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Currently Available: Volume 2: Lectures on Microeconomic Theory (Second Revised Edition) E. MALINVAUD Volume 5: Applied Consumption Analysis (Second Revised Edition) L. PH LIPS Volume 11: Collective Choice and Social Welfare A.K. SEN Volume 12: General Competitive Analysis K. J. ARROW and F. H. HAHN Volume 14: Distributed Lags (Second Revised Edition) P.J. DHRYMES Volume 17: Stochastic Methods in Economics and Finance A. G. MALLIARIS and W. A. BROCK Volume 19: International Trade and Resource Allocation (Second Revised Edition) A. D. WOODLAND Volume 23: Public Enterprise Economics (Second Revised Edition) D. BOS Volume 24: Optimal Control Theory with Economic Applications A. SEIERSTAD and K. SYDSAETER Volume 24: Capital Markets and Prices: Valuing Uncertain Income Streams C. G. KROUSE Volume 26: History of Economic Theory T. NEGISHI Volume 27: Differential Equations, Stability and Chaos in Dynamic Economics W. A. BROCK and A. G. MALLIARIS Volume 28: Equilibrium Analysis W. HILDENBRAND and A. P. KIRMAN Volume 29: Economics of Insurance K. H. BORCH t; completed by K. K. AASE and A. SANDMO Volume 30: Microeconomics: Institutions, Equilibrium and Optimality M. C. BLAD and H. KEIDING Volume 31: Dynamic Optimization (Second Revised Edition) M. L. KAMIEN and N. I. SCHWARTZ t

DIFFERENTIAL EQUATIONS, STABILITY AND CHAOS IN DYNAMIC ECONOMICS

ADVANCED TEXTBOOKS IN ECONOMICS

VOLUME 27 Editors: C.J. BLISS M.D. INTRILIGATOR Advisory Editors: W.A. BROCK D.W. JORGENSON A.P. KIRMAN J.-J. LAFFONT L. PHLIPS J.-F. RICHARD

ELSEVIER AMSTERDAM - LAUSANNE - NEW YORK - OXFORD - SHANNON - TOKYO

DIFFERENTIAL EQUATIONS, STABILITY AND CHAOS IN DYNAMIC ECONOMICS

W.A. BROCK

University of Wisconsin

A.G. MALLIARIS

Loyola University of Chicago

ELSEVIER AMSTERDAM - LAUSANNE - NEW YORK - OXFORD - SHANNON - TOKYO

ELSEVIER SCIENCE B.V. Sara Burgerhartstraat 25 P.O. Box 211, 1000 AE Amsterdam, The Netherlands

First edition: 1989 Second impression: 1992 Third impression: 1996 Library of Congress Cataloging in Publication Data

Brock, W.A. Differential equations, stability and chaos in dynamic economics W.A. Brock, A.G. Malliaris p. cm. Includes index. ISBN 0-444-70500-7 1. Economics, Mathematical. 2. Differential equations. I. Brock, W.A. II. Title. HB135.M3346 1989 330'.01'51—dc19 ISBN 0 444 70500 7 © 1989 ELSEVIER SCIENCE B.V. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the publisher, Elsevier Science B.V., Copyright & Permissions Department, P.O. Box 521, 1000 AM Amsterdam, The Netherlands. Special regulations for readers in the U.S.A.-This publication has been registered with the Copyright Clearance Center Inc. (CCC), 222 Rosewood Drive Danvers, MA 01923. Information can be obtained from the CCC about conditions under which photocopies of parts of this publication may be made in the U.S.A. All other copyright questions, including photocopying outside of the U.S.A., should be referred to the copyright owner, Elsevier Science B.V., unless otherwise specified. No responsibility is assumed by the publisher for any injury and/or damage to persons or property as a matter of products liability, negligence or otherwise, or from any use or operation of any methods, products, instructions or ideas contained in the material herein. This book is printed on acid-free paper. Printed in The Netherlands

INTRODUCTION TO THE SERIES

The aim of the series is to cover topics in economics, mathematical economics and econometrics, at a level suitable for graduate students or final year undergraduates specializing in economics. There is at any time much material that has become well established in journal papers and discussion series which still awaits a clear, self-contained treatment that can easily be mastered by students without considerable preparation or extra reading. Leading specialists will be invited to contribute volumes to fill such gaps. Primary emphasis will be placed on clarity, comprehensive coverage of sensibly defined areas, and insight into fundamentals, but original ideas will not be excluded. Certain volumes will therefore add to existing knowledge, while others will serve as a means of communicating both known and new ideas in a way that will inspire and attract students not already familiar with the subject matter concerned. The Editors

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7. Introduction 2. 7. 6. 4. Linear differential equations 1. Basic properties of differential equations 1. 9. 2. Introduction Preliminaries Existence Continuation of solutions Uniqueness Successive approximations Dependence on initial data and parameters Miscellaneous applications and exercises Further remarks and references xi xv 1 1 2 6 11 13 18 23 25 27 31 31 32 33 38 46 50 51 53 53 55 Chapter 2. 2. Definitions . 6. Stability methods: an introduction 1. 5. .CONTENTS Preface Acknowledgements Chapter 1. 3.3. Introduction Linear systems Basic results Linear systems with constant coefficients Jordan decomposition Miscellaneous applications and exercises Further remarks and references Chapter 3. 8. 4. 5.

4. Microeconomic dynamics 1. 6. 9. 3. Introduction First best regulatory modes in a two sector model Second best modes of regulation Multiple optimal paths Examples 159 159 162 176 181 185 . 5. 6. 2. 10. 7. 5. 5.viii Contents 3. 8. 7. Introduction Linear quadratic approximation to general problem The general nonlinear nonquadratic problem Stability results based on V1 Stability results based on V2 Linear quadratic approximation Results based upon the Liapunov function V3 The Liapunov function V4 Miscellaneous applications and exercises Further remarks and references 131 131 135 139 140 143 147 149 151 153 157 Chapter 6. 4. Stability of optimal control 1. 3. 6. 2. 3. 5. 2. 4. 8. Preliminaries Local stability and instability for autonomous systems Local stability for nonautonomous systems Global asymptotic stability Stable manifold Miscellaneous applications and exercises Further remarks and references 89 89 93 106 110 125 126 129 Chapter 5. Stability of linear systems Stability of linear systems with constant coefficients Routh-Hurwitz criterion Two dimensional linear systems Miscellaneous applications and exercises Further remarks and references 59 66 75 77 84 85 Chapter 4. Advanced stability methods 1. 4. 7.

4. 3. 7. Macroeconomic policies 1. Miscellaneous applications and exercises 7. 6. Introduction A first result on G. 5. Stability in investment theory 1. 10. 3.S. 5. 2. 3. 5. 8. 4. 8. 6. 11. 6. Further remarks and references 187 196 Chapter 7. Stability in capital theory 1. 2. 4. 7. Introduction The macroeconomic structure Perfect foresight equilibrium Determination of optimality conditions for households Determination of optimality conditions for firms Equilibrium structure and dynamics of system Steady state Characterizations of alternative steady states Dynamics in a simplified case Miscellaneous applications and exercises Further remarks and references 225 225 228 234 234 236 243 245 247 252 254 261 Chapter 9.Contents ix 6. Convergence of bounded trajectories A more general result Miscellaneous applications and exercises Further remarks and references 271 271 211 281 287 292 294 . 2. 9. Introduction Samuelson's Correspondence Principle Abstract results on comparing optimal steady states Applications to adjustment cost models Generalized capital deepening More on the adjustment cost model Miscellaneous applications and exercises Further remarks and references 199 199 201 204 207 212 214 219 223 Chapter 8.A.

5. 3. 6. 4.X Contents Chapter 10. Introduction to chaos and other aspects of nonlinearity 1. Introduction Statistical theory for nonlinear dynamics Roads to chaos in macroeconomics Applications to finance Miscellaneous applications and exercises Further remarks and references 297 297 306 312 322 333 340 343 357 383 Appendix Selected bibliography Index . 2.

capital theory. uniqueness. stability and chaos in dynamic economics introduces the reader to three advanced mathematical methods by expositing both their theoretical underpinnings and their applications to a wide range of economic models. p. investment theory. However. Chapter 2 discusses linear differential equations with a balanced approach between their properties and solutions. dates back. During the past forty years. stability techniques and chaotic dynamics. business cycles. This is done in chapters 1 and 2. continuation of solutions. generality and simplicity are relentlessly pursued. 1265) Differential equations. successive approximations and dependence on initial data and parameters is given in chapter 1. The use of ordinary differential equations in economics. it was Samuelson's (1947) Foundations of Economic Analysis which firmly established the appropriateness of using ordinary differential equations in dynamic economics. financial economics and many others.PREFACE As a formal model of an economy acquires a mathematical life of its own. ordinary differential equations have been employed extensively by economic researchers and such a use has created the need for an exposition of the fundamental notions and properties of these equations. Walras in 1874. it becomes the object of an inexorable process in which rigor. As the title of the book indicates. Debreu (1986. the . at least to L. macroeconomic policies. the mathematical methods presented are ordinary differential equations. an emphasis on existence. The applications selected to illustrate these methods are numerous and include microeconomic dynamics. We note that although the classical approach to differential equations concentrates on methods and techniques for finding explicit solutions.

Chapter 3 gives numerous definitions and examples of stability notions. chapter 5 surveys the stability contributions of mathematical economists. It also gives a comprehensive presentation of two dimensional systems and their phase diagrams. Chapter 4 continues on the topic of stability at a more advanced level. all of which took place since the mid 1970s. In other words. While chapters 3 and 4 are a collection of stability results contributed by mathematicians that were essentially completed prior to 1965. However. Through the contents of this book we hope to show that the stability analysis of an economic model is an integral part of economic research. Furthermore. This chapter surveys several important methods of stability analysis of optimal control problems. and discusses the stability properties of linear dynamic systems. The above is not all we have to say on stability methods. the recent results of several mathematicians. Markus and Yamabe (1960) and Olech (1963) on global asymptotic stability receive special attention in a unique way which has not previously been done by mathematical economics textbooks. Samuelson and others. the counting and examination of roots of characteristic equations while chapter 4 is more topological in nature. Although conditions of the . This chapter unites the economic analyst and the mathematician at the forefront of stability research and is used as a foundation for later chapters. stability methods continue to remain under-utilized by economists partly because our profession has not been taught these methods in any detail and partly because the critical role played by stability analysis has not been fully appreciated outside theoretical circles. The notion of stability in economics. The last thirty years have seen numerous papers on stability analysis applied to economic models. was not completely formulated until the late 1950s in the papers of Arrow and his collaborators.xii Preface modern approach endeavors to obtain information about the whole class of solutions and their properties. Hicks. The stability properties of an economic model must be investigated and become understood before such a model is used to supply insights into the workings of the actual economic system. such as Hartman and Olech (1962). the linearization of nonlinear systems. Thus. introduced by Walras and Cournot and later studied by Marshall. the emphasis of chapter 1 is on properties while chapter 2 balances abstraction with concreteness and illustrates some problem solving techniques. An additional important contribution is chapter 5. Liapunov theory for local stability and global asymptotic stability receive the bulk of our attention. chapter 3 illustrates the significance of linear systems.

