against a Dove (payoff = 3), while a Dove only gets 1
when meeting a Hawk. But Dove outperforms Hawk in encounters with its own type: payoff 2
versus payoff 0. In evolutionary biology these numbers are called the fitness of a type in an
encounter, and usually represent the amount of offspring a type expects to get after an encounter
with another bird. For example the zero for a Hawk-Hawk encounter shows that two Hawks don’t
expect any offspring anymore after a meeting, because they will typically kill one another. (You
could compare this to two firms engaged in a price war!)
23
Now suppose that a fraction p of the population is of type H and a fraction 1-p of type D. In this
case the expected fitness for a bird of type H equals
EF(H)  p  0  (1  p)  3  3(1  p).
QUESTION.
What is the expected fitness EF(D) for a bird of type D?
Now the average fitness AF within the population when a fraction p is of type H is given by the
formula
AF  p  EF(H)  (1  p)  EF(D).
According to evolutionary biologists the average fitness governs the change of the fraction of a
type of bird within the population: they argue that for example the fraction of Hawks will increase
over time as long as the expected fitness EF(H) of Hawks is above the average fitness AF (which
does indeed sound like a reasonable argument).
The classical way to put this into a more formal model (due to Maynard Smith in The theory of
games and the evolution of animal conflicts) is to assume that
p  p( EF(H)  AF).
This specific equation is called the replicator dynamics of the population. As you can see, the
fraction of Hawks within the population does indeed increase as long as EF(H)  AF and grows
proportionally to the current size of the population because of the factor p (if there are relatively
many Hawks, they will produce more offspring).
Now notice that the replicator dynamics is a simple differential equation. So, the system is in
equilibrium for a certain fraction p of Hawks if for this specific value of p we have that
p(EF(H)  AF)  0.
In that case after all we have that according to the replicator dynamics the change in the fraction p
of Hawks equals zero, i.e. it stays constant over time.
EXERCISE 2.15
Compute the replicator dynamics of the Hawk-Dove model and determine its equilibria. Explain
why the phase diagram of the replicator dynamics looks as follows:
p
0.1
0.05
-0.2 0.2 0.4 p* 0.6 0.8 1

-0.05 p
-0.1
FIGURE 2.10 Phase diagram of replicator dynamics.
As you can see, if the value of p is below p * , the derivative of p is positive, which means that the
value of p increases over time. Conversely, if the value of p is above p * , the derivative of p is
negative, which means that the value of p decreases over time. Thus, p * is a locally stable
equilibrium (well, even almost globally, as p will only attain values between 0 and 1).
EXERCISE 2.16
Compute the replicator dynamics, find the equilibria, draw the phase diagram and determine the
locally stable equilibrium of the following fitness matrix:
H D
H 0 4 
  3
D  
Example 2.9 Linear simple differential equations

Already familiar types of simple differential equations are the 1st order linear differential
equations. And from exercise 2.4 (directly using the definition of global stability) you already
know that the equilibrium x*  0 of the simple differential equation x  rx is globally stable if
and only if r  0 . In the next exercise you are asked to do the same analysis again, only using
phase diagrams.
EXERCISE 2.17
Draw the phase diagram of the simple differential equation x  rx for r  0 . Use the diagram to
locate the equilibrium and decide whether it is stable (globally or locally), repellent, or not one of
these. (Hint: treat the cases r  0 and r  0 separately.). What happens when r  0 ?
So here you see the big advantage of the use of phase diagrams. You can qualitatively analyze the
behavior of a dynamical system and its equilibria without computing any of its solutions.
Application 2.2 The Solow model

