Approximate Solutions To DSGE Models

Quantitative Macroeconomics
Approximate Solutions to DSGE Models

– An Application to the RBC Model
Andreas Tischbirek
Department of Economics
HEC Lausanne
9 November 2020
Introduction Log-linear solution method History of the RBC model
Introduction
Last week
Introduction to the RBC model
Model solution for the special case of full capital depreciation
Today
How can one solve the model without restrictive assumptions about its
parameters?
How can one find the solution to DSGE models more broadly?
Solving DSGE models many times requires solving a system of
equations that contains
highly non-linear terms
conditional expectations
variables with different time subscripts
⇒ Generally a closed form solution does not exist
Idea: Simplify equations in a way that permits finding a good
approximation of the exact solution
UNIL-HEC Solving DSGE Models 9 November 2020
1. A (log-)linear solution method
Overview
Different solution algorithms exist

The most widely used algorithm relies on bringing the equation
system that has to be solved into (log-)linear form and solving the
resulting system
Recall that a Taylor series expansion can be used to find a linear
approximation of a function f (x) at the point x̄
f (x) ≈ f (x̄) + f 0 (x̄)(x − x̄)
Steady state typically serves as the approximation point

To summarise, the steps involved are
1 Calculate the steady state of the (non-linear) model
2 Find a log-linear approximation of the (non-linear) model around the
steady state
3 Solve the resulting (linear) system of expectational difference equations

Steady State
To solve for the steady state, we can set all exogenous shocks to their
means and drop all
time subscripts
expectations operators
Recall that exact solution to the RBC model is described by the
following (non-linear) system
At ktα (1 − lt )1−α = ct + kt+1 − kt + δkt (1)

ln At = ρ ln At−1 + εt (2)
ct α−1
(1 − lt+1 )1−α + 1 − δ = 1

Et β αAt+1 kt+1 (3)
ct+1
1
(1 − α)At ktα (1 − lt )−α = χ (4)
ct

Steady State
From Equation (2), we get
ln A = ρ ln A + 0
Assuming that |ρ| < 1, this implies A = 1

With A = 1, the remaining equations in steady state become
k α (1 − l)1−α =c + δk
β αk α−1 (1 − l)1−α + 1 − δ =1

1
(1 − α)k α (1 − l)−α =χ
c
This is a system of three equations in the three unknowns k, l and c,
which can be solved by hand
To do so, it his helpful here to introduce the capital-labour ratio
(klr ≡ k/(1 − l)) as an auxiliary variable
Steady State
One can then show that the steady state is given by
A=1
1
1 − β(1 − δ) α−1
klr =
αβ
1−α α
c= klr
χ
c
k= α−1
klr −δ
k
l =1−
klr
We proceed by log-linearising the model equations around this steady
state

Log-Linearisation – Methodology
The Taylor approximation of the logarithm of some function f (xt )
around its steady state x is given by
1 0
ln f (xt ) ≈ ln f (x) + f (x)(xt − x)
f (x)
This expression can be re-written as follows
1 0 xt − x
ln f (xt ) ≈ ln f (x) + f (x)x
f (x) x
0
f (x)x
≈ ln f (x) + x̂t (5)
f (x)
x̂t ≡ (xt − x)/x is the percentage deviation of xt from its steady state
Note that ln f (x) and f 0 (x)x/f (x) are constants
⇒ We have approximated the logarithm of an arbitrary function f (x)
by a function that is linear in x̂t ,
i.e. we have found a and b such that ln f (xt ) ≈ a + bx̂t when xt is
close to x
Log-Linearisation – Methodology
Applying the same steps to the logarithm of a multivariate function
yields
f1 (x1 , x2 , x3 , . . .)x1
ln f (x1,t , x2,t , x3,t , . . .) ≈ ln f (x1 , x2 , x3 , . . .) + x̂1,t
f (x1 , x2 , x3 , . . .)
f2 (x1 , x2 , x3 , . . .)x2
+ x̂2,t
f (x1 , x2 , x3 , . . .)
f3 (x1 , x2 , x3 , . . .)x3
+ x̂3,t
f (x1 , x2 , x3 , . . .)
+ ... (6)
where fj (·) is the derivative of f (·) with respect to xj,t