and the necessity of the transversality condition at infinity for identical infinitely lived agents eliminate Hahn (1966) type problems. although growing very rapidly. Multiple optimal paths are also investigated. Chapter 10 attempts to give a mathematically precise version of recent tests on an observed time series for the presence of low dimensional deterministic chaos. First. remains limited. an infinite horizon two sector economy in which one sector is decreasing returns and the other is increasing returns may fail to achieve Pareto optimum. Having argued that differential equations abound in economics and that stability methods form a limited subset of the former. A simple methodological connection between stability and chaos explains why chaos is introduced in this book. chapter 6 is written to make two points. Fully one half of this book is devoted to applications. More specifically. what can we say about chaotic dynamics? Methods related to chaos and nonlinearity are very new to economics. stability is viewed as a property of the solution of the differential equation and chapter 3 makes explicit the connection between the property of dependence on initial data and the concept of stability. efficient markets prevail. it is not always true that the same is done for stability. The exposition of differential equations. Second. To encourage this methodological approach. The chapter also provides an analytically tractable framework where the impact of different modes of regulation upon economic development paths may be studied. there is a tendency for the increasing returns sector to overexpand although this is not always the case.Preface xiii existence and uniqueness of equilibrium are investigated almost automatically in economic model building. this chapter proposes a novel way of studying stability as a methodological consequence of a modified Correspondence Principle. the number of economic papers in this area. stability and chaos as a collection of important mathematical methods has not been made at the expense of illustrations. As chapter 10 documents. This may occur even when the increasing returns sector is regulated in a first best fashion. The famous original Correspondence Principle of Paul Samuelson is discussed and a . with most of these papers having been written in the 1980s. under decentralized institutions. Instead of just citing results. Chapter 7 addresses stability issues in investment theory with primary emphasis on cost of adjustment models. Chaos theory removes the emphasis from stability by stressing instabilities. The many stability methods discussed in this book and the numerous illustrations are intended to persuade the economic theorist to become more comprehensive in his or her analysis of economic models. rational expectations obtain.

it specifies a more complete corporate sector that such models usually contain and. This process generates a system of differential equations that is called a modified Hamiltonian dynamical system. Furthermore. Chapter 8 extends some of the recent macrodynamic models in two ways. In total the reader will find a valuable guide to over 500 selected references that use differential equations. The equilibrium structure and dynamics of this model are studied in detail and the stability of a simplified case is analyzed. nor are there any books with such a comprehensive coverage of applications. A capital theory generates a capital-price differential equation by using the Pontryagin maximum principle to write the necessary conditions for an optimal solution. This chapter analyzes the stability properties of such modified Hamiltonian dynamical systems. An attempt has been made to keep the mathematical background to a minimum. All chapters conclude with two sections on miscellaneous applications and exercises and further remarks and references. The Appendix cites numerous definitions and theorems to help readers with insufficient mathematical background and gives references for further study. second the relationships describing the private sector are derived from explicit optimizing procedures by households and firms. There are currently no books available covering all the methods presented here. We are quite certain that this is the first economics monograph of its kind offering the economic theorist the opportunity to acquire new and important analytical tools. Finally. stability analysis and chaotic dynamics. Chapter 9 applies the results of chapters 1 through 5 to capital theory. The primary audience of this book will include PhD students in economics with a special interest in economic theory. economic researchers should benefit from this book by developing expertise in the methods studied. applied mathematicians will find fresh mathematical ideas in chapter 5 relating to the stability of optimal control and can broaden the domain of their stability and chaos examples from chapters 6 through 10. . First. Many parts of this book can be understood by someone with a good background in analysis.xiv Preface modification is proposed and utilized to obtain stability results in investment models.

Benhabib (New York University). A. Elizabeth Steber. M.V. Takayama (University of Southern Illinois) and anonymous referees. Judd (University of Chicago). J. J. Dechert (University of Iowa). III (Rochester University). The late W. Several research assistants helped with proofreading. John Gogniat and Hang Chang. Scheinkman (University of Chicago). Numerous individuals helped through insightful comments. to the North-Holland Publishing . G. M. M. Becker (Indiana University). We are thankful to the Academic Press and the editors of the Journal of Economic Theory. S. former and current editors respectively of Elsevier Science Publishers B. Boyd. Hadjimichalakis (University of Washington). Chang (Indiana University) and S. encouragement and interest in our work and among them we mention: N. Burmeister (University of Virginia). Constantinides (University of Chicago). E. H. Carmela Perno has shown outstanding patience and extraordinary skills in typing various versions during a period of five years. T. Stefani (University of Brescia. have been a pleasure to work with. K. R. J. Norman Lebovitz (Mathematics Department. R. D. Meyer (Loyola University of Chicago). Reid. creative and valuable contributions which form the substance of this book. F. John Potthast. Alexander Valvassori. They gave us the original. University of Chicago) and Jerry Bona (Mathematics Department. Pennsylvania State University) gave valuable instruction on differential equations and stability.ACKNOWLEDGEMENTS We happily acknowledge an enormous intellectual debt to each of the mathematicians and economists cited in this book. editing and bibliographical work. D. We are grateful to Carol Ross. Turnovsky (University of Washington) wrote detailed comments that helped us improve our exposition. suggestions. Barron (Loyola University of Chicago). Pamela Kellman made numerous editorial suggestions that improved the presentation of our ideas. Intriligator has supported us enthusiastically and Drs Ellen van Koten and Mr Joop Dirkmaat. Italy). (North-Holland). Magill (University of Southern California). to Springer-Verlag. Adrienne Colvert.

. G. Brock. patience and joy". A. W. Malliaris dedicates his portion to his wife Mary Elaine and their children Maryanthe and Steven for "their love. Stanford University. Indiana University and Loyola University of Chicago and we are grateful to all students who have read and commented on the manuscript.xvi Acknowledgements Company and to the editors of the International Economic Review for giving us permission to use copyrighted papers authored and coauthored by W. A. Parts of the book have been used by numerous students at the University of Wisconsin. Finally. Brock dedicates his portion of this book to his wife Joan "who makes his work possible and his life fun" and A.

the important property of stability is introduced in this chapter and then left to be treated in some detail in the following chapters. Introduction The study of ordinary differential equations may be pursued from at least two broadly distinct approaches. differentiability of solutions and stability. First. dependence of solutions on initial data and parameters. we discuss in some detail the following topics: existence and uniqueness of solutions. Hirsch and Smale (1974. Alternatively. putting aside all endeavors to master skillfully a myriad of methods yielding closed form solutions. In this sense.CHAPTER 1 BASIC PROPERTIES OF DIFFERENTIAL EQUATIONS The importance of the ordinary differential equations vis a vis other areas of science lies in its power to motivate. p. unify and give force to those areas. On the one hand. In this chapter we select the latter approach to study the basic properties of ordinary differential equations and their solutions without expositing methods of solution. Actually. with its emphasis on properties of solutions rather than on methods yielding explicit solutions. one may endeavor to learn a large number of methods and techniques by which certain elementary equations can be solved explicitly. the notion of stability and its applications both seek to obtain information about a property of the whole class of solutions. There are at least three reasons justifying our approach in this chapter. ix) 1. More specifically. one may concentrate on obtaining information about the whole class of solutions and their properties. the present chapter's emphasis on properties will prepare the .

and many others during the seventies and early eighties. Birkhoff and Rota (1978). our approach illustrates the modern inclination and interest of mathematicians with preference for abstraction and generality rather than amplification and specification. An element of D is written as (t.f:D^>R".2 Differential equations. Braun (1978. Roxin (1972). Preliminaries Let t be a real number on an open interval / c R and denote by D an open and connected set in Rn+l. An equation of the form is called an ordinary differential equation. this book viewed in its entirety blends in a unique way the theory with the many economic applications of ordinary differential equations. Thus most applications strive for generality and so does our analysis. 1983). Suppose that / is a continuous function with domain the set DC: Rn+l and range the space R". Equation (2. Although in chapters 1 through 4 we concentrate primarily on the theoretical underpinnings of ordinary differential equations.1) may also be written as where x = dx(t)/dt. x) e / x R". If there is a continuously differentiable function 4>(t] defined on some open real interval / such that for t e / we have both that . Arnold (1973). that is. Finally. stability and chaos in dynamic economics reader to view stability and its many applications as a fundamental property of certain ordinary differential equations. 2. almost all economic applications of stability exposited in this book or found in the general literature concentrate on the property of stability which is not dependent upon a specific and explicit solution of a differential equation. An open and connected set is called a domain and is denoted by D. in chapter 2 we supplement our theoretical analysis by showing how certain linear systems can be solved explicitly. During the past three decades a modern approach has emerged which blends the theory of ordinary differential equations with techniques for solving them. This approach was pioneered by Coddington (1961) and Pontryagin (1962) and was followed by Plaat (1971). however. We note. Second. that our approach is not carried to an extreme.

x 0 )e D.1) on 7.1.Basic properties of differential equations 3 and also then we say that (f>(t) is a solution of the differential equation (2. is a function whose graph has the slope f(t. 0(0) for each ?e /. The function / in (2. tel. Let (t0. x ( t ) ) at each point (t. x) = ax so that the vector field depends only on the variable x. x0) is called the initial condition. geometrically. x ) e D and a solution (f>(t). the solutions 0(0 of (2.1) consists of finding an interval / containing t0 and a solution 0(0 of (2. we consider two examples. (2. Geometrically.1) is called a vector field on D because it takes the vector (t. A differential equation of the form in which the right side does not include the independent variable t is called an autonomous or a time independent differential equation.1) prescribes a slope f ( t . This problem is denoted by We say that t0 is the initial point or initial time and x0 the initial value. See also section 6 of chapter 3. An initial value problem for (2.5) means that we are searching for a solution passing through the point (t0.2) or (2. x) e Rn+l to the vector x e R". 0(0) for t e /. The space of the variables x which contains the paths is called the phase space of (2. Integrating (2. Here/(t. Geometrically. Consider the differential equation where a is a real number.4) can be pictured as curves in the x-space with t as a curve parameter.4). In other words. Such a curve is called a path. To illustrate the concepts of a solution to a differential equation and the initial value problem.1) such that 0(t 0 ) = x0. (2. Example 2. The point (t0. In R2.6) we obtain a solution of the form . x0). In other words. By graph we mean the set of all points (t. a solution 0(0 is a curve whose direction at any point t e / coincides with the direction of the vector field. the paths are the projections of the graphs on any hyperplane with t being a constant.

oo) because it is continuously differentiable in this interval . oo). 1). We write the initial value problem as and its solution is stated as The solution in (2. Consider the differential equation Here f(t. Assume that c > 0. assume that t0.9) yields at time t the total value of $1 earning instantaneously compounded interest for t periods. stability and chaos in dynamic economics where c is an arbitrary real number.9) denotes the initial amount invested. so that the differential equation is autonomous.9) is a specific solution passing through the point (0.10) for t G (-c. we need to specify a certain point t0 and the corresponding value x(t0). Its solution in (2. x) = x2. in addition to (2. As an illustration. Then is a solution of (2.10) for t G(-C. We find that -x l = t + c.7) denotes the current value of a sum of capital c with instantaneously compounded interest. Example 2. In this special case. In the special case when t > 0 and a > 0.6).11) is a solution of (2. Observe that (2.6) because For the initial value problem. (2. Note that (2. its solution in (2.10) in the following manner. the initial value problem (2.6) can be used to denote instantaneous interest earned by an x amount of dollars. Thus the 1 in (2.8) specifies both the instantaneous interest earned by x dollars and the initial amount of capital.2.7) is continuously differentiable for t e R and satisfies (2. Assume that x 9=0 and integrate (2.4 Differential equations.0 and x(t0) = x(0) = 1. for c an arbitrary nonzero real constant and 0(0) = -1/c.

However.11) is a solution for f > 0 . consider From the preceding analysis. Assume that f ( t . we conclude this section with a useful lemma. x) is defined and continuous on some domain D for t G / and that . we conclude that is a solution for t e (-1. This observation suggests that existence of a solution is a local property.10) allows us to integrate in order to find a solution to the differential equation. its solution is restricted to a subset of the real line which depends on the value of the constant c. if c = 0.12) to then the solution becomes for te(—oo.-1/t is discontinuous and does not qualify as a solution.11) is a solution of (2. (2. the method usually followed consists of replacing the differential equation by an integral equation. although/(f. in order to establish the existence of solutions. x) in (2. oo) since c = 1. then (2. In general. -c). Therefore. This example illustrates that. In the two examples above. This illustrates that a change in initial values may affect the interval of the existence of a solution. then (2. Note that if c = 0. 4>(t) . the continuity of f(t.11) is not a solution for the differential equation for t G R because <fr(t} = —\/1 is not continuously differentiate on the real line.10) for t£ (-00. If we change the initial value problem in (2.Basic properties of differential equations 5 and also If we assume that c<0. x) = x2 is a continuous function on the whole real line.6) and (2. 1) since now c = — 1. For an example of an initial value problem. Actually at t = 0.

