Difference Equation

Time Path

Oindrila Dey, PhD

Mathematics for Economics
 Why?
✘ Dynamic economic models
✘ Determination of the time path (not optimal)
✘ Time is discrete : Cant calculate marginal
effects

2
 Concept
✘ Framing
✗ Suppose employee on a contract will be paid Rs. 10000 for the first month and then after
Rs. 1000 will be added each month to his initial salary
✗ 𝑦𝑡 − 𝑦𝑡−1 = 1000 where 𝑦𝑡 is the income in period t, 𝑦𝑡−1 is the income in period 𝑡 − 1 and
𝑡, (𝑡 − 1) = 1,2, …
✗ Alternatively ∆𝑦𝑡−1=1000
✗ Equivalently 𝑦𝑡+1 − 𝑦𝑡 = 1000
✗ Order of a difference equation determines the highest difference involved.
First Order
✗ 𝑦𝑡 − 𝑦𝑡−1
Second Order
✗ 𝑦𝑡 − 2𝑦𝑡−1 + 𝑦𝑡−2 = 𝑎
2
≡ ∆ 𝑦𝑡−2 = a
nth order
✗ 𝑎0 𝑦𝑡 + 𝑎1 𝑦𝑡−1 + ⋯ + 𝑎𝑛 𝑦𝑡−𝑛 = 𝑏
✗ 𝑏 is a constant, 𝑏 = 0 homogenous, 𝑏 ≠ 0 non- homogenous
✗ Order of the equation: (Highest – lowest) order

3
 Example
✘ 𝑦1 = 5𝑦0
✘ 𝑦2 = 5𝑦1 = 52 𝑦0
✘ 𝑦3 = 5𝑦2 = 53 𝑦0
✘ …𝑦𝑡 = 5𝑦𝑡−1 = 5𝑡 𝑦0 General solution

Q: what is the ‘ general’ about general solution?

A: 1) 𝑦0 is not specified
2)We can show that f(t) and Af(t) are solution to
4
5
 Propositions
✘ If f 𝑡 = 𝛽𝑡 is a solution to a difference
equation then f 𝑡 = 𝑡𝛽𝑡 is also a solution to
the same equation
✘ If 𝑓1 (𝑡) and 𝑓2 (𝑡) are solutions of a difference
equation then 𝐴1 𝑓1 𝑡 + 𝐴2 𝑓2 𝑡 will also satisfy
the same difference equation where 𝐴1 and 𝐴2
are constants.

6
 First Order Difference Equation
✘ 𝑦𝑡 − 𝑎𝑦𝑡−1 = 𝑏
where 𝑏 ≠ 0 ⇒ Non- homogenous
𝑏 = 0 ⇒ Homogenous
✘ Method I (Iterative Method)
𝑏 𝑏
✘ General Solution : 𝑦𝑡 = 𝑎𝑡 (𝑦0 − ) +
1−𝑎 1−𝑎
✘ Problem with the method
✗ Cumbersome
7
 Method II : Trial Solution
✘ Solution of Homogenous Equation
✘ Let 𝑦𝑡 =𝛽𝑥 𝑡
✗ => x=a
✗ General Solution : 𝑦𝑡 =𝛽𝑎 𝑡
✗ For 𝛽 we need Initial Condition, let 𝑦𝑡=0 = 𝑦0
✗ Definite Solution: 𝑦𝑡 =𝑦0 𝑎𝑡
✘ Example:
✘ Find the solution of the difference equation ∆𝑦𝑡 = 4𝑦𝑡 𝑎𝑛𝑑𝑦0 =6
8
✘ 𝑦 =6.5𝑡
 Method II : Trial Solution
✘ Solution of Non-Homogenous Equation
✘ 𝑦𝑡 − 𝑎𝑦𝑡−1 = 𝑏
✘ 𝑦𝑡 =𝑦𝑃 +𝑦𝐶
✘ For 𝑦𝑃 , take 𝑦𝑡 =𝑦
✘ For 𝑦𝐶 , same as homogenous case

9
10
 Nature of the Time Path
✘ The general form of 1st order, linear, non-homogeneous difference
equation –
𝑦𝑡 = β𝑎𝑡 + 𝑦
✘ Whether this general solution is dynamically stable or not?
✘ An equilibrium is said to be dynamically stable if the variable has a
tendency to approach the equilibrium level (𝑦) over time.
✘ Stability implies- β𝑎𝑡 0, as t∞ (then 𝑦𝑡 ⇒ 𝑦)
✘ Stability of the equilibrium depends on β & 𝑎.
✘ Assume, (i) β 𝑡𝑜 𝑏𝑒 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑎𝑛𝑑 𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 1, (ii)𝑦=0.
11
 Case (a): β = 1; 𝑎 > 1
✘ As t increases, β𝑎𝑡 increases.
✘ Assume, 𝑎=4, then 𝑎𝑡 =1,4,16,64… as t=0,1,2,3…
✘ Time path of y will be explosive and value of y
moves away further and further from the
equilibrium.
✘ Diverging and dynamically unstable.

12
 Case (b): β = 1; 𝑎 = 1
✘ As t increases, β𝑎𝑡 remains constant at 1.
✘ Time path of y will be constant divergence
from the equilibrium, dynamically unstable.
Horizontal straight line.