In block 1.3 last year, you have met the Solow growth model. At its heart is the production
function F, which relates real output Y to the production factors capital and labour, K and N, and an
index of labour-augmenting technological progress A. We typically assume that this production
function is Cobb-Douglas:
25
Yt  F ( Kt , At Nt )  Kt ( At Nt )1 0   1
It turns out to be convenient to analyze the model in terms of output and capital per effective
worker, say yt  Yt / At Nt and kt  Kt / At Nt . Dividing both sides of the Cobb-Douglas equation by
At Nt , you can easily derive the so called intensive production function f:
yt  f (kt )  kt 0   1
This equation implies that output per effective worker depends on the amount of capital per
effective worker, which may be intuitive. The Solow model now assumes that labour N grows
exponentially at a constant rate gN, while technology A progresses at rate gA. This makes capital K
the only endogenous input. It develops according to the following first-order difference equation:
Kt 1  (1   ) Kt  It
In words: next year’s capital stock is equal to this year’s stock, plus gross investment I, minus
depreciation, which is assumed to be a constant fraction δ of this year’s capital stock. Finally, we
assume that a constant fraction s of GDP is saved, and thus invested:
I t  sYt
After some tedious but straightforward manipulations, we can combine the equations and the
exponential growth of A and N to get the following, approximate, key dynamic equation:
kt 1  kt  sf (kt )  (  g A  g N )kt
So far, following Blanchard (2003), we have developed the model in discrete time. This was done
for purposes of instruction only. In practice, the model is typically analyzed in continuous time.
The analogue of the 1st order difference equation above is the following 1st order differential
equation:
k  sf (k )  (  g A  g N )k
Our job is to investigate the dynamic behaviour of k as determined by this differential equation.
The intensive production function f is clearly differentiable, increasing and concave, and f (0)  0 .
This leads to the figure below.
f(k)
FIGURE 2.11 The graph of f.
Additionally, you can easily check that limk 0 f '(k )   and limk  f '(k )  0 . This implies that,
apart from k  0 , the graph of s  f (k ) has precisely one positive point of intersection with the
line through the origin whose slope equals   g A  g N . See the figure below.
l(k)
s.f(k)
FIGURE 2.12 Point of intersection of s  f (k ) with l (k )  (  g A  g N )  k .
EXERCISE 2.18
a) Draw the phase diagram of the Solow equation, determine the equilibrium k * , and check
whether k * is locally stable or not.
b) Which solutions to the Solow equation do not converge to k * ?
The equilibrium k * satisfies s  f (k*)    g A  g N   k * . For this reason the expression
  g A  g N   k is called the break-even investment. It is the quantity one needs to invest
effectively to maintain the current level of capital stock per unit of effective labor.
c) Taking yt  f (kt )  kt , find an explicit expression for the equilibrium k * as a function of
the parameters s, gA, gN, δ and α of the model, where 0    1 .
27
Application 2.3 Logistic growth

Another familiar example of a simple differential equation is the logistic growth equation
 x
x  rx1  
 K
(see the introduction section 2.1).
EXERCISE 2.19
a) Draw the phase diagram of the logistic growth equation. Determine the equilibria of the
differential equation, and check whether they are repellent or stable.
b) Show that in the long run all solutions found in the introduction section 2.1 do indeed
converge to the (locally) stable equilibrium you found in a).
2.5 Systems of differential equations

Also in case there are more variables involved in the process differential equations can sometimes
be solved. We will briefly discuss systems of differential equations of two variables of the form
 x  f ( x, y )

 y  g ( x, y ),
a special type of a system of autonomous 1st order differential equations. We will refer to a system
of this format as a simple system of differential equations.
Example 2.10
In the simple system
 x  x2 y  2 x

 y  x 1
we have f ( x, y)  x2 y  2 x and g ( x, y)  x  1 .
Solving systems of two variables involves finding time paths of the form  x(t ), y(t )  for all t  0 .
Such a time path specifies for each moment t  0 in time the precise location  x(t ), y(t )  of a
solution as it moves through the plane.
 x  f ( x, y )
A time path  x(t ), y(t )  for t  0 is a solution of the simple system 
 y  g ( x, y )
 x (t )  f ( x(t ), y (t ))
if for all t  0 it holds that 
 y (t )  g ( x(t ), y (t )).
In other words, whenever  x(t ), y(t )  satisfies both equations of the system for all t  0 .
EXERCISE 2.20
Consider the simple system
 x  y

 y  x.
Show that the time path  x(t ), y(t )    cos t ,sin t  is a solution to this system. Find at least two
other solutions by yourself.
Obviously, the wilder a system of differential equations is, the harder it is to solve. It is for
example not clear at all how you could find all solutions to the system
 xy  xx  25  x2 y  t 2

 xyy  x 3  1.
However, it is possible to at least partially analyze simple systems of differential equations. We
will discuss two tools you have already seen before that you can use in this context, namely the
notion of an equilibrium and phase diagrams.
Equilibria
Just like we saw for one-dimensional simple differential equations, also for a simple system of two
variables it is relatively straightforward to find its equilibria.
A point  x*, y * is an equilibrium of the simple system

 x  f ( x, y )