. t E I is equivalent to Volterra's integral equation 3. By integrating (2.1. x(t0)-x0. stability and chaos in dynamic economics (t0. Conversely.5) since x ( t ) is continuously differentiable and satisfies (2. by putting t . that is. all theorems and proofs can be generalized by essentially replacing absolute values by vector norms. From the continuity of f we know that its integral exists. x) results and thus (2. The analysis in this section proceeds in terms of the first order differential equation. we know that by differentiating (2.15) is a solution of the initial value problem in (2. Xo) ED. x).5) on some open interval I including the point t0. we obtain Volterra's integral equation Note that x ( t ) in (2.6 Differential equations. We summarize this analysis in Lemma 2. Existence Consider the first order differential equation where / is a real-valued continuous function on a domain D c R2.15). x) is continuous.15). Furthermore. x=f(t. for any continuously differentiable function x ( t ) of the form (2.t0 we immediately obtain x(t0) = x0.2) between the limits t0 and t. then the initial value problem x-f(t.15) yields the initial value problem. No loss of generality is suffered by treating this simple case. If the function f ( t .

x) is assumed to be continuous on a domain D^R2. . Therefore. f ( t . there is no hope of finding a solution <£(*) satisfying (3. assuming f ( t .2). and second. x) in (3. x) is a Dirichlet function which is not Riemann integrable. it is shown that an approximate solution to equation (3. we must find a theorem which guarantees the existence of a unique function having certain properties in order to qualify as a solution. Thus we establish the existence of a solution without having to explicitly state the solution itself. Note that assuming / to be continuous is an assumption without which we cannot go very far. any general existence theorem must be of a local nature and an existence theorem for the whole space can be obtained only under additional conditions on f. Therefore. We say that <£ has a simple discontinuity at a point if the right and left limits of (f> at this point are finite but not equal. defined by For f ( t . chances are that we will be unable to solve it explicitly. Even when/(t. First. instead of more than one or even infinitely many? To answer these questions.0(0) e D for t € I.Basic properties of differential equations 1 In most applications. it is shown that a sequence of such approximate solutions exists which converges to a solution. as in (3. and specifically in the many economic applications of subsequent chapters. x).1) actually has a solution and how do we know that only one solution exists. it is prudent to ask the questions: how are we to know that (3.1) on an interval / to be a continuous function satisfying: (1) (2) «. In this section we study the question of existence and leave the question of uniqueness for section 5. <£ is continuously differentiable except for a finite set of points S<= / where <j> may have simple discontinuities.1) exists. We define an e-approximate solution </>(?) of the ordinary differential equation x=f(t. An element of the set D is written as (t. Furthermore. for consider the simple case where f ( t . Recall that f(J. x) is not explicitly stated. The analysis of local existence is done in two steps following Coddington and Levinson (1955).1). x) to be continuous does not guarantee the existence of a solution everywhere as the earlier example x = x2 suggested. without actually having to write down this function explicitly. x) for t belonging to an interval /. x) is explicitly stated. We begin with the necessary definitions and theorems of the first step.

Choose a partition for the interval [t0. we infer that / is bounded there.1. the rectangle R is closed and bounded. such that if (t.\t-s\<8and |x-y|< 8. stability and chaos in dynamic economics The first lemma establishes that an e-approximate solution exists for the initial value problem Lemma 3. t0+a] of the form in such a way that An e-approximate solution can now be constructed for the interval [to. x) is continuous on the rectangle R and let e > 0 be given. (s. Then there exists an e-approximate solution (f>(t) on some interval / that satisfies the initial value problem in (3. One can proceed in a similar manner to construct a solution for . depending on e. that is. R is compact and we know that a continuous function on a compact set is actually uniformly continuous. Choose any two positive real numbers a and b and let R be the rectangle: Suppose that f(t. X) E R. t0+ a]. Let and set Furthermore.8 Differential equations.3). From the assumed continuity of f in the rectangle R. y) . Thus given e > 0 there is a 5. Proof.

For each en. The path will lie between the lines in (3. X1) up to its intersection with t — t2. . with slope f ( t 1 .t0 + a. This follows immediately from the construction of (j)n because for t and se[t 0 .Basic properties of differential equations 9 [t0 — a. n — 1. tQ+a]. .8) yields which means that the sequence {<£„} is uniformly bounded. Furthermore. The e. Such a finite number of straight lines is called a polygonal path or an Euler polygon. Let {en}.3). of {</>„}.1 guarantees the existence of an e n -approximate solution. Repeating the same process a finite number of times.6) by definition of a and the fact that |/(f. lemma 3.7) for s = t0 we get since \t-t0\<b/M. Let us move on to the second step towards establishing an existence theorem. limit function . Furthermore. t0]. :c)|<M. Our goal now is to construct a sequence of e-approximate solutions and show that these solutions converge to a solution of (3. t0+a]. By the Ascoli lemma in the appendix. deduce that there is a subsequence {<pnk}. denoted as <£„. x0). From the initial point and the initial value (to. x 1 ).0 as n-»oo. .f 0 | < o such that tf>n(t0) = x0. 2 . k = 1. t0+a]. be a monotonically decreasing sequence of positive real numbers such that e n . for the initial value problem in (3. x0) until this intersects the line t = t1. We wish to conclude that the sequence {</>„} is equicontinuous.1 and we do so immediately. the resultant path <f>(t] will meet the line t . this construction specifies the interval of existence which is \t . construct a straight line with slope f(t0.t0\ < a. . 2 . Note that (3. . where the first line ends. One can verify that 4>(t] is the required e-approximate solution. .3) on | f . Then construct another straight line starting at (t 1 . Thus {</>„} is a sequence of en-approximate solutions that is both equicontinuous and uniformly bounded on a bounded interval [t0-a. or Cauchy polygon.approximate solution consists of a finite number of straight line segments joined end to end and sandwiched between the lines for the interval [t 0 . . This concludes the proof of the lemma. converging uniformly on [t0 —a. Of course. applying (3. t 0 + a ] t o a. we plan to use lemma 3.

it follows that f(t.9) becomes which verifies that 4>(t] is a solution.9). t0+a] we have Therefore.4>nk(t}}^f(t. in the limit (3. We have proved an existence theorem. Since / is uniformly continuous on R and <p n k -»0 as fc-»oo uniformly on [t0-a.10 Differential equations. stability and chaos in dynamic economics denoted by <£. Also. To show that </> is a solution to (3. t0+a]. x) is a con- . Furthermore.3) we let and we write the e^-approximate solution as an integral equation of the form Choose a subsequence {</>nJ of (3.4>(t}} uniformly as k->oo on the same interval. by definition of An(t] for t E [ t 0 — a.) tinuous function on the rectangle R. note that cf> is continuous because each </>„ is continuous. (Cauchy-Peano existence theorem. Theorem 3. where If f ( t .1.

see exercise (4) in section 8. therefore. the method of construction in the proof of theorem 3. therefore. the choice of a converging subsequence is necessary to establish existence of a solution. Note that at t = l. and if ifj(t) = <f>(t) for re /. First. where / contains properly /. 1). 4. If ijs(t) is also a solution of (3. there may exist polygonal paths {(/>„} which diverge everywhere. Second. however. then 4>(t}. It is mathematically interesting and in some applications it becomes important to know if solutions can be continued on an extended interval. Continuation of solutions Theorem 3. Let </>(0. Put differently. it is impossible to extend it to (-00.1 cannot in general give all such solutions of the initial value problem.3). For the analysis in the remainder of this section we make use of left and right limits which we immediately define and indicate by the appropriate notation. with the maximal interval of existence being (—00. in section 6 that if we know the solution is unique. Finally. if more than one solution exists. Below we give a precise meaning to the concepts of a continuation of solutions and extended interval. . theorem 3. then we say that ijs(t) is a continuation of (f>(t) and J is called an extension of /. 1].1. and we explore the conditions under which such a continuation is possible. te I. the existence theorem claims that. only under the stated assumptions a solution exists. tzl is called a maximally continued solution and / is a maximal interval of existence. For an illustration.Basic properties of differential equations 11 then there exists a continuously differentiable solution </>(f) on the interval \t —10\ < a that solves the initial value problem Three clarifications seem appropriate about the last theorem. Its solution <f>(t) = l / ( l — t) is maximally continued.1 assures us that a solution exists for the initial value problem on some interval /.3) on an interval /.14) where x = x2 and x(0) = 1. be a solution of the initial value problem in (3. then the sequence of sn-approximate solutions can be used to construct this solution. To illustrate these concepts consider the initial value problem in (2. If there is no such ifr(t).1 is not helpful in showing how to construct a solution.(f>(t) becomes unbounded and. We will see. Example 4.

6) of the real line. ' e ( a . then 0 can be continued to the left of a. t e ( fl . 0(a + 0)) e D. From (4. b). x). Theorem 4. t e (a. Proof.0(6 — 0)) as an initial condition. x) be continuous in a domain D<^R2 and suppose that f(t. and similarly if (a. Define <f/(t) as follows Then «A(0. 6).1. &)• Actually. x) is bounded on D. then 0 ( w ) — 0(u)-»0 which implies by the Cauchy convergence criterion that A similar argument establishes the existence of 0(a+0). stability and chaos in dynamic economics Consider the finite interval (a. b). Note that if a<u<v< b. then Here M is the bound of f on D. b]> is a continuation of 0(0. we define We are now prepared to state the next theorem.12 Differential equations. 0(6-0))£ D. x(t0) = x0 on an interval (a. For a function </>(0. . 6). To show that 0(6 — 0) exists. Furthermore. then 0 can be continued to the right of b. that is. the continuation can be extended by using (6. we use Volterra's equation for t0 and t e (a. Next.1) as w and u approach b from the left.) Let f(t.0 ) ) e D. then the limits 0(a + 0) and 0 ( 6 — 0 ) exist. Similarly we write t -» b — 0 to mean that t approaches b from the left. we write t -> a + 0 to denote that t approaches a from the right. |f| < M <oo. 0 ( 6 . suppose that (b. (Continuation theorem. For t e (a. If 0(0 is a solution of the initial value problem x = f(t. if (b.

1. *e (a. Having obtained such information about existence of solutions and their continuation.3). it is of practical importance to know whether a solution of the equation is unique. . We want to find all solutions to the initial value problem By inspection we conclude that x ( t ) = Q. the applied researcher still does not know which one of the perhaps infinitely many solutions represents the true behavior of the dynamic model. x) — 3x 2/3 .1 there is a solution x(t). The next example shows that continuity alone is not sufficient to guarantee uniqueness. Example 5. &] and 0(t) satisfies the initial value problem in (3. suppose that x ^ 0 and integrate to conclude that x ( t ) = (t + c)3.Basic properties of differential equations 13 because by theorem 3. here f(t. t e (a. f°r *e [b. 5. Define 0(0 as It is easy to check that 0 ( t ) . by We note that tf>c(t) is a solution of (5. 6 + /3]. 6 + /3] is a continuation of i/KO. To search for other solutions. If uniqueness of the solution is to prevail. /3 >0 such that*(fc) = <M&-0). x) to satisfy some restriction in addition to continuity. Despite its great value. the existence theorem only asserts that a solution exists on some neighborhood of the initial point t0. Let c be a positive number and define <£t.1) for all real t and therefore conclude that this initial value problem has infinitely many solutions generated by arbitrary positive constants c. Suppose that f(t. it is reasonable to expect f(t. Uniqueness In economic applications and more generally in dynamic models described by a differential equation. This concludes the proof. teR is one solution. x) is continuous. The continuation theorem specifies how far a solution can be extended.

x) = 3x2/3 we compute which becomes unbounded as x -> 0. (Uniqueness. Our purpose is to use the added restriction about df/dx to show that 4>(t) = ij/(t) for te[t0. Example 5. Then the initial value problem has a unique solution for te[t0. x) and theorem 3.14 Differential equations. Proof. Upon reflection we conclude that the partial derivative df/dx does not exist at x = 0. we state and prove the next result. It is therefore both necessary for applications and interesting mathematically to uncover restrictions that will guarantee uniqueness of solution. t0+a]. To remove this difficulty and obtain the uniqueness property.1 can help us discover what is wrong with the initial value problem in (5.1). To show uniqueness we assume that (f>(t) and^(f) are two solutions. be continuous on the rec- with a and b positive and let M = max|f(t.t0+a]. Theorem 5. From the continuity of f ( t .1. stability and chaos in dynamic economics The above example illustrates how a fairly simple initial value problem has infinitely many solutions. x)| and a -min(a. using the mean . For f(t. We obtain.) Let/ and df/dx tangle R. Express Denote by L the maximum value of \df/dx\ for t and x in the rectangle R and compute the difference of the two solutions. Dynamic models with nonunique solutions are unacceptable in applications because it is usually difficult to decide which solution represents the correct behavior of the model. b/M).1. we conclude that at least one such solution exists.