To log-linearise an equation, we can thus
1 take the logarithm on both sides
2 apply the formula above (which collapses to (5) in the univariate case)
Let us turn back to the RBC model to see how this works in practice
Log-Linearisation
Recall that Equation (1), the first of the four equilibrium conditions
of the RBC model, is given by
At ktα (1 − lt )1−α = ct + kt+1 − kt + δkt
Taking the logarithm on both sides yields
ln At + α ln kt + (1 − α) ln ht = ln [ct + kt+1 − (1 − δ)kt ] (7)
where hours worked, defined as ht ≡ 1 − lt , have been substituted to
simplify the maths
Applying Equation (5) to each term of the sum on the left-hand side
of Equation (7) gives
ln At + α ln kt + (1 − α) ln ht
≈ ln A + Ât + α(ln k + k̂t ) + (1 − α)(ln h + ĥt )

Log-Linearisation
Using Equation (6), the right-hand side of (7) can be approximated as
ln [ct + kt+1 − (1 − δ)kt ]

c
≈ ln [c + k − (1 − δ)k] + ĉt
c + k − (1 − δ)k
k (1 − δ)k
+ k̂t+1 − k̂t
c + k − (1 − δ)k c + k − (1 − δ)k
Thus the approximated version of Equation (1) is
ln A + Ât + α(ln k + k̂t ) + (1 − α)(ln h + ĥt )

c
≈ ln [c + k − (1 − δ)k] + ĉt
c + k − (1 − δ)k
k (1 − δ)k
+ k̂t+1 − k̂t
c + k − (1 − δ)k c + k − (1 − δ)k

Log-Linearisation
In steady state, (7) implies
ln A + α ln k + (1 − α) ln h = ln [c + k − (1 − δ)k]
Making use of this fact, we can simplify the approximated equation by

cancelling the respective terms on both sides to get
c k
Ât + αk̂t + (1 − α)ĥt ≈ ĉt + k̂t+1
c + k − (1 − δ)k c + k − (1 − δ)k
(1 − δ)k
− k̂t
c + k − (1 − δ)k
Finally, collecting terms yields

(1 − δ)k c k
Ât + α + k̂t + (1 − α)ĥt ≈ ĉt + k̂t+1
c + δk c + δk c + δk
Note that this is a linear equation with coefficients that depend on
the steady state values derived before
Log-Linearisation
Proceeding with the equations (2) – (4) precisely as with (1) yields
the following log-linearised system

(1 − δ)k c k
Ât + α + k̂t + (1 − α)ĥt ≈ ĉt + k̂t+1 (8)
Ât ≈ ρÂt−1 + εt (9)
ĉt + [1 − (1 − δ)β] Et Ât+1 + (α − 1) [1 − (1 − δ)β] Et k̂t+1
+ (1 − α) [1 − (1 − δ)β] Et ĥt+1
≈ Et ĉt+1 (10)
−ĉt + Ât + αk̂t − αĥt ≈ 0 (11)
We can now solve the linear system (8) – (11) to find an

approximation of the solution to the original non-linear equation
system (1) – (4)
Benefit of reduced complexity comes at the cost of introducing
approximation error
Solving the linearised equation system – Methodology

Finding a solution to the approximated equation system is
complicated by the fact that it contains
variables that are dated differently
expectation operators
To solve the (log-)linearised system it is convenient to work with
matrix notation
First note that a system of linear expectational difference equations
can be brought into the following form
BEt xt+1 = Axt + Get (12)

where
xt is a vector of all endogenous variables of the model
A, B and G are matrices containing parameters
et is a vector of all shocks
The equation above is called the state space representation of a
linear model