 y  g ( x, y ).
of differential equations when the constant time path  x(t ), y(t )    x*, y * for t  0 is a solution
of the simple system.
And just like in the one-dimensional case, also in the two dimensional case we have that on a
constant time path  x(t ), y(t )    x*, y * for t  0 the derivatives are zero. In other words,
x (t )  0 and y (t )  0 for all t  0 . So, when such a time path solves the simple system
 x  f ( x, y )

 y  g ( x, y )
we automatically get that f  x*, y *  0 and g  x*, y *  0 . And also here the converse statement
is also true.
2.5 SYSTEMS OF DIFFERENTIAL EQUATIONS 29
 x  f ( x, y )
A point  x*, y * is an equilibrium of the simple system 
 y  g ( x, y )
 f ( x*, y*)  0
if and only if 
 g ( x*, y*)  0.
So, this way we can find all equilibria of a simple system of differential equations. Simply solve
the system of equations you obtain when you put the derivatives x&and y& to zero. Each solution to
this system is an equilibrium of the system of differential equations and there are no other
equilibria.
EXERCISE 2.21
a) Determine all equilibria of the simple system
 x  xy  2

 y  x  1.
b) Determine all equilibria of the simple system

 x  yx 2  y 3

 y  xy  x.
c) Determine all equilibria of the simple system

 x  y

 y  x.
We will briefly discuss the notion of stability of an equilibrium for the two-dimensional case.
An equilibrium ( x*, y*) of a system of differential equations is globally stable if for every solution
( x(t ), y(t )) for t  0 of that differential equation we have that
lim( x(t ), y(t ))  ( x*, y*).
t 
And again, global stability is a very rare feature for a system of differential equations. More
common is the less ambitious notion of local stability.
An equilibrium ( x*, y*) of a system of differential equations is locally stable if for every solution
( x(t ), y(t )) for t  0 of that differential equation whose starting point  x(0), y(0)  is sufficiently
close to the equilibrium ( x*, y*) we have that lim( x(t ), y(t ))  ( x*, y*).
t 
Phase diagrams
Also local stability, even though more common than global stability, is difficult to verify. The
reason for this is simply that in general it is not possible to find explicit expressions for all
solutions to the system of equations, and therefore it is impossible to check the stability conditions.
There are several ways to get around this problem, for example Lyapunov functions, but these
techniques are beyond the tools we discuss in this reader. Still, it is possible to get a fairly good
insight in the behavior of a system of differential equations (and the –possible lack of– stability of
its equilibria) from studying its phase diagram.
As we have seen in the case of differential equations of one variable, also for a system of
differential equations of two variables does a phase diagram contain a lot of information about
directions of movement of solutions to the differential equations and, related to that, about the
location of equilibria and their stability. Only in the case of two variables these phase diagrams
will now be two-dimensional. Consider the simple system
 x  xy  2

 y  x  1.
The phase diagram for this system is constructed as follows. In each point in the  x, y  -plane we
plot the vector x, y   xy  2, x  1 , which is an arrow of movement. The result looks as
follows.
3
-1 -0.5 0.5 1 1.5 2
-1
FIGURE 2.13 The directional field of x, y   xy  2, x  1 .
This diagram is sometimes also called the directional field. Using graphical packages these
graphics are fairly easy to produce. If you have to do this by hand though it is not an easy task as
you can easily imagine.
You can also get a bit more feeling for how a solution should behave though when you look at the
behavior of x and y separately. First consider the equation x  xy  2 . From this equation it is
clear that for any solution the movement into the x-direction should be as follows:
2.5 SYSTEMS OF DIFFERENTIAL EQUATIONS 31
4
y
3
2
x = 0
1
-3 -2 -1 1 2 3 4
-1 x
x = 0
-2
-3
FIGURE 2.14 Direction of movement prescribed by x  xy  2 .
The curves in the figure correspond to the equation xy  2  0 , which comes from x  0 . So, on
these curves there is no movement in the x-direction. It is clear that above the right curve and
below the left curve x  xy  2  0 , so the movement will be to the right. In the same way you can
see, that the movement between the curves will be to the left.
Also for the second equation y  x  1 we can draw this graphical representation of the
movements in the plane it prescribes, but now into the y-direction.
5
y y = 0
4
3
2
1
-3 -2 -1 1 2 3 4
-1 x
-2
-3
FIGURE 2.15 Direction of movement prescribed by y  x  1 .
It will be clear, that right from y  x  1  0 we have y  x  1  0 , so the movement will be