5). x} plane and suppose that there exists a positive constant k such that for every (t. x) and (t. Such a condition is called a Lipschitz condition and is defined as follows.To verify this claim. which in turn implies that 10(0-^(01 = 0 because This completes the proof. uniqueness of solutions can be established under a condition that is less restrictive than the existence and continuity of the partial derivative df/dx.2) as with l/(f 0 ) = 0. set and rewrite (5.4) to get In (5. Integrate (5. We claim that this inequality implies that 0(0 = <MO. Actually. x) be defined on a domain D of the (t. U(t0) — Q. y) in D . This implies that U(t) = 0.Basic properties of differential equations 15 value theorem. Let/(f.

7). y) in the rectangle R of (5. x) in the rectangle R in (5. and k in (5. x) = tx2 satisfies a Lipschitz condition. x) and (t. stability and chaos in dynamic economics we then say that / satisfies a Lipschitz condition with respect to x. Consider the initial value problem and let the rectangle R be We wish to show that/( t. This holds because the continuity of Bf/Bx on the closed and bounded rectangle R implies that Bf/8x is bounded.7).9) and using (5. furthermore. by (5. x) satisfies a Lipschitz condition in the specified rectangle R with 2 as a Lipschitz constant.8) that for all (t.1 are sufficient to imply that/( J. we conclude that the hypotheses of theorem 5. given by with a and b positive and. we have which implies by placing absolute values in (5. Example 5. x) is continuous on the rectangle R. x) satisfies a Lipschitz condition. if df/dx exists and is continuous on the rectangle R in (5.16 Differential equations. Therefore.10) for the initial value problem in (5.6) is called the Lipschitz constant. We immediately observe that if f ( t . .11). This follows immediately because Therefore.7). x) satisfies a Lipschitz condition. From the continuity of Bf/dx on the rectangle R. We write for some positive k and (t. then/(f.2. f(t.

3. First.7) and that df/dx exists and is bounded on the same rectangle R with |d//dx|< k. By inspection we see that/(/.Basic properties of differential equations 17 Example 5. x): t\ < 1 and |x < 1}. for each fixed t£ [t0 — a. x) satisfies a Lipschitz condition. the mean value theorem implies that for some u e (x. . then f(t. Second.Q)/dx does not exist for t^O. we must require that D be convex in order to be able to use the mean value theorem. x) is continuous on the rectangle R in (5. x) = 3x 2/3 of the initial value problem in (5. then becomes unbounded as x->O and (5. x) satisfies a Lipschitz condition. >>). x) satisfies a Lipschitz condition. Consider the function on R = {(t. if x > 0.1) does not satisfy a Lipschitz condition on the rectangle R where This is so because.7). it does not necessarily follow that df/dx exists.12) and using the assumption of the boundedness of df/dx.12) lies in D. Such convexity guarantees that the point u in (5. The function f ( t . and if df/dx exists and is continuous on the same rectangle R. Some additional remarks about the concept of the Lipschitz condition seem desirable. x) satisfies a Lipschitz condition. Taking absolute values in (5. k a positive constant. Assuming that f(t. we have already shown that if f(t. with k as the Lipschitz constant. x) satisfies a Lipschitz condition with 1 as a Lipschitz constant because However. we conclude that f(t. t0+a]. Now we note that a Lipschitz condition can be deduced under slightly weaker hypotheses. x) is continuous on the rectangle R in (5. then a direct application of the mean value theorem of differential calculus shows that f(t. Specifically. a rather simple example illustrates that even when a function f(t.6) is not satisfied. df(t. It is worth pointing out that if the rectangle R is replaced by a closed domain D.

the result we are about to state also asserts the uniqueness of the solution which is obtained from the added hypothesis that f(t. The successive approximations. x) is uniformly continuous in x. b/M). This follows immediately from the definition of uniform continuity and (5. Let \ f ( t . that the continuity of f(t. as before.6) implies which says that/(f. then for each t. for . Then for |x — y\<8. also called Picard iterates. x) satisfies a Lipschitz condition. x) is uniformly continuous with respect to x. x) is continuous and satisfies a Lipschitz condition. x) satisfies a Lipschitz condition with respect to its variable x. the Lipschitz condition in (5. x) with respect to t. where for positive a and b. f(t.6) by choosing 8-e/k. however.18 Differential equations. Successive approximations An important existence and uniqueness theorem can be obtained by assuming that f(t. More about the implications of Lipschitz conditions is presented in the sequel. We know. x) on R implies that f(t. although mathematical historians suggest that this method had been used earlier by Liouville and Cauchy in certain special cases. of course. x) is bounded. The continuity of f(t. x)|<M on the rectangle R and. one should remember that uniform_continuity does not imply a Lipschitz condition. if a function f(t. x) is sufficient for the existence of a solution on some interval containing the initial point f0. stability and chaos in dynamic economics Third. Furthermore. The technique used in the proof of the next theorem is called the method of successive approximations and is attributed primarily to Picard (1890) and Lindelof (1894). 6. set a — min(a. Note that nothing is implied about the continuity of f(t. Consider the initial value problem and suppose that / is continuous on the rectangle R. 0 < x < 1 is uniformly continuous but does not satisfy a Lipschitz condition. The function f(x) = \/x.

t0+a]. .1.To do so we first need to show by induction that . If we assume that the same conditions hold for 4>n(t). $. 2 . We establish the theorem for the interval [ 10. This implies that tf)n+l(t) given by (6.1). .) Let f(t.1). 1.2). Since </>o(0 = *o. . t0 + a ]. x).. </> n (0) is defined and continuous on [t0. . n = 0.. it follows that Next. <£o(0 is a constant and satisfies these conditions. then/(f.3) and the boundedness of f ( t . 1. t0+a] as continuous functions. and t e [t0 — a. (Picard-Lindelof existence and uniqueness. ^o+«]. .. 2 .. 2 . exist on [t0. Then the successive approximations (f>n(t). The next theorem establishes that the successive approximations converge uniformly to the unique solution of (6. Furthermore. t0+a] and is continuously differentiable. we establish that </>„(?) converge uniformly on [f 0 . . 1. f 0 +a].1) are defined to be functions <f>0.3) also exists on [t0. from (6. Theorem 6. Inductively. . t0+ a~\. x) be continuous and satisfy a Lipschitz condition on the rectangle R as in (6.Basic properties of differential equations 19 the initial value problem (6. A similar proof holds for [t0-a. this establishes that (f>n(t). x)\ on the rectangle R and set a = min(a. Let M be a bound for \ f ( t . b/ M). given recursively as follows for n = 0. and is continuously differentiable.'t0]. Proof.. . n =0. exist on \t — t0\< a as continuous functions and converge uniformly on this interval to the unique solution tf>(t) of the initial value problem in (6. We first show that every <f>n(t} exists on [t0. .

the series .5) follows immediately from (6.5) which is used to conclude that the terms of the series are majorized by those of the power series for ( M / k ) e f e | r '°.20 Differential equations.6) to get This analysis verifies (6.5) holds.3) for n>\. (6. stability and chaos in dynamic economics For n — 0.8) is uniformly convergent on [t. t0+a]. assume For the last step in the induction note that which is obtained from (6.4). and thus (6. Assume that for n > 1. that is. Therefore. (6. Use both the hypothesis that f(t. x) satisfies a Lipschitz condition with a constant k and the induction assumption in (6.

Consider the initial value problem This initial value problem is equivalent to Volterra's equation .1. It is easy to verify that the limit function </> (t) is a solution since the uniform continuity of f(t. This proves the theorem.1) on [r 0 . 0(0) as n-»oo. where converges uniformly to a continuous function 4>(t) on [t0. Example 6. t0+a] and write An induction similar to (6.3) yields Finally. (f>n(t)) converges uniformly to/(r.Basic properties of differential equations 21 is absolutely and uniformly convergent on [t0. t0+ a]. t0+a~\ and n = 0. that is. let ij/(t) be another solution of (6. x) on the rectangle R implies that/(f.if/(t)\ < 0. we provide two examples.5) shows that for te[t0. <f>(t) = $(t). A term by term integration in (6.2. to prove uniqueness. As HH>OO we know that 4>n(f)-»0(0 uniformly and (6. 1.11) yields \(f>(t) . t0+a] and the partial sum <f>n(t). To show how the process of successive approximations works to produce a solution of the initial value problem.

Next. Let the initial value problem be given by The integral equation that is equivalent to this problem is The first three successive approximations now follow. which is the required solution for all real t. But as n-»oo. Example 6. . we compute <£i(f) to get For </> 2 (0 we have In general.2.22 Differential equations. stability and chaos in dynamic economics and yields <f>0(t) -1. ^ n (r)^e'.

3). A simple illustration is provided by the initial value problem which is only slightly more general than (7. Actually.2) since it incorporates the parameter a. which is the required solution for all real t. 7. we clarified that such a solution (f>(t) was really a function not only of the variable t but also a function of the initial data t0 and x0. We may recall example 2. Assuming a solution existed. Its solution is given by . t0 and x0. we see that (f>(t) is indeed a function of three variables: t. <£ n (f)-»e' / 2 .Basic properties of differential equations 23 In general. we have As n^oo. Here a is a real number. we can go a step further and indicate that a solution may also depend on a parameter.1 and reconsider the initial value problem whose solution is given by Inspecting (7. Dependence on initial data and parameters Earlier sections analyzed the initial value problem and established theorems about the existence and uniqueness of the solution (f>(t).

therefore. t0. t0. This result is presented in the next theorem.7) is a continuous function of t. Then the solution </>(f.2. For a proof see Coddington and Levinson (1955. p) of the initial value problem is a continuous function of t.6) be written as to explicitly show its dependence on t. stability and chaos in dynamic economics and. (Differentiability of the solution. t0. Under rather mild assumptions. we can conclude that d(f>/dx0 exists and is a continuous function. it satisfies a Lipschitz condition with respect to x on D. We consider here only one parameter for simplicity. but (7. p) is continuous in all three arguments on a closed and bounded domain D and second. x0 and a are slightly changed? To answer this question denote the initial value problem by where p indicates that the function/depends on a parameter/?. pp. The practical implication of this result is that small changes in initial data and/or a parameter do not cause large changes in the solution. if we make an additional assumption. The question then arises: how is the solution (f>(t) affected when tQ. Theorem 7. Theorem 7. Let the general solution of (7. The next theorem assures us that small statistical measurement errors do not significantly alter the results of the model and. 23-24).6) can be generalized to denote a parameter vector. that. x) is continuous in both t and x on a closed and bounded domain D . The above theorem establishes the continuity of 4> with respect to its arguments. x0. t0.5) depends not only on t but also on f0. x0 and p. the next theorem establishes that <£ in (7. but due to errors in statistical measurement we are not certain about the values of the initial data t0 and x0. (Continuity of the solution on initial data and a parameter.) Assume first that the function f(t. x0 and a.24 Differential equations. This result is particularly useful in economic applications. Suppose that the dynamic behavior of an economic variable is described by the solution <f>(t). it is clear that <HO in (7.1.) Assume that the function f(t. x. Actually. x0 and p. <f>(t) can be used as a close approximation of the true behavior. x0 and p.