Among the endogenous model variables, one can distinguish
control variables—are chosen by model agents in response to
contemporaneous shocks
state variables—are either not actively chosen by model agents or
predetermined (chosen in a previous period)
Endogenous state variables are many times stock variables, while
controls many times are flow variables
Intuitively, all state variables jointly contain sufficient information for
agents to choose the value of the controls
Let xst be a vector of all endogenous states and xct be a vector of all
controls, then the variables in xt can be ordered such that (12) can
be expressed as s s
xt+1 x
BEt c = A ct + Get (13)
xt+1 xt

Pre-multiplying (13) with B−1 yields
xst+1
s
−1 xt
Et = B A + B−1 Get
xct+1 xct
An important result from linear algebra is that the matrix B−1 A

(under certain conditions) can be decomposed as B−1 A = MLM−1
where L is a matrix with zeros everywhere except the main diagonal
This way of diagonalising a matrix is called a “Jordan decomposition”
Then
s s
xt+1 −1 xt
Et c = MLM + B−1 Get (14)
xt+1 xct


Blanchard and Kahn (1980) showed
If the number of elements on the main diagonal of L (“eigenvalues”)
that are larger than one in absolute value is equal to the number of
control variables of the model, then there is a unique stable solution
to Equation (14) of the form
xct = C1 xst + C2 et (15)
xst+1 = C3 xst + C4 et (16)
where C1 , . . . , C4 are parameter matrices

The proof is beyond the scope of the course
Note that the two equations above together with initial conditions for
the state variables completely describe the equilibrium, because
given xs0 and draws for e0 , (15) determines xc0
given xs0 and draws for e0 , (16) determines xs1
given xs1 and draws for e1 , (15) determines xc1
given xs1 and draws for e1 , (16) determines xs2
etc.
Solving the linearised equation system

Let us now confirm that the log-linearised RBC model can indeed be
written as s s
xt+1 x
BEt = A ct + Get
xct+1 xt
The system (8) – (11) has
four endogenous variables (ĉ,k̂,ĥ and Â), and
one exogenous shock (ε)
Which of the endogenous variables are states and which are controls?
consumption—ĉt chosen by househod in t after observing εt ⇒ control
capital—k̂t chosen in t − 1, before εt is realised ⇒ state
hours worked—precisely as consumption ⇒ control
technology—not actively chosen by a model agent ⇒ state
There are two state, two control variables and one shock, so in the
equation above
capital and technology are part of xs (at the top)
consumption and hours are part of xc (at the bottom)
the only element of e is ε

Consequently, we wish to write the model as
   
k̂t+1 k̂t
 Ât  Ât−1 
ĥ  = A  ĥ  + Gεt
BEt    
t+1 t
ĉt+1 ĉt
Observe that technology is dated back by one period to account for
its law of motion (see next slide)
Equation (8) is

(1 − δ)k c k
Ât + α + k̂t + (1 − α)ĥt ≈ ĉt + k̂t+1
The first rows of B, A and G are therefore given by
−k

B1 = c+δk 1 0 0
h i
(1−δ)k c
A1 = −α − c+δk 0 −(1 − α) c+δk
G1 = 0

We wish to write the model as
   
k̂t+1 k̂t
 Ât  Ât−1 
BEt 
ĥ  = A  ĥ  + Gεt
  
t+1 t
ĉt+1 ĉt
Equation (9) is
Ât ≈ ρÂt−1 + εt
The second rows of B, A and G are therefore given by

B2 = 0 1 0 0

A2 = 0 ρ 0 0
G2 = 1
The remaining two equations can be fully captured using the last two
rows of B, A and G
(To bring (10) into the right format, use the fact that Et Ât+1 = ρÂt )
Concluding Remarks on the Solution Algorithm
Thus, under the conditions outlined by Blanchard and Kahn (1980),

the (log-)linearised equations can be solved
An important question is how well the equilibrium of the
(log-)linearised system approximates the solution to the original
(non-linear) model ⇒ The farther the model variables deviate from
steady state in equilibrium, the worse the approximation becomes
(Taylor series expansion gives only a local approximation)
Clearly, deriving a solution in this way is time-consuming, especially
with larger models
The good news—We can use the computer to do all the steps
outlined above for us
⇒ Dynare (Next Lecture!)