upward. Left from the line it will be downward.
Combined these graphics constitute the following representation of the dynamical system. This
diagram is what we will from now on refer to as the phase diagram of the system of differential
equations.
5
y = 0
4
y
3
2
x = 0
1
-3 -2 -1 1 2 3 4
-1 x
x = 0
-2
-3
FIGURE 2.16 Phase diagram of x, y   xy  2, x  1 .
EXERCISE 2.22
Use the above phase diagram to explain why the equilibrium  x*, y *  1, 2  cannot be locally (so
certainly not globally) stable.
Usually, like we did just now, the phase diagram helps you to establish that an equilibrium is
definitely not locally stable. In general though it does not guarantee stability (although in some
special cases it does as we shall see momentarily in the case of linear systems).
EXERCISE 2.23
Use phase diagrams to discuss the (lack of) stability of the equilibria you found for the other
systems of exercise 2.21.
2.6 Linear systems

When a simple system of differential equations is linear, the analysis can even be carried on a little
further. Suppose we have a system of the form
 x  ax  by

 y  cx  dy
where a, b, c and d are real numbers.
EXERCISE 2.24
a) Show that  x*, y *   0,0 is the unique equilibrium of this system if and only if
a b 
ad  bc  0 . (In other words, whenever det    0 .)
c d 
b) What are the equilibria when ad  bc  0 ?
2.6 LINEAR SYSTEMS 33
We will only consider the case where ad  bc  0 and discuss the (lack of) stability of the
unique equilibrium  x*, y *   0,0  in a few examples. We will also analyze the phase diagram
for such linear systems.
Example 2.11
Consider the linear system
x  ax
y  dy.
So, we have set both b and c to zero (and of course assume that a and d are both not equal to zero).
This is a very trivial case, because there is no interdependence between the variables x and y, a so-
called uncoupled system of differential equations. Consequently it is very easy to deduce the
general solution of this system, based on what you know from linear differential equations of one
variable. It is given by
 x(t ), y(t )    Aeat , Bedt  for t  0
where A  x(0) and B  y(0) .
EXERCISE 2.25
a) Determine under which conditions on a and d the equilibrium  x*, y *   0,0  is globally
stable.
b) What is the general solution if you do take a  d  0 . Why doesn’t this surprise you?
Phase diagrams revisited

Switching back to the general form
 x  ax  by

 y  cx  dy
we want to check the (non)-stability of the equilibrium  x*, y *   0,0  . So, let us first see how
phase diagrams look like in this context. Again we do not aspire to produce a veritable phase
diagram in which every direction is exactly determined, but we aim for a more humble goal,
namely to identify those regions in the plane where for example x and y are both increasing, or the
region where x is decreasing and y increasing.
Let us first check where x is increasing/decreasing. In other words, we want to find the region
where the sign of x is positive (so x is increasing) or negative (x is decreasing). And since
x  ax  by
at least we know that x& 0 precisely on the line given by the equation ax  by  0 . The only
question is on which side of the line we find the area where x increases, and on which side we have
a decrease of x. This though is easy to establish and can be done in two different ways:
 When a  0 , analysis of the level curves of the function l ( x, y )  ax  by shows that we have
a movement of x towards the line ax  by  0 , and when a  0 , we have a movement of x

away from the line ax  by  0 . (We will not consider the case in which a  0 .)
 Simply take a point at one side of the curve (line) and observe the sign of x& at that point.
When a  0 , then e.g. at the simple point (1,0) x  a  0 , which means, that x is moving to
the left (the negative x-direction), whereas for a  0 the movement at (1,0) is in the opposite
direction. As the sign only can change when passing the line, we see immediately where x is
moving to the right and where it is moving to the left.
Of course both ways lead to the same conclusion. See also the pictures below.
y y
a = -1 4 a=1 4
b=2 x = 0 b = -2 x = 0
2 2
-4 -2 2 4 x -4 -2 2 4 x
-2 -2
-4 -4
FIGURE 2.17 Directions of movement of x(t ) when a  0 and when a  0 .
In the same way we find that when d  0 , we have a movement of y towards the line cx  dy  0 ,
and when d  0 , we have a movement of y away from the line cx  dy  0 .
Or, y is moving upward at e.g. (0,1), if d  0 and downward if d  0 . See the picture below.
y .
y .
c 2 4 y 0 c 2 4 y 0
d 1 d 1
2 2
4 2 2 4 x 4 2 2 4 x
2 2
4 4
FIGURE 2.18 Directions of movement of y (t ) when d  0 and when d  0 .
Convergence and stability