8. Miscellaneous applications and exercises (1) Consider the autonomous differential equation Integrate in the following manner to obtain the function Verify that <£(0 is a solution of (8. consider the initial value problem Verify that this initial value problem has </>(r) = 0 for all real t as a solution and that (2) is also a solution. Then the solution 4>(t.1) and notice that </>(?) = x = 0 is also a solution. that is. d<f>/dx0 exists and is continuous. x0) of the initial value problem is also differentiate with respect to x0. 25-28). Conclude that the continuity of f(t. This application illustrates the nonuniqueness property of this differential equation. For a proof see Coddington and Levinson (1955. pp.Basic properties of differential equations 25 and that df/dx exists and is continuous on D. x) = x1/2 is not sufficient for a unique solution. Next. t0. Consider the nonautonomous differential equation .

-1). the function 4>c is a solution on [0. Conclude that the method of theorem 3. oo). x). 1]. Verify that (3) defines three solutions of equation (8. and in each interval take the indefinite integral of f(t. note that if the construction of section 3 is applied in this example. (-1. the only polygonal path starting at (0. x) = 2/(t2.4) corresponding to the three intervals. . To find a solution to this equation. divide the real line into three intervals. 1]. that is. for any constant real number c such that c e [0. Note that f(t.1 does not give all the solutions of this initial value problem. 1) and (l.1 ] by verifying that.1) has discontinuities at the points t — 1 and t = —l. stability and chaos in dynamic economics Note that f(t. (-00. where Furthermore.26 Differential equations. x) may be written as which simplifies the integration. 0) is c^. (4) Consider the initial value problem Show that there are an infinite number of solutions on [0. Consider the initial value problem and let the rectangle R be given by Show that a solution $(f) exists for this initial value problem for *E[(U].

T] if p is small enough. Show by continuity in parameters that there exists a solution in any interval [0. . Finally. x) is continuous on the closure of some domain D and that (f>(t) is a right hand maximal solution of the initial value problem x =f(t. Let U <=• D be a compact set and suppose that the set is convex. x(t0) = x0 on an interval (a. with c being a positive constant. x) is continuous in a domain D<^Rn+l and let fx denote the matrix of partial derivatives. b).Basic properties of differential equations 27 (5) Assume that f ( t . oo) if p > c. x) satisfies a Lipschitz condition on U. Mathematicians such as Lagrange and Laplace seem to have taken the existence of solutions for granted. Show also that there exists no solution in [0. x). it was not until the beginning of the 19th century that the great French mathematician Cauchy proved for the first time an existence theorem. Verify that one of the following must hold: (6) Show whether the following functions satisfy a Lipschitz condition in the corresponding rectangle R and compute the Lipschitz constant when appropriate: (7) Find the successive approximations and if applicable. (8) (9) 9. the limit function for the following initial value problems: Suppose that f(t. Consider the scalar initial value problem where p denotes a positive parameter. calculate the second approximation <f)2(t) in the sequence of successive approximations. Show that f(t. Suppose that fx exists and is continuous in D. Further remarks and references Although differential equations must have been introduced in one form or another by Newton.

T. Simmons (1972). The order of an ordinary differential equation is the maximal order of differentiation which appears in that equation. derivatives enter into the equation. and not partial. The analysis in section 2 is carried out in terms of a differential equation of the form (2.28 Differential equations. Lefschetz (1962) and Arnold (1983) emphasize the geometric theory. Braun (1978. Reid (1971). Plaat (1971). Plaat (1971) and Roxin (1972) constitute a welcome departure from the classical treatment with its preoccupation on methods for an explicit solution to the modern approach emphasizing the interplay between theory and techniques for solving equations. the reader may consult Coddington (1961). The literature in the field of ordinary differential equations is quite extensive. and Sanchez and Allen (1983). Braun (1978) follows the modern approach with a rather unique blend between theory and realistic applications to real world problems. Chiang (1984) and Takayama (1985). Pontryagin (1962). either at the elementary or the more advanced level. Hale (1969) treats the subject from an advanced point of view and simultaneously devotes considerable space to specific analytical methods which are widely used in certain applications. Some books written primarily for economists interested in the use of differential equations in economic analysis are Benavie (1972). the independent variable in this book is real and is denoted by t to symbolize time. Miller (1987). Hartman (1964) and W. Roxin (1972). Hirsch and Smale (1974) present the dynamical aspects of ordinary differential equations and the relationship between dynamical systems and certain applied areas. do not treat any economic applications. 1983). among others. The books indicated above. consider a system of n ordinary . Gandolfo (1980) and Murata (1977). Birkhoff and Rota (1978). Among these books Coddington (1961). McCann (1982). At an introductory level. Pontryagin (1962). Arnold (1973).2). stability and chaos in dynamic economics In this book we are interested in ordinary differential equations. Martin (1983). The advanced theory of ordinary differential equations is skillfully presented in the classic books of Coddington and Levinson (1955). Differential equations with economic applications are treated among other topics in Intriligator (1971). reproduced here for convenient reference We note that this equation embraces not only the simple ordinary differential equation of the first order but also the nth order equation as well as systems of differential equations. Furthermore. Boyce and Di Prima (1986). The word ordinary refers to the fact that only ordinary. For example. Hirsch and Smale (1974).

. p. Finally.(x t .1). It is of some historical significance to mention that the Cauchy-Peano theorem of section 3 can be traced back to Cauchy in the early part of the 19th century and to Peano (1890) who offered a substantial generalization of Cauchy's work.fn are n real continuous functions defined on some domain DC: Rn+}.2) provided that vector norms replace absolute values whenever the order of the equation is higher than one. f2.1) can be used to represent (9. x) using measure theoretic techniques that originate in Caratheodory (1927). x2. see also Simmons (1972). .. consider the substitution which transforms (9.5) is equivalent to the nth-order equation in (9. can also be expressed by (9. The original ideas on uniqueness may be found in Lipschitz (1876).2).Basic properties of differential equations 29 differential equations written as where n is a positive integer and f1... there is no loss of generality in using (2. If we regard the n dependent variables xt as the coordinates of a single vector variable written as x . Given what was said about (9.. The nth-order equation with one dependent variable of the form where n is a positive integer and / is a real continuous function defined on some domain D <= #"+1.3) into a system of equations This system in (9../2. Detailed historical remarks on various existence theorems are found in Hartman (1964. note that existence can also be established using modern functional analysis techniques as is done in Coppel (1965). f n ) . Also. To see the appropriateness of (9. In conclusion.3). existence theorems have been established under assumptions weaker than the continuity of f ( t .1) in this case. Hale (1969) and several other standard advanced differential equations books.. . our claim is verified. then (9.2). xn) and the n functions f{ as the coordinates of a single vector function / = (/i. 23) and his detailed bibliographical references. • • • .

stability and chaos in dynamic economics The main sources of the exercises in section 8 include Braun (1978). . Pontryagin (1962) and Roxin (1972). Hale (1969). Coddington (1961).30 Differential equations. Coddington and Levinson (1955).

CHAPTER 2 LINEAR DIFFERENTIAL EQUATIONS Mathematical theories in the sciences. must thus be built on the basis of differential equations. This chapter presents an analysis of linear equations. Allen (1938. The computational examples are appropriate illustrations which follow naturally from the general theory applied to the special case of linear systems. R. relations between the derivatives or differentials of varying quantities. It is then the business of the theories to deduce the functional equations between the variables which lie behind the differential equations. Furthermore. Introduction Linear differential equations are an important special case of ordinary differential equations. if they are to be realistic. 412) 1. D. G. some computational techniques are demonstrated to familiarize the reader with a number of available methods for solving linear differential equations. first. to express the general laws whose variations correspond to the given data.e. . As was stated in chapter 1. In this chapter we continue to be guided by the same motivation. to supply some additional results that are needed in stability theory. p. to illustrate the applicability of the general theorems obtained thus far and second. i. we wish to emphasize the general theory of ordinary differential equations rather than accumulate an exhaustive list of computational methods.

b]. b] is usually taken to be [0.1. Then. because linear systems satisfy the Lipschitz condition.1 of chapter 1. Furthermore. .-(0» i = 1. there exists a continuously differentiable unique solution <j>(t) on the entire interval [a. . a solution exists for all t e [a. 2 . Consider the initial value problem for the linear nonhomogeneous system and suppose that A(t) and h(t) are continuous for t e [a. . if ft(f) = 0. where implies that a solution exists on some interval containing t0. In matrix notation (2. b] that solves (2. The system (2. 2 .y(0 and h t ( t ) are continuous real valued functions with i. then (2. . This result is the consequence of the continuation theorem 4. By theorem 3. . 2 . . Linear systems Consider the linear system of n first order differential equations where for t&[a. for linear systems. . Actually. . oo).3). stability and chaos in dynamic economics 2. x is a column vector with x. . j = 1. Note that h(t) is called the forcing function or the input function.2) is called a linear homogeneous system. a. b].1) can be written as where A(t) is an n x n matrix whose elements are the fly(f) functions for i. more can be said than existence on some interval containing t0. n. oo) or (-00. . n.1 of chapter 1 because a linear system is bounded in the rectangle R. b~\. In applications [a. . Let be an initial value problem for the nonhomogeneous linear system. the continuity of A(t) and h ( t ) on the rectangle R. « . and thus.2) is called a linear nonhomogeneous system. b]. Therefore we can state Theorem 2. . a solution can be extended to [a. . elements and h ( t ) is a column vector with elements Ji.32 Differential equations. Namely. if a solution exists it is also unique. j = 1.

^(0 = [</>.1) if each column of <P(t) satisfies (3.. . . A(t) = [aij(t}~\ denotes the n x n matrix in (3. X(t) = [xij(t)'\ denotes an n x n matrix. 2 .1) is an n x n matrix with each column satisfying (3.1). If a matrix solution <P(t) is also nonsingular. . In all above cases i.5) are continuous for re (-00.4) can be written in matrix form as Inspection of (2. with / being the identity n x n matrix. In other words.1. oo).4) of chapter 1. These properties are presented after the notation used is introduced.Linear differential equations 33 Example 2. a fundamental matrix solution of (3. j = 1.5). A principal matrix solution of (3. .1) at initial time t0 is a fundamental matrix solution such that 4>(f 0 ) = /. . it follows from theorem 2. <P(t) = [4>tj(t)] and X(0 = [x«/(0] denote the derivatives of <P(t) and X(t).5) indicates that the 0-solution satisfies (2. These substitutions yield: Thus (2. it is called a fundamental matrix solution.1) and such that det <P(t) T* 0. n./(01 denotes the matrix solution or the fundamental matrix solution of (3. Since the functions of the matrix in (2. Basic results In this section we state some definitions and theorems about the homogeneous system An n x n matrix <P(t) is said to be an n x n matrix solution of (3. The second order homogeneous initial value problem can be written in matrix form by making the substitutions (9.1 that the 0-solution is the only solution for this initial value problem.1). 3.1). Matrix solutions satisfy certain properties.

. Consider the matrix differential equation If 0 is a fundamental matrix solution of (3. b]..2) for *€[«.1).&]. Theorem 3.1).1. Then for te[a. Since ^ is a fundamental solution of (3. Proof.) Suppose that <P is a matrix solution of and let t0E [a. then <£ satisfies (3.1) each of its columns satisfies (3. Then for every te [a.2. . stability and chaos in dynamic economics Theorem 3. Denote the columns of <P by $.34 Differential equations. Proof. (Abel's formula. The generalization is straightforward. Note that . . We prove the theorem for the special case n = 2. < / > „ . . b]. b].