2. A few words on the history of the RBC model
Critical Reception
RBC theory was highly controversial when it was first released,
perhaps because it was strongly at odds with views held by many at
that time
Supply side vs. demand-side driven fluctuations
In the postwar period, macroeconomics was dominated by the
Keynesian view that short-run fluctuations in output and employment
were mainly due to variations in aggregate demand
In RBC theory, shocks causing fluctuations stem from technology, i.e.
the supply side
Developments in the 1970’s (simultaneous inflation and unemployment)
seemed more related to supply-side phenomena such as oil price shocks
and a worldwide slowdown in productivity growth
Role of policy
The Keynesian view was that aggregate demand fluctuations were
caused by market failures
⇒ Role for government interventions
In the RBC model, fluctuations are not a result of market failures
⇒ No role for government interventions
Critical Reception
The following two quotes show how controversial RBC theory was in
the 1980’s
Prescott (1986)
“Economic theory implies that, given the nature of the shocks to
technology and people’s willingness to intertemporally and
intratemporally substitute, the economy will display fluctuations like
those the US economy displays [...] Indeed, if the economy did not
display the business cycle phenomenon, there would be a puzzle.”
Response by Larry Summers
“If these [RBC] theories are correct, they imply that the
macroeconomics developed in the wake of the Keynesian Revolution is
well confined to the ashbin of history and they suggest that most of the
work of contemporary macroeconomists is worth little more than that
of those pursuing astrological science [...]. My view is that RBC models
[...] have nothing to do with the business cycle phenomenon observed
in the US.”
It is worth noting that the most widely used models today have both
Keynesian and RBC elements
References
Further Reading
DeJong, David N. with Chetan Dave (2011): “Structural
Macroeconometrics,” Princeton University Press, 2nd edition,
Chapter 2
Background information on Kydland and Prescott’s work from the
Nobel Committee
https://www.nobelprize.org/uploads/2018/06/
advanced-economicsciences2004.pdf, Section 3

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Quantitative Macroeconomics

Different solution algorithms exist

f (x) ≈ f (x̄) + f 0 (x̄)(x − x̄)

Steady state typically serves as the approximation point

UNIL-HEC Solving DSGE Models 9 November 2020

At ktα (1 − lt )1−α = ct + kt+1 − kt + δkt (1)

UNIL-HEC Solving DSGE Models 9 November 2020

Assuming that |ρ| < 1, this implies A = 1

One can then show that the steady state is given by

UNIL-HEC Solving DSGE Models 9 November 2020

where fj (·) is the derivative of f (·) with respect to xj,t

UNIL-HEC Solving DSGE Models 9 November 2020

ln [ct + kt+1 − (1 − δ)kt ]

ln A + Ât + α(ln k + k̂t ) + (1 − α)(ln h + ĥt )

UNIL-HEC Solving DSGE Models 9 November 2020

Making use of this fact, we can simplify the approximated equation by

We can now solve the linear system (8) – (11) to find an

Solving the linearised equation system – Methodology

BEt xt+1 = Axt + Get (12)

Solving the linearised equation system – Methodology

UNIL-HEC Solving DSGE Models 9 November 2020

Solving the linearised equation system – Methodology

Pre-multiplying (13) with B−1 yields

An important result from linear algebra is that the matrix B−1 A

UNIL-HEC Solving DSGE Models 9 November 2020

Solving the linearised equation system – Methodology

where C1 , . . . , C4 are parameter matrices

Solving the linearised equation system

Solving the linearised equation system

Solving the linearised equation system

Concluding Remarks on the Solution Algorithm

Thus, under the conditions outlined by Blanchard and Kahn (1980),

UNIL-HEC Solving DSGE Models 9 November 2020

UNIL-HEC Solving DSGE Models 9 November 2020

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