Now consider the situation in which we have both a  0 and d  0 , and where the lines cross each
other as follows. Actually we took a  1 , b  2 , c  1 and d  1 .
y
4
.
x=0
2
-4 -2 2 4
x
-2
.
y=0
-4
FIGURE 2.19 Phase diagram of a linear system. The case a  -1, b  2, c  -1 and d  -1 .
What will happen in the region where x increases and y decreases? Well, we move towards the line
ax  by  0 and will eventually end up somewhere on this line, in a point whose y-coordinate is
less than the y-coordinate of the point we started in!
4
.
x=0
2
-4 -2 2 4
-2
.
y=0
-4
FIGURE 2.20 Tracking a solution of the system of differential equations.
Moreover, once we are on the line ax  by  0 , the increase in x has dropped to zero. In other
words, the movement on this line is vertical, downwards in this case (upwards is obviously the
only other possibility).
Iteration of this argument shows that we will slowly spiral inwards towards the equilibrium.
4
.
x=0
2
-4 -2 2 4
-2
.
y=0
-4
FIGURE 2.21 Two steps in the tracking process.

Thus we see that the equilibrium  x*, y *   0,0  will be globally stable. (Compare this with
your results from exercise 2.25)
y
4
.
x=0
2
-4 -2 2 4 x
-2
.
y=0
-4
FIGURE 2.22 Convergence of a solution to the equilibrium  x*, y *   0,0  .
QUESTION.
Are you really convinced by the pictures in figures 2.19 – 2.22? Mind: a critical note could be
made! If you look carefully at these pictures then, using these rather rough phase diagrams where
only regions are given with up-down and left-right movement, it might occur that solutions move
away from the equilibrium point. Check this for yourself!
A slightly different case, when taking a  2 , b  1 , c  1 and d  1 , gives clear, convincing
convergence. Sketch the phase diagram for this problem and show that solutions must converge.
Finally, to give you some confidence that the above procedure can be really effective, below you
can see a diagram of a simulation of the system with a  1 , b  2 , c  1 and d  1 by
Mathematica, a computer algebra package. Plotted are the directional field and six solutions of the
system.
-6 -4 -2 2 4 6
-2
-4
FIGURE 2.23 Directional field and solutions according to Mathematica.

QUESTION.
Try to guess what are the initial points that are used to generate the Mathematica solutions in the
phase diagram in Figure 2.23.
Conversely, when we had exactly the opposite values for a, b, c, and d ( a  1 , b  2 , c  1 and
d  1 ), then we would have got an almost identical picture, with the only difference that this time
we will spiral outwards, away from the equilibrium. In this case the equilibrium  x*, y *   0,0 
is repellent.
EXERCISE 2.26
Draw the phase diagrams and discuss the (lack of) stability of the equilibrium  x*, y *   0,0  for
the following linear systems.
 x  2x  y
a)  .
 y   3x  y
 x   2x  y
b)  .
 y  3x  y
 x   2 x  y
c)  .
 y  x  2y
The associated 2nd order equation in one variable.

It is not always clear from the phase diagram whether an equilibrium point is an attractor or a
repellor, so in some cases it can be useful to be able to solve a system. Although we will not
present a general method for solving systems of differential equations in this course, there is a trick
that sometimes enables us to find solutions for this case and to decide whether the equilibrium is
stable or not. We will show in an example how to do this for a homogeneous system of two linear
equations. The principle is universal, it will work no matter what a, b, c and d are (except in
degenerate cases like a  b  c  d  0 of course).
Example 2.12
 1
 x   x  y
 2

 y  6 x  y.
The trick is to derive a 2nd order differential equation in one variable (usually x, but there is no law
against eliminating x and keeping y instead) and to solve that equation first. In order to derive this
equation, we are going to eliminate the y-variable from the second equation. We do that as follows.
Notice that the first equation states that y  2 x  2 x . By taking the derivative of this equation we
get that
y  2 x  2 x
y  2 x  2 x.
Plugging these expressions for y and y into the second equation yields
2 x  2 x  6 x  2 x  2 x