Then <PC is also a fundamental matrix of (3. Theorem 3. Calculate Thus <PC is a matrix solution. There then exists a constant n x n nonsingular matrix C such that . Proof. Suppose that <P(t] and W(t) are two different fundamental matrix solutions for t e [a. Theorem 3.1). This completes the proof. Let 0 be a fundamental matrix of the linear homogeneous system in (3.4. 6] or d e t # ( f ) = 0 for all f e [ a .5. b] is arbitrary.3. This operation results in Therefore. This is an immediate consequence of (3.3) follows.Linear differential equations 35 The last two determinants are not changed if: in the first determinant we subtract a12 times the second row from the first row. furthermore. Theorem 3. either det 0(t)=0 for all re [a. this calculation shows that and upon integration (3. 6] of the linear homogeneous system in (3.3) since t0e[a. b]. which establishes the result.1) and let C be a nonsingular n x n constant matrix.1). in the second determinant we subtract a2\ times the first row from the second row. Proof. Then. Suppose that <P is a matrix solution.

Specifically. However (3.8) and therefore is a matrix solution. 0 is a fundamental matrix solution which implies that det 0(0 ^ 0 for all t e [a. . Consider the linear system which is written in matrix notation as Note that ^ = [S ] and </> 2 -[o ] solve (3. On the other hand. oo). note that From (3. where C is an n x n constant nonsingular matrix. oo). b]. stability and chaos in dynamic economics Proof.9) is not a fundamental matrix solution since det 0 = 0 for all t e (-00. Example 3.7) conclude that 0 ] V = C or that V = 0C. Therefore.8) and det 0 = e' e~' = 1 ^ 0 for all t G (-00. b] and 00 ~J = /.1.6) is needed to show that (d/df)(0 ' #") = (). Taking the time derivative on both sides of 00 ' = / gives from which we conclude that The result in (3.36 Differential equations. By hypothesis. if we let <f>i = [Q] and $2= [e~'L then the matrix is a fundamental matrix solution because each of its columns solves (3. 0"1 exists for all t G [a.

7.Linear differential equations 37 This section concludes with a definition and two additional theorems. oo). If 0 is a fundamental matrix solution of x = A(t)x.1) then <P~l is a fundamental matrix solution of (3. It gives the solution of the nonhomogeneous system and it will be used several times throughout the book. Theorem 3. The next result is very important.6.1) where x and x are column vectors of dimension n. The next theorem establishes that if <P is a fundamental matrix solution of (3. (Variation of constants. then the matrix 0"1 is a fundamental matrix solution of the adjoint equation Proof. Proof. By theorem 3. the adjoint equation is defined to be where y and y are row vectors of the same dimension n.11). Let <£ be a fundamental matrix solution of the homogeneous linear system. Given (3. which shows that 3> } is a solution of (3.4 the general solution of the homogeneous system can be written as . Theorem 3.11).) If 0 is a fundamental matrix solution of the homogeneous linear system x = A(t)x then every solution of the nonhomogeneous system x = A(t)x + h(t) is given by for any real t0E (-00. Differentiate both sides of 3><P l = I to obtain Therefore.

13) In (3. If. We wish to satisfy the nonhomogeneous equation by the same expression as (3. stability and chaos in dynamic economics where c is an arbitrary constant vector. (4. a matrix with n2 numbers and h ( t ) is a continuous n vector function.38 Differential equations. 4. Thus c= <3>~lh or equivalently. to get In order for (3. as and differentiate. then the solution of the nonhomogeneous equation becomes which establishes the theorem. instead.2). this explains the name of the theorem as variation of constants. if we integrate from t0 to t.12) with c now being a variable. Even when n — 2. Rewrite (3.12) but allow c to be a function of t.14) and (2. that is.14) to satisfy the nonhomogeneous equation. using (3. . then the solution (f>(t) will satisfy the initial condition O(t 0 ) = 0.1). This follows from inspection of (3. Linear systems with constant coefficients In this section we discuss the system where A is an n x n constant matrix. it is instructive to analyze linear systems with constant coefficients because of their importance in economic applications and in stability analysis. Although we do not wish to deviate from our methodology which emphasizes basic properties of differential equations.1) is not trivial to solve. it must be the case that <Pc = h.15). the initial condition is <f>(t0) = x0. We first consider the homogeneous case when h ( t ) = 0 in (4.

that is. Proof of theorem 4. we must define eA' to avoid ambiguity. the definition exp(A/) is: The infinite series (4. See Arnold (1973. recall example 2. and so a good guess for the solution of x = Ax would be 4>(t) = QA'C.Linear differential equations 39 To motivate the solution of the homogeneous case in (4.1) with h ( t ) = Q and n = 1. t0 and x0 are finite. oo).1 in chapter 1.1. otherwise <P and </> are not well defined.7) of chapter 1 as 0(0 = c e°". Its solution is given in (2. 94).1. so that eA( is well defined for all square matrices. Let A be an n x n constant matrix.1. with c an arbitrary constant n vector. 97-107) or Hale (1969. pp. and consider the corresponding homogeneous system A fundamental matrix <P for (4.6) converges for every A and t. First note that t. The next theorem establishes that this guess is correct. For an n x n constant matrix A. Theorem 4. This example is the simplest case of (4.1). P. te R = (-00. To show that 3>(t) = eA' is a solution we must show that it satisfies (4. . Second.2) is given by and the solution of the initial value problem is given by Remark 4.2).

for A a constant n x n matrix express where a0.5) is immediate.1 gives (4. This concludes the proof.. that is. stability and chaos in dynamic economics To establish (4. using theorem 3. an_i are functions of t which are determined in the next step. Let h > 0 and compute In the last step the limit is A because by (4. The definition of eAf in (4. . Remark 4. See Coddington and Levinson (1955. the reader should not assume that the solution of x = A(t)x is given by This last equation need not be a solution of x = A(t)x unless A(t) and \\Q A(s) ds commute.5) as the solution of the differential system x = Ax for A being an n x n constant matrix. One method for computing eAt involves the following steps. First.40 Differential equations. alt. if the elements or entries of A(t) are functions of time.7) use the definition of a derivative and (4..2.6).. Theorem 4.6) is not generally useful in computation. Note that they do commute if A is constant or if A(t) is diagonal.6) Furthermore.2 on Abel's formula obtain that Thus <P(t) is fundamental and (4. If A(t) is an n x n nonconstant matrix. p. 76).

. an_l. (4. If A.11) and (4. From (4.Linear differential equations 41 Second. . . The eigenvalues of At = [20' 2°. a 1 } . Compute eAr for A = [20 °2].1. is an eigenvalue of At of multiplicity k. al . Example 4. is an eigenvalue of At of multiplicity 1 then use to solve for a0. The two equations are and solving them for a0 and a1 yields Now that a0 and a1.10) obtain and use (4. define If A.. .2. .9) can be applied to give the final result Example 4.12) to get two equations that will determine a0 and a1. then use with all derivatives in (4. . «„_. k> 1. have been found.12) being evaluated at A.] are given by which means that A = 2f is an eigenvalue of multiplicity 2. Compute eA' for A = [l 4l- . as functions of t. to solve for the appropriate a 0 .

11) to obtain Solving these last two equations obtain Using Euler's relations . Example 4.11).9) to get the final result In examples 4. stability and chaos in dynamic economics The eigenvalues of At are \l-2t (4. one may also use directly the definition in (4.42 Differential equations. Substitute these two eigenvalues into (4. with A being diagonal.1 and 4. Compute eA( for A = [0 1 £]. The two equations are and A2 = —3t and to find a0 and a} use Solving these equations yields Put a0 and a{ in (4.2.6) because A" is also diagonal. The eigenvalues of At = [_° o] are computed from and they are A t = if and A 2 = —if.3.

Linear differential

equations

43

conclude that

Finally,

These three examples illustrate how to compute eAr in three representative cases: distinct roots, repeated foots and complex roots. Using theorem 4.1 we can immediately obtain the solution of the initial value problem (4.4) written as

Furthermore, the solution of the nonhomogeneous linear system with constant coefficients

is obtained from an application of theorem 3.7. The variation of constants theorem yields

or, equivalently,

We illustrate by solving a homogeneous and a nonhomogeneous initial value problem for a constant matrix A in the next examples. Example 4.4. Solve the initial value problem

44

Differential equations, stability and chaos in dynamic economics

This initial value problem can be written in matrix notation as

Using the same procedure as in the last three examples we find that the eigenvalues of At are A, = 2t and A2= -4t. Next, solving

we determine that

Therefore, after making the necessary simplifications, we conclude that

Once eAl is obtained, the remaining is straightforward. Note that t0 = 1 and

Example 4.5.

Solve the nonhomogeneous initial value problem

This problem can be written in matrix form as

Since t0 = 0, eA(t '()) = e'4', which is computed in (4.15). Matrix multiplication of (4.15) times [ \] yields

Linear differential

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45

Next, we need to compute

Integrate (4.18) by integrating each element of the vector to obtain

Matrix multiplication of eAf times (4.19) gives

Combining (4.17) and (4.20), the final result is

Example 4.6. The last example of this section involves a nonhomogeneous initial value problem with complex roots. Consider the problem

and write it in matrix form as

46

Differential

equations, stability and chaos in dynamic economics

Note that A = [_° Q] is the same as in example 4.3. Therefore, using the results of example 4.3, compute for t0= TT to find that

Finally, combining the computations above, conclude that

5. Jordan decomposition This section describes a second method of evaluating eAr and of solving the initial value problem (4.4), that is, x = Ax, x(t0) = x0 for A a constant n x n matrix. This method uses the transformation of A into a Jordan canonical form and plays an important role in the stability analysis of linear systems with constant coefficients. Consider the initial value problem

Linear differential

equations

47

with A being an n x n constant matrix and let P be a real n x n nonsingular matrix. Consider the transformation x = Py or equivalently y = P~lx, and differentiate both sides to obtain Observe that the solution of (5.2) denoted by tf/(t) is given by From the transformation x = Py and (5.3) we conclude that the solution of (5.1) denoted by $(/) is Consider the simplest case before studying the general expression for <f>(t). Assume that the constant n x n matrix A in (5.1) has n distinct eigenvalues denoted by A1, A 2 , . . . , A n , and choose eigenvectors Pi, P2, • • •, Pn so that Pi corresponds to A,, i = 1, 2, . . . , n. Let P denote the matrix having for columns the eigenvectors, that is let P = [p1, . . . , pn]. Then the matrix J = P-1 AP takes the form

Applying the definition of ej' we obtain

Therefore 0(0 of (5.4) can be written as

Example 5.1.

We solve the initial value problem

using the method of this section and apply (5.7).

