Difference equations

Van Nam Tran1

1
HCMC University of Technology and Education

June 20, 2020

First-order linear difference equations

Definition
Let Yt be some variable at time t. A first-order linear difference
equation is defined by an equation of movement

Yt = α + φYt−1 (1)

and by a starting value Y0 which gets the process started.

Theorem (Solution)
The solution to a first-order linear difference equation (1) takes the
form
Yt = Y ∗ + φt (Y0 − Y ∗ )
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First-order linear difference equations

Definition
Let Yt be some variable at time t. A first-order linear difference
equation is defined by an equation of movement

Yt = α + φYt−1 (1)

and by a starting value Y0 which gets the process started.

Theorem (Solution)
The solution to a first-order linear difference equation (1) takes the
form
Yt = Y ∗ + φt (Y0 − Y ∗ )
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Equilibrium value

Definition
The equilibrium value Y ∗ is that value of Yt such that if Yt = Y ∗ then
Yt+k = Y ∗ for all k > 0.

Remark
The equilibrium value for the first-order linear difference equation (1)
satisfies Y ∗ = α + φY ∗ . Hence, if φ 6= −1 then
α
Y∗ =
1−φ

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Equilibrium value

Definition
The equilibrium value Y ∗ is that value of Yt such that if Yt = Y ∗ then
Yt+k = Y ∗ for all k > 0.

Remark
The equilibrium value for the first-order linear difference equation (1)
satisfies Y ∗ = α + φY ∗ . Hence, if φ 6= −1 then
α
Y∗ =
1−φ

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Stability

Definition
A difference equation is stable if for any starting value Y0 ,

lim Yt = Y ∗
t→∞

Theorem
The difference equation (1) is stable if and only if −1 < φ < 1.

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A Macroeconomic example

Suppose Yt is GNP, Ct is consumption, It is investment and Gt is

government expenditure at time t. Then

Yt = Ct + It + Gt .

Because both It , Gt are exogenous, It = I, Gt = G where I, G are

constants.
Ct = C + cYt−1 , 0 < c < 1

c is marginal propensity to consume. It follows that

Yt = (C + I + G) + cYt−1

which is a first-order difference equation.

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The equilibriumvalue of GNP is thus
α C +I +G
Y∗ = =
1−φ 1−c

Remark
∂Y ∗ 1
=
∂G 1−c
the conventional multiplier.

Remark
The economic is stable since φ = c and 0 < c < 1. In fact,
 
C +I +G C +I +G C +I +G
Yt = + ct Y0 − →
1−c 1−c 1−c

as t → ∞.

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The Cob-Web model

Qdt = a − bPt
where Qdt is the quantity demanded, Qst is the
Qst = c + dPt−1
quantity supplied and Pt is the price at time t. In equilibrium
Qdt = Qst , which is equivalent to
a−c b
Pt = − Pt−1
b d
The equilibrium price is
a−c
a−c
P∗ = b d =
1+ b b+d
Hence,  t
∗ −d
Pt = P + (P0 − P ∗ )
b
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Second-order linear difference equations

Definition
A second-order linear difference equation has an equation of motion
given by
Yt = α + φ1 Yt−1 + φ2 Yt−2 (2)

with given starting value Y0 and Yt .

The equilibrium value satisfies

Y ∗ = α + φ1 Y ∗ + φ2 Y ∗

or
α
Y∗ =
1 − φ1 − φ2
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A macroeconomic example

Consider the model Yt = Ct + It + Gt . Now let investment be

endogenous according to the accelerator theory of investment so that

It = I + γ(Yt−1 − Yt−2 )

and suppose Gt = G and Ct = C + cYt−1 , 0 < c < 1. Then

Yt = (C + I + G) + (c + γ)Yt−1 − γYt−2

It follows that
C +I +G
Y∗ =
1−c

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Characteristic polynomial

The characteristic polynomial of the second-order difference equation

(2) is
P (r) = r2 − φ1 r − φ2 .
Remark
The roots of the
p characteristic polynomial are
φ1 ± φ21 + 4φ2
r1 , r2 =
2

The solution to the difference equation (2) is given by

Yt = Y ∗ + A1 r1t + A2 r2t ,

where A1 , A2 are constants.

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Remark
A1 , A2 are determined by the system

Y0 = Y ∗ + A1 + A2
Y1 = Y ∗ + A1 r1 + A2 r2

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Stable conditions

Theorem
The difference equation (2) is stable if and only if |r1 | < 1 and
|r2 | < 1.

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The behaviour of Yt with complex roots

Suppose the characteristic polynomial has complex roots which is

written in the polar form r1 = reiθ and r2 = re−iθ .
it can be shown that then A1 = Aeiα , A2 = Ae−iα .
So
Yt = Y ∗ + 2Art cos(θt + α).

What happen if r > 1 and r < 1?

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Example
Solve the difference equation

Yt = 100 + 1.3Yt−1 − 0.4Yt−2

Y1 = 850, Y0 = 800

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