2 x  8 x.
EXERCISE 2.27
a) Solve the differential equation 2 x  8 x .
b) Derive a formula for the general solution of the simple system.
c) Draw a few of these solutions in the plane. (You are free to use whatever electronic device
you feel comfortable with, or to simply figure it out by hand.)
d) What can you say about the stability of the equilibium  x*, y *   0,0  ?
The phase diagram for the system in exercise 2.27, including the directional field and some
solutions, is given in the picture below. The equlibrium point (0,0) is not stable, but its instability
is of a special nature: we call this kind of equilibrium points, with these "hyperbolic shaped"
solution paths saddlepoints.
10
7.5
2.5
-8 -6 -4 -2 2 4 6 8
-2.5
-5
-7.5
-10
FIGURE 2.24 The characteristic pattern of a saddlepoint.
EXERCISE 2.28
x  x  y
1 1
y   x  y.
3 6
a) Derive the associated 2nd order differential equation in x and solve it.
b) Derive a formula for the general solution of the simple system, so also give the general
solution for y.
c) What can you say about the stability of the equilibium  x*, y *   0,0  ?
Application 2.4 The tâtonnement process

Consider a model with two agents, i and j, that can trade in two goods. Initially agent i owns an
amount 1 of good 1 and 2 of good 2. In other words, his initial endowment is  x, y   1 , 2  .
In this example we will assume that agent j initially owns the same amounts x and y of each good
as agent i does. So, agent j’s initial endowment is also given by  x, y   1 ,2  . Both agents
derive utility from the ownership, or consumption, of certain amounts of the two goods. We
assume that the utility for consumption of  x, y  for agent i is given by the Cobb-Douglas utility
function
1 1
ui ( x, y )  x 2 y 2
while the utility for agent j is given by the Cobb-Douglas utility function
1 3
u j ( x, y )  x 4 y 4 .
Now suppose that initially prices are given for both goods. Assume that the initial price of good 1
equals p1* and that p2* is the initial price of good 2. We will assume for simplicity that p1*  p2*  1
. Given these prices both agents have a budget equal to
B  p1*1  p2*2 .
When the prices change to p1 and p2 the agents have the opportunity to use their budget B to
acquire different amounts of goods 1 and 2. From consumer theory you know, given the budget B
and prices p1 and p2 , how to compute the most preferred endowment for the agents. In other
words, you can compute their demands from these data.
EXERCISE 2.29
Given the budget B and prices p1 and p2 , compute the demand  xi  p1 , p2  , yi  p1 , p2   of agent i
and the demand  x j  p1 , p2  , y j  p1 , p2   of agent j as functions of B, p1 and p2 .

A price vector  p1 , p2  is a Walrasian equilibrium if the total demand of the agents equals the total
supply. In this case (where the initial endowments are equal for both agents)
xi  p1 , p2   x j  p1 , p2   1  1  21
yi  p1 , p2   y j  p1 , p2   2  2  22 .
EXERCISE 2.30
Show that in any Walrasian equilibrium  p1 , p2  in our example it holds that
5 p11  3 p22 .
Interpret this result. E.g., what would happen when we would double the amount of good 2 that is
initially available?
Now we will construct a procedure that, given the initial price vector  p , p  , generates a time
*
1
*
2
path  p (t ), p (t )  for t  0 of prices that starts with the initial prices --so  p (0), p (0)    p p  -
1 2 1 2
*
1
*
2
- and that converges to a Walrasian equilibrium. The price adjustment process is governed by the
system of differential equations
p 1  p1 xi  p1 , p2   x j  p1 , p2   21 
p 2  p2  yi  p1 , p2   y j  p1 , p2   22 
under the initial condition that  p1 (0), p2 (0)    p1* , p2*  . This adjustment process is known as the
tâtonnement process.
Let us start by leaning back a bit and see what we can say about this system without any
computations. First notice that it is a simple system of differential equations, even though it will in
general not be a linear system. Furthermore, as you can see in the first equation, the price of good
1 will increase as soon as the total demand xi  p1 , p2   x j  p1 , p2  for good 1 is larger than the
total available amount 1  1  21 of good 1, and it will decrease otherwise. Of course the
second equation states something similar for the second good.
EXERCISE 2.31
Use exercise 2.29 to show that in our example the system of differential equations can be written
as
5 3
p1   p11  p22
4 4
5 3
p 2  p11  p22 .
4 4
Determine the equilibria of this system. Draw the phase diagram of this differential equation for
the special case 1  2  4 .
Now we could try to see if solving the associated 2nd order differential equation in one variable
could be of any use to us.
EXERCISE 2.32
Use this strategy to analyze the system for 1  2  4 . So,
a) derive the associated 2nd order differential equation for p1
b) find the general solution of the associated 2nd order differential equation
c) find the general solution of the original simple system
d) analyze the long run behavior of each solution.
For arbitrary 1 and 2 this trick is not so easy to perform. Luckily there is also another trick in
this case that makes life easier. This trick basically relies on the fact that only relative prices are
important for changes in demand. We will guide you through the computations along the lines of a
few exercises.
EXERCISE 2.33
Use the system you found in exercise 2.31 to show that p1 (t )  p2 (t )  1 , the sum of the initial
prices. (Hint: take the derivative of the function t a p1 (t )  p2 (t ) with respect to t and use the
equations from the system. Next use the assumption that p1*  p2*  1 .) Thus we see that the sum of
the prices is constant over time. You may draw this assumption in the phase diagram in exercise
2.31.
So now we know that the (unique) solution  p1 (t ), p2 (t )  to the differential equation that satisfies
the initial conditions p1 (0)  p1* and p2 (0)  p2* will satisfy the equation p1 (t )  p2 (t )  1 . Thus we
can substitute p2  1  p1 into the first equation of the system of differential equations, and we
obtain that the solution we are looking for satisfies the equation
3 5 3 
p 1  2   1  2  p1 .
4 4 4 
We have found a 1st order inhomogeneous linear differential equation for the time path p1 (t ) of
the price of good 1! Notice that this trick is indeed easier than going through the process of
elimination of both p2 and p 2 from the 2nd equation.
EXERCISE 2.34
Find the solution p1 (t ) for t  0 to the differential equation
3 5 3 
p 1  2   1  2  p1
4 4 4 
that satisfies the initial condition p1 (0)  p1* . Show that the time path  p1 (t ), p2 (t )  of the price
vector converges to
 32 51 
p
, p2    , 
 51  32 51  32 
1
as t goes to infinity. Show that  p1 , p2  is indeed a Walrasian equilibrium.
Finally notice that in this example we have that
p1 32