48

Differential equations, stability and chaos in dynamic economics

The characteristic polynomial of A = [3 Jj] is given by

Solving (5.9) we get two distinct eigenvalues: A, -1 and A2 = -5. Next, we need to choose eigenvectors corresponding to these two eigenvalues. For A, =7 solve

to get that Pn=2p 1 2 which means that ^i = [?] is an eigenvector of A corresponding to Aj =1. Similarly, for A. 2 = -5 solve

to get p2\ = -2p22 which gives the vector p2 = \_ ?]. Now note that P = [ p 1 , P2]= [l i] and compute its inverse to find that P~1 = [_i|]. The solution of (5.8) is given by (5.7), that is,

At this point, we wish to study the general case when the n x n matrix A of (5.1) has repeated eigenvalues. In this case it is not always possible to diagonalize A by using a similarity transformation P. However, we can generate n linearly independent vectors PI, ... ,pn and an n x n matrix P -[p\, • • • ,Pn] which transforms A into the Jordan canonical form with J = P~1AP where

In (5.10), J0 is a diagonal matrix with diagonal elements A1 , . . . , Ak, which are not necessarily distinct, that is,

Linear differential equations

49

and each J1, i = 1,..., s is an n, x n, matrix of the form

Note that in (5.12), \k+i need not be different from \k+j if i^j, and k+nl + n2+- • - + ns - n. Finally observe that the numbers A,, i = 1, 2 , . . . , k + s denote the eigenvalues of A. If A; is a simple eigenvalue, it appears in the block J0. The blocks J0,Jl, . . . ,JS are called Jordan blocks. Next use (5.10) and the power series representation of the exponential of a matrix to deduce for t e R,

and to conclude that the solution of the general initial value problem (5.1) is given by

Remark 5.1. Observe that for any matrix J, in (5.12) we can write where /, is the ni x ni, identity matrix and Ni, is the ni x ni nilpotent matrix, that is,

Since Ak+l/, and Nt commute it follows that

50

Differential equations, stability and chaos in dynamic economics

Repeated multiplication of JV, by itself shows that TVf = 0 for all k>nt. Therefore the series that defines e N/? terminates and from (5.16) we conclude that

Remark 5.2. The Jordan canonical form is a very useful theoretical tool but it is not always easy to apply to a specific matrix if there are multiple eigenvalues. To illustrate possible difficulties, consider the simplest case with n — 2 and suppose that A! = A2 = 5 is a multiple root. Then according to the Jordan canonical form, / could be either [« 5] or [Q 5] and it is unclear without further study which of the two possibilities is correct. For a detailed presentation of a procedure for computing the Jordan canonical form, the reader is referred to Miller and Michel (1982, pp. 84-88) and Hale (1969, pp. 96-100). 6. Miscellaneous applications and exercises (1) Indicate in which intervals the existence and uniqueness theorem 2.1 applies to the matrix differential equation x — A(t)x where:

(2)

In each of the following cases, show that <£(0 satisfies the matrix differential equation X = AX. Indicate in which cases <P(t) is a fundamental matrix:

Further remarks and references Linear differential equations play an important role both because of their intrinsic interest and because of their use in approximating nonlinear equations. Compute eA' for the following matrices: (5) Solve the initial value homogeneous linear system.Linear differential equations 51 (3) (4) Equation (4. (6) Solve the initial value homogeneous linear system. (7) Solve the initial value nonhomogeneous linear system (8) Put in matrix form and solve the second order differential equation 7. the infinite series must converge to a limit.6) defines eA' as an infinite series. Establish that convergence of the series holds. The next chapter on stability methods illustrates the usefulness of linear equations in approximating nonlinear ones. . The intrinsic interest of linear differential equations is demonstrated in this chapter where several theorems describe the nature and properties of solutions. For this definition to make sense.

Plaat (1971) and Roxin (1974). For a proof see Brauer and Nohel (1969. = a + /cu. if A is a constant 2 x 2 matrix. 1969b). 284-289). such as. The purpose of the Jordan canonical form is to make the matrix / = P~1AP as simple as possible by choosing the transformation P appropriately. where P is a constant nonsingular matrix. A brief overview of various methods can be found in Apostol (1969a. 2x2 constant matrix. Hartman (1964). . \2 = a-i(t). Birkhoff and Rota (1978).1. When A is a 2 x 2 matrix it is possible to list all of the canonical forms. Hirsch and Smale (1974). then there exists a nonsingular 2 x 2 matrix P such that P~*AP is one of the following: the last case corresponds to the complex characteristic roots A. Additional methods exist. The interested reader may consult: Roxin (1972). The discussion of linear systems with constant coefficients introduces the reader to only one method for solving such systems. We close this chapter with the following: Remark 7. transforms the system x = Ax into y P~lAPy = Jy. Our analysis in sections 4 and 6 relies heavily on numerous examples found in Bronson (1973). In the special case of the linear system x = Ax when the matrix A is a. Braun (1983). and Sanchez and Allen (1983).52 Differential equations. Bronson (1973). the method of Laplace transforms and Putzer's method. We have also used the comprehensive book of Miller and Michel (1982) and the rather specialized book of Harris and Miles (1980). stability and chaos in dynamic economics The basic bibliographical sources of this chapter are the standard texts of Coddington and Levinson (1955). Hale (1969) and Reid (1971). This classification will be helpful in the analysis of phase portraits for the two dimensional linear systems presented in chapter 3. the transformation x = Py. More specifically. pp. among a few others. Introductory books on ordinary differential equations treat linear equations rather exhaustively.

there is only limited value in writing down a differential equation describing a dynamic economic process. can supply the researcher with insightful understanding about the nature of the economic problem. As emphasized earlier the real usefulness is contained in the variety of properties that differential equations can possess which. upon careful restatement in economic terms. pp. that is. To this. In chapter 1 several properties are exposited and chapters 3 and 4 are devoted to the important property of stability. or the quality of the agreement between the interpreted conclusions of the model and the data of the experimental domain. 138-143) adds the criterion of stability.CHAPTER 3 STABILITY METHODS: AN INTRODUCTION Traditionally. Duhem (1954. Subsequent chapters illustrate the use of stability methods in economic analysis. The analysis proceeds along mathematical lines in order to lay an appropriate methodological foundation. . Abraham and Marsden (1978. Introduction Ordinary differential equations have proven to be a powerful tool in formulating and analyzing continuous time dynamic economic models. p. the philosopherscientists judge the usefulness of a theory by the criterion of adequacy. In general. This book supplies numerous illustrations of the applicability of differential equations to a broad spectrum of economic problems to demonstrate the usefulness of these dynamic methods. the verifiability of the predictions. xix) 1.

T]. Actually. Therefore it is justified to search for a solution by integrating (1. conclude that is a solution on (—00.4) suggests that some form of a boundedness property holds for the solution in its domain [0. is unique.4) describes how close <f>(t. the question can be reformulated: can a restriction be placed on the initial value so that . We ask the question: can a restriction be placed on the initial value x(0) = c> 0 so that Equation (1.2) for x ( t ) and using the initial data in (1. x(0) = 0. 0) = 0 is its solution. T] with T a positive real number and let e > 0 be given. Consider the interval [0. Inspection of the initial value problem x . c). this solution. x) = x2 guarantees the existence of a solution on some appropriate interval. passing through the point (0. stability and chaos in dynamic economics To review the basic properties already presented and to motivate the notion of stability consider the initial value problem The continuity of f ( t .54 Differential equations. Actually (1. to arrive immediately at Solving (1. 0) = 0. Using the 0-solution as a reference. 1/c). the interval (—00. 0. 0>c) m (1-3) is unique and continuous in all arguments in its domain of definition. indicates that (f>(t) = </>(*. Finally continuous dependence with respect to initial data x(0) = c > 0 holds since </>('. 1/c) is the maximal interval and the solution cannot be continued to the right because <fr(\f c) does not exist.1).x2. Moreover.t0.1). 0. Let us go a little further. x0) is to the 0-solution denoted by cf>(t.

5 can be chosen such that This estimate of 8 follows from (1. oo). 8 must approach zero. c) is due to a change in the initial value at t = 0 from 0 to c. 1/c). the answer to the question asked is: for T> 0 and e > 0. The above analysis of the initial problem x . oo) let alone a stable solution. depending on both T and e. 0. While such information is useful we must now ask what happens to the continuous dependence of solutions on initial data as the interval is extended to become [0. Actually. where the latter is being used as a reference point. The analysis of continuous dependence of solutions on initial data on an infinite interval of time is known as stability analysis which describes one more important property of differential equations. The source of change from (f>(t. no solution exists on [0. This computation illustrates the importance of the continuous dependence of solutions on initial data on a finite interval [0.Q.6) we conclude that as the length of the interval [0. 2. oo). oo).3) with c replaced by 8 and t replaced by T. The purpose of the analysis is to determine the consequences that a disturbance in the initial value may have in reference to the equilibrium solution.0. x(0) = c>0 shows how the properties of existence. and the appropriate domain for this variable is [0.5) is motivated by the researcher's interest in knowing the deviation of a solution from its 0-solution. oo). Definitions Consider the differential equation . there is a 8 = 8(e.c) is not uniform with respect to t in the interval [0. uniqueness and continuity with respect to initial data hold on a finite interval [0. but that stability fails to hold on [0. Actually for this initial value problem.0) to (f>(t. T] increases with T^oo. In many applications the independent variable t denotes time. T] which is a subset of (-00.x2. This implies that the continuity of the solution (f>(t. T]. T) > 0.4) holds. for 8 as in (1. such that if c < 8 then (1. both given.Stability methods: An introduction 55 Equation (1.6) it follows that if \c\ < 8 then From (1. For the initial value problem in (1.1). Furthermore.

from (2. tQ. x0) or by </> (/11 0 .2) suggests. x): [0.2). In most. Cj) and (f>(t. ct) is a solution of (2.3) and (2.5) is a definition and that if y = 0 then g(t. in how close a solution remains to the equilibrium . the researcher is not primarily interested in how close two arbitrary solutions remain as f-»oo. by defining that is.Q. x0) or x(t. This is so because. then Combining (2. it is necessary to specify its initial conditions. namely (0. has an infinite number of solutions. uniqueness and continuous dependence of solutions on initial conditions. without loss of generality. c2) both in [0. c2) behave as /H»OO? DO 0(f. y denotes the difference between two solutions.1). Therefore to find a certain solution. The solution of (2. 0. 0.4) gives Observe that the last step in (2. Studying the stability properties of (f>(t. how do the solutions 4>(t. t0. if not all applications.0. or do they drift away from one another as f-»oo. x ) satisfies the conditions ensuring existence.56 Differential equations. by taking time derivatives and rearranging terms. it follows that Since $(f. Consider (2. To once again motivate the intuitive notion of stability. Cj) and (0.1). x0) or x(t\ t0. which is stability. oo) x R". A system of ordinary differential equations such as (2.Q.Q. 0. c2) remain very near to one another as f-»oo. ct) and (f)(t. 0) = 0. c2) is equivalent to studying the stability of y relative to the 0-solution. Cj) relative to (f>(t. XQ) so that This notation is identical to the one used earlier and it suggests that we intend to examine stability with respect to the initial conditions. we ask the question: if c. stability and chaos in dynamic economics with f(t. as (2. which is instability? The mathematical treatment of the problem of stability becomes simpler.1) which at time t0 passes through the initial point x0 is denoted by $ (t. but more importantly. oo) x R" -» R" and assume that the function f ( t .1) and two initial conditions. and c2 are close.

Specifically let and suppose that f(t. denoted by x. By choosing the initial points in a sufficiently small ball we can force the graph of the solution to remain for t > tQ entirely inside a given cylinder of radius e. p. 26). If the equilibrium solution is stable at t0. x 0 )^0 as f-»oo. x0) | -» 0 as t -* oo. The property of the 0-solution being stable can be visualized geometrically by considering the solutions of (2. there exists a 80 = 80( /0) > 0 such that JCD| < 80 implies | </> (t. An equilibrium solution or a trivial solution or a rest point is a solution. Definitions 2.1. Therefore. if 5 0 (f 0 ) by the definition of asymptotic stability can be chosen independent of f0 — 0. the various definitions of stability that follow are made with reference to the 0-equilibrium solution. oo) xR"-> R" satisfies the conditions ensuring existence. The inequality |x0| < 8 defines a ball in the hyperplane t . x0) < e determines a cylinder of radius e about the f-axis.5) to conclude that there is no loss of generality in translating the equilibrium solution x to the 0-solution. then it is also stable at every initial time f. x0)\<rj if t>t0+T(rj). t0. Finally. that satisfies the equation One may repeat the analysis in equations (2. The 0-solution is uniformly asymptotically stable if it is uniformly stable. In other words. > f0. the 0-solution is unstable if it is not stable.Stability methods: An introduction 57 solution. possibly requiring a different value for 8. the 0-solution is asymptotically stable if it is stable and if for every t0>0.1 and Hale (1969. ?0.7) as curves in a (n + 1)dimensional space. tQ. See figure 3. The 0-solution is uniformly stable if it is stable and if 8 can be chosen independently of t0 > 0.t0 and the inequality \(f>(t.1. and also. The 0-solution is called stable in the sense of Liapunov if for every e > 0 and f0 > 0. t0. . Remark 2. uniqueness and continuous dependence on initial data and parameters. This consideration also reveals an important property of the stability for differential equations.2)-(2. x):[0. t0) > 0 such that |x0| < 8 implies that The 0-solution is asymptotically stable in the sense of Liapunov if it is stable and if $(t. if for every r\ >0 there is a 7(17)>0 such that |jc0|<§0 implies |<£(r. there is a 8 = 8(e.