13
 Case (c): β = 1; 0 < 𝑎 < 1
✘ As t increases, β𝑎𝑡 decreases.
✘ Assume, 𝑎=1/4, then 𝑎𝑡 =1,1/4,1/16,1/64… as
t=0,1,2,3…
✘ Time path of y will be always positive, less than
unity and value of y steadily approaches to the
equilibrium (equal to 0).
✘ Converging and dynamically stable.
14
 Case (d): β = 1; 𝑎 = 0
✘ As t increases, β𝑎𝑡 remains constant at 0.
✘ Time path of y will coincide with the horizontal
axis (equilibrium time line).
✘ Equilibrium is not disturbed. No question of
stability.

15
 Case (e): β = 1; −1 < 𝑎 < 0
✘ As t increases, β𝑎𝑡 changes its sign but gradually
decreases the mode value.
✘ Assume, 𝑎=-1/4, then 𝑎𝑡 =1,-1/4,1/16,-1/64… as t=0,1,2,3…
✘ Time path of y will be oscillates and converges to the
equilibrium (equal to 0).
✘ Oscillation implies at outset, it is positive then negative
then again positive and so on.
✘ Dynamically stable with damped oscillation.

16
 Case (f): β = 1; 𝑎 = −1
✘ As t increases, β𝑎𝑡 oscillates (takes only two
value +1 & -1).
✘ Time path of y will be oscillates but in a
constant manner.
✘ Dynamically unstable with constant oscillation.

17
 Case (g): β = 1; 𝑎 < −1
✘ As t increases, β𝑎𝑡 changes its sign but
gradually increases the mode value.
✘ Assume, 𝑎=-4, then 𝑎𝑡 =1,-4,16,-64… as t=0,1,2,3…
✘ Time path of y will be explosive oscillation and
value of y moves away further and further
from the equilibrium.
✘ Diverging oscillation and dynamically unstable.
18
19
 Relaxation of the assumptions
✘ Assumption I: (i) β 𝑡𝑜 𝑏𝑒 𝑐𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑎𝑛𝑑 𝑒𝑞𝑢𝑎𝑙 𝑡𝑜 1.
✘ For positive value: Shift the time path parallel to up or down (known as
scale effect).
✘ For negative value: Shift the time path parallel to up or down on the
reverse side of the horizontal axis (known as mirror effect) .
✘ Note: the time path with positive β will be a mirror image of the time path
with negative β .
✘ Assumption II: (ii) 𝑦=0.
✘ 𝑦𝑝 > 0 equilibrium timeline will be parallel to the horizontal axis and lies
above to that.
✘ 𝑦𝑝 < 0 ????
✘ Note: A change in the value of alters the vertical intercept.
20
Cobweb Model
 Cobweb Model
✘ The cobweb model is based on a time lag between supply and demand decisions.
✘ Agricultural markets are a context where the cobweb model might apply, since there is a lag between
planting and harvesting.
✘ Suppose for example that as a result of unexpectedly bad weather, farmers go to market with an
unusually small crop of strawberries.
✘ This shortage, equivalent to a leftward shift in the market's supply curve, results in high prices.
✘ If farmers expect these high price conditions to continue, then in the following year, they will raise their
production of strawberries relative to other crops.
✘ Therefore when they go to market the supply will be high, resulting in low prices. If they then expect
low prices to continue, they will decrease their production of strawberries for the next year, resulting in
high prices again.

22
 Structure of Cobweb Model
✘ Given Difference Equations:

✘ Reduced difference equation:

✘ Normalised equation:

✘ Particular Solution:
✘ Complementary solution:
✘
✘ General solution:
✘ General solution with initial value:

23
 Time Path
✘ If 𝑃𝑜 = 𝑃, then 𝑃𝑡 = 𝑃. Equilibrium Price is maintained.
✘ If 𝑃𝑜 ≠ 𝑃, then,timepath depends on 𝐴/𝑎 [where, A>0 & a<0]
✘ Case I: 𝐴/𝑎 < 1
✘  Damped Oscillation or Convergent Cobweb.
✘ Case II: 𝐴/𝑎 > 1
✘  Explosive Divergent Oscillation or Divergent Cobweb.
✘ Case III: 𝐴/𝑎 = 1

✘  Regular Oscillation.

24
25
26
Application: Convergent Agricultural Market
Figure illustrates this process. The equilibrium
price is at the intersection of the supply and
demand curves. A poor harvest in period 1 means
supply falls to Q1, thus prices rise to P1. If
producers plan their period 2 production under the
expectation that this high price will continue, then
the period 2 supply will be higher under expansion
phase, at Q2. Prices therefore fall to P2 when they
try to sell all their output. Under the expectation of
price will remain low, producers will reduce their
production, at Q3. This is called contraction phase.
As this process repeats itself, oscillating between
periods of low supply with high prices and then
high supply with low prices, the price and quantity
trace out a spiral. They may spiral inwards, as
shown27
in figure.
28
Dynamic Multiplier of National Income

29
 Dynamic Multiplier of National Income
✘ National Income identity-
✘ 𝑌𝑡 = 𝐶𝑡 + 𝐼𝑡
Where, 𝐶𝑡 = 𝑐𝑌𝑡−1 and 𝐼𝑡 = 𝐴.
✘ General Solution,

✘ 𝐴
𝑌𝑡 = (𝑌0 − 1−𝑐)𝑐 𝑡
𝐴
+ 1−𝑐

✘ Or, 𝑌𝑡 = (𝑌0 − 𝑌)𝑐 𝑡 +𝑌

✘ 0<c<1 and c=MPC.
✘ As t∞, 𝑌𝑡 ⇒ 𝑌 .
✘ Equilibrium is stable and converging.
✘ Otherwise Not.

30
Problem Set

31