p2 51
(compare with exercise 2.30). So, when there is a relatively large amount of good 2, the price of
good 1 will be relatively high compared with the price of good 2, a sound economic principle. The
3
factor comes from the fact that the utility functions of the two agents are not identical.
5
Application 2.5 : an augmented Solow model (application 2.2 continued)

(EXAMPLE OF A NONLINEAR SYSTEM)
In block 1.3 last year you have already seen that, apart from physical capital (say machines),
human capital (say education) is probably a crucial production factor in modern Western society.
This suggests that we generalize our production function F to explicitly include human capital,
denoted H, along with the original production factors:
Yt  F ( Kt , Ht , At Nt )  Kt Ht ( At Nt )1   0     1
Make sure you get the picture here: it may be helpful to think of N as “raw labour” or “muscle”,
and of H as “skill” or “brains”. Again, it is convenient to analyze the model in terms of output,
physical and human capital per effective worker, say yt  Yt / At Nt , kt  Kt / At Nt and
ht  Ht / At Nt . Dividing both sides of the Cobb-Douglas equation above by At Nt , you can derive
the generalized version of our intensive production function f:
yt  f (kt , ht )  kt ht 0     1
Not surprisingly, the amount of output per effective worker now depends on both the amounts of
physical and human capital per effective worker. We still assume that A and N grow exponentially
at constant rates gA and gN. Additionally, we assume that human capital is accumulated in much the
same way as physical capital, i.e. through a process of investment and depreciation. So we now
have two endogenous inputs, K and H, obeying two very similar first-order difference equations:
Kt 1  (1   ) Kt  ItK
Ht 1  (1   ) Ht  ItH
For simplicity, we assume that the depreciation rates of physical and human capital are the same.
Concerning investment we assume that, while a constant fraction sK of GDP is again invested in
physical capital, another constant fraction sH is invested in human capital (this would e.g. include
government’s spending on education):
I tK  sK Yt ItH  sH Yt
Reasoning by analogy, it will not surprise you that the model now leads to the following two key
dynamic equations:
kt 1  kt  sK f (kt , ht )  (  g A  g N )kt
ht 1  ht  sH f (kt , ht )  (  g A  g N )ht
Or, in continuous rather than discrete time:
k  sK f (k , h)  (  g A  g N )k
h  sH f (k , h)  (  g A  g N )h
It will be clear that these two equations constitute a simultaneous dynamic system in terms of k and
h. Let’s start with the dynamic behaviour of k. Plugging the intensive production function f into the
first of these equations, we get:
k  sK k  h   (  g A  g N )k
An equilibrium is obtained for k when k& 0 , or sK k  h  (  g A  g N )k , which solves for
1/(1 )
 sK 
k   h  /(1 ) (or k  0)
   gA  gN 
Now note that     1 implies that  /(1   )  1 . Consequently, with h along the horizontal
axis, this last equation implies a concave curve which obviously passes through the origin. See the
figure below.
k
.
k0 .
k0
.
k0
FIGURE 2.25 The dynamics of k.
EXERCISE 2.35
a) Show that the arrows of movement in Figure 2.25 point as they do.
b) Sketch a similar figure for the dynamics of h.
c) Combine both figures and argue the stability of the equilibrium point.
h * sH
d) Show that at the equilibrium point (h*, k*) we have  and give an economic
k * sK
interpretation.

Quantitative Methods 3: Dynamic Models

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Quantitative Methods 3: Dynamic Models

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Year 2, Course Period 1

Academic year 2017-2018

Economics (code EBC2011)

School of Business and Economics

© March 2017, Hans de Graaff, Dries Vermeulen

For background reading we refer to the books below:

Hans de Graaff, Dries Vermeulen

1.1 Classification of difference equations

1.2 First order linear difference equations

Example 1.1 The growth of a capital

This growth process can easily be summarized in a single equation:

Kt  1.05Kt 1 with t  1,2,3,...

FIGURE 1.1 The growth of capital Kt with K0 = €10.000,-.

Example 1.2 The growth of a capital with periodic deposits

FIGURE 1.2 The growth of capital Kt with periodic deposits.

Definition 1st order linear difference equation

Solution of homogeneous equations

The solution of the 1st order linear difference equation xt  axt 1 is

FIGURE 1.3 Solutions of xt  a xt 1 , with x0 = 15.

Solution of inhomogeneous equations

Don't misunderstand: a particular solution is just a solution of the inhomogeneous equation, in

Theoretical background. Why GIS = GHS + PS.

Let us first motivate the first statement:

General rule of thumb for finding PS:

a  1.05 a  1.05b  100

3t we get k  2  k  31  3 , so k  9 . Hence the complete general solution is

Consider the equation xt  xt 1 +10 . The corresponding homogeneous equation xt  xt 1

c) xt  xt 1  t  1 and x0  1 f) Kt  1.05Kt 1  21(1.05)t

Equilibrium and stability

We call x* an equilibrium point or fixed point of the system xt  f ( xt 1 ) , if the constant

FIGURE 1.5 Time path of xt  0.5xt 1  3 with x0 = 4.

FIGURE 1.7 Time path of xt   xt 1  4 with x0 = 3.

Economic application 1.1 Supply-demand model with price-adjustment

where D is demand, S is supply and P is the price. a is a parameter. It seems reasonable to

1.3 Second order linear difference equations

Definition 2nd order linear difference equation

where the coefficients c and d  0 do not depend on t.

The free coefficient bt may depend on t.

Solution of homogeneous equations

Assuming   0 we can simplify to

A linear combination of basic solutions is a sum of multiples of these solutions.

   0 . The difference equation xt  c xt 1  d xt 2  4 xt 2 , with c  0 and d  4 has

xt  k1 r t sin  t  k2 r t cos t  k1 2t sin  t  k2 2t cos t

with parameters k1 and k2.

Solution of inhomogeneous equations

Equilibrium and stability

The equilibrium point can be found directly from the equation

converging. Notice that no equilibrium point exists in this case.

verified, that pt  8 is a particular solution. So the general solution is

 Consider the difference equation xt  xt 1  0.81 xt 2  2 . The corresponding

FIGURE 1.10 Time-path for xt  xt 1  0.81 xt 2  2 .

1.4 Systems of difference equations

then the system can be described by

FIGURE 1.11 Phase diagram for the xt, yt system.

1.5 Nonlinear equations

with parameter r. The corresponding nonlinear 1st order difference equation is

0.2 0.2 0.4 0.6 0.8 1 1.2

As we assumed f to be differentiable, we have the following condition for local stability:

An equilibrium point x* of the difference equation xt  f ( xt 1 ) , where f is a differentiable

Economic application 1.2

The following application is an example of a nonlinear system of difference equations, which

Application 1.3 Predator-prey model

Application 1.4 The multiplier-accelerator model