5. this is as example 2. The equation x = x has solutions of the form x ( t ) = x0e' when x0 is an arbitrary constant. the 0-solution is unstable if A > 0. the 0-solution is also uniformly stable. Example 2. asymptotically stable and uniformly asymptotically stable if A < 0. The 0-solution is stable. Example 2.58 Differential equations. The 0-solution is unstable because x0 e' does not approach zero uniformly on [0. The solutions of this equation are x ( t ) = x0.2. Example 2.1. where x0 is an arbitrary constant. Finally. but it is not asymptotically stable. The solutions are of the form x(r) = x 0 e At . The 0-solution is stable and uniformly stable if A = 0. uniformly stable.2. Consider the equation x = 0.1.1 Example 2. Consider with \eR. has a 0-solution that is unstable because neighboring solutions are not defined for all t e [0.3. analyzed in the previous section. oo). This example generalizes the previous two examples. since the solutions are independent of time. stability and chaos in dynamic economics Figure 3. The 0-solution for t>0 is stable. Example 2. Consider the system . oo) as x0 approaches zero.4. The equation x = x2. Furthermore. as example 2.

Example 2. By choosing y0/ x0 small. and x and x are n column vectors. The continuity of A(t) implies the existence and uniqueness of a solution satisfying certain initial data.e. Observe that the ratio of the solution paths is constant. with reference to the 0-solution.1) and therefore all the definitions of stability presented in the preceding section.6. i. 3. .. Modify the previous example to consider with solutions x ( t ) = x0e ' and y(t)=y0e '. the solution paths are circles centered at the origin.Stability methods: An introduction 59 and let x ( t ) and y ( t ) denote the corresponding solutions.7. Observe that This means that. that is. y ( t ) / x ( t ) =y0/Xo = constant. This means that the paths are rays through the origin. the 0-solution is shown to be uniformly asymptotically stable and therefore also uniformly stable. thus the 0-solution is stable. Note that 4>(t] = 0 is an equilibrium solution for (3. Example 2. Stability of linear systems We begin the stability analysis of ordinary differential equations by studying the stability of linear equations of the form assuming that A(t} is an n x n continuous matrix. apply to the homogeneous linear system. for r a positive real constant. For the system the 0-solution is unstable since the solution paths are of the form x ( t ) = x0 e1 and y(t)=y0e'. but it is not asymptotically stable. The circles can be made arbitrarily small by choosing r to be small.

x) we will need to apply Taylor's theorem. x) . which studies the linear approximation of a nonlinear system near the equilibrium. stability and chaos in dynamic economics The stability analysis of the homogeneous linear system is a natural point of departure. and using (3. Taking the time derivative of z ( t ) . x + z) in (3. x + z). Note that we can use Taylor's theorem to write Denote the Jacobian matrix of the first order partials by A(t).4) and the fact that/(f. we have simply reviewed what was stated in the previous section. we wish to approximate /(t. t £ [0. x). x) = 0. oo) be an equilibrium solution of x =f(t. we conclude that . that is. x)/dx = A(t) where Thus.0. Consider x=f(t.3). but also because nonlinear systems can be approximated by linear ones. x) are equivalent to the stability properties of the 0-solution of the system z=f(t.60 Differential equations. This assumption is needed because in linearizing x-f(t.2) it follows immediately that Observe that the solution z ( t ) = 0 is an equilibrium solution of the system z=f(t. let df(t.3) and that the stability properties of the solution x ( f ) of x -f(t. using (3. recalling that f ( t . It is instructive at this point to introduce the concept of linearization. Thus far. Next. x) and set This is a translation of coordinates using x ( t ) as a reference-point and defining z ( t ) = x(t}-x(t). not only because of the relative simplicity and usefulness of such a system. Let x ( t ) . where f:R"+l-*R" has at least two continuous partial derivatives with respect to its variable x. x + z). (3.

then the stability properties of the 0-solution of (3. In summary.2 in the next section. A is the Jacobian of the first order partials evaluated at x. This suggests that the study of the linear homogeneous system should receive our primary attention and will lead us to theorem 4. f ( x ) . If the nonlinear term is small compared to |z|.1) for A(t) being a continuous n x n matrix.Stability methods: An introduction 61 with h(t. This system (3. Using Taylor's theorem as in (3.5) can be deduced from the stability properties of the linear system z = A(t)z. the stability properties of x ( t ) can be studied by analyzing the stability properties of the 0-solution of the nonlinear system in (3. Identically the same procedure of linearization can be applied to the autonomous differential equation x =f(x). Once again the approximate linearized system z = Az can be used to deduce. the stability of x = Ax when A is an n x n constant matrix and then move on to study the stability or instability of the 0-solution .4) write In this last equation.5).0. among other things. x + z) as the sum of a linear system and a residual nonlinear system. given a nonlinear system x=f(t.5) consists of a linear term and a nonlinear term with higher polynomials of z. In the next section we will study. \h(t. z)|/|z|-»0 it may be expected that the 0-solution of (3. Since for fixed /. under certain conditions. 0)/dz = 0. the stability properties of the 0-solution of The next four theorems establish various stability properties of (3. where f: R" -> R" is assumed to have two partial derivatives with respect to x Let x be an equilibrium solution of x =f(x) and suppose that (3. uniformly in t. 0) = 0 and dh(t.5) shows the same stability behavior as the 0-solution of the linear variational system z = A(t)z. x) with an equilibrium solution x ( t ) . and h ( z ) / \ z \ is a continuous function of z which vanishes for z = 0. by using a translation of variables and Taylor's theorem. we can write z — f ( t . that is.2) holds. Therefore.

1-3. Recall from (3. Let f0e R and suppose that \3>(t)\ < K for t> t0. Choose c = <P~l(t0)x(t0) and write the solution as Given e > 0 choose 8 = 8(e.1) are bounded. if |x0| < 5 then \3>(t)<P~l(t0)x0\ < e. there is a 5(e. that is.12) of chapter 2 that any solution </>(0 of the linear homogeneous initial value problem x = A(t)x. Let <£(0 be a fundamental matrix solution of (3. for any e > 0 and t0.1) and let )8 e R. The first theorem below establishes that the 0-solution is stable if and only if the solutions of the linear homogeneous system (3. The various applications of subsequent chapters will make use repeatedly of the linearization method.5 follow Hale (1969. 84-89). The system (3.1. where 4>(0 is a fundamental matrix solution and c is an arbitrary constant vector. Let 0(0 be a fundamental matrix solution of (3. suppose that stability holds. Theorems 3. stability and chaos in dynamic economics of the nonlinear system x = Ax + h ( x ) . Stability follows because if \XQ\ < 8 then Conversely. The system (3.1) is uniformly stable for f0> (3 if and only if there is a positive constant K = K(fi) such that . pp. x(t0) = x0 can be written in the form <f>(t) = <P(t)c.1).62 Differential equations.1) is stable for any t0e R if and only if there is a positive constant K = K(t0) such that Proof. t0) < e/K\<P I(t0)\.2. This means that From this last step obtain Theorem 3. Theorem 3. t0) > 0 such that.

1). Furthermore. Theorem 3.4.1) is uniformly asymptotically stable for t0> B if and only if it is exponentially asymptotically stable. let e > 0 be given and choose 8 = 8(e) < e/K. For (3. we deduce stability. Then. 8 = <5(e). we want to show that there is a T(TJ) > 0 such that l if t0>(3 and t>t0+T(rj).1) is asymptotically stable for any f0e R if and only if Proof. The converse follows in exactly the same way as the converse of theorem 3. that is. it follows that |<£(f)|-»0 and asymptotic stability holds.1. 0 < T 7 < 5 0 .11) holds.1. Let 0(0 be a fundamental matrix solution of (3.13) deduce that . |x 0 |^5 0 .11) and by theorem (3. The system (3. Let <P(t) be a fundamental matrix solution of (3.12) and therefore (3. uniform stability holds. with the remark that assuming uniform stability means that for a given e > 0. The system (3.12) to hold. From (3. Suppose that (3. that is. for any f0€ R there is a positive constant K = X(f 0 ) such that |<f>(f)|< K for f > f0 and by theorem 3.Stability methods: An introduction 63 Proof. Theorem 3.9).1) and let B e R. Suppose that \<P(t)\-*Q as f-»oo. Assume (3. suppose that the 0-solution is uniformly asymptotically stable for t0>fi.3.10). Let x0\ < 1 and note that for any 77 > 0 such that 0 < 17 < K. There is a 5 0 >0 such that for any 77. there are constants K = K(/3)>0 and a = a((3)>0 such that Proof. 8 is independent of tQ.9) follows from (3. This value of T establishes (3. Then for any t0 > (3 if |x0| < 8 it follows that and uniform stability holds. The converse is immediate because |</>(f)| = \0(t)^~l(to)x0\^0 implies (3.11) implies uniform asymptotic stability of the 0-solution of the linear system. choose T=-a \n(rj/K}.2). there exists a T= T ( T ? ) > O such that by definition of uniform asymptotic stability and all f 0 >/3. Conversely. Then (3. since </>(0 = <P(t)(P~l(t0)x0 with |4>(f)|-»0 and ^"'(O^ol a constant.

From theorem 3.Finally. Note that for any t> t0. Finally. So far. Since x = A(t)x is uniformly asymptotically stable for f0> /8 by theorem 3.2.4 there are constants K = K((3) and a = a((3) such that .64 Differential equations. stability and chaos in dynamic economics for t0>p. use (3. Proof.2 in section 4. B e R and suppose that h(t.5. t>t0+T.1) is uniformly asymptotically stable for t0>(B. there is a positive integer k such that /cT< r . In particular for t > /3.15) to compute This computation completes the proof. the stability analysis presented in the last four theorems deals with the homogeneous linear system x = A(t)x of (3. x). x):R x R"^R" is continuous for (t. there is a 8 > 0 such that Then.f 0 < ( f c + l ) ^ .1). both because of its intrinsic importance and its use in linear approximations of the form (3. uniform stability implies that there is a positive constant M = M(/3) such that Let a — -In(i7/5 0 )/r and K = M eaT. Suppose that x — A(t)x in (3. which is a generalization of theorem 4.5). we present a theorem concerning the stability of the perturbed linear system. Also suppose that for any s > 0. Theorem 3. the 0-solution is uniformly asymptotically stable for t0 > )3.

21) to obtain which implies for all values of t > t0 for which |0(0| < & Since a .1. the equation .17). The second-order linear equation has two solutions </>(0 = sin t and 0(0 = cos t and is uniformly stable but not asymptotically stable.18) and (3. Coppel (1965. However.23) implies |0(0| < 8 for all t> t0 provided \4>(t0)\ < d/K.17) is uniformly asymptotically stable. Thus the 0-solution of (3.17) is of the form Choose e so that eK < a and let S be such that (3.Stability methods: An introduction 65 Furthermore.21) in chapter 2. 71) and Hale (1969. p. Example 3.19) to write Make the transformation z(0 = e a '|0(0l and use it to rewrite (3. (3. For t > t0 such that 0(f)| < 5 use (3. p.16) holds.eK > 0 by choice of these constants. recall that from the variation of constants theorem. any solution of the nonhomogeneous linear system (3.24) is a special case of (4. Recall that (3.20) as Apply Gronwall's inequality to (3. 87) report the following example to illustrate that extreme caution must be exercised in treating perturbed linear systems such as (3.

10) of chapter 2. stability and chaos in dynamic economics which can be considered as a perturbation of (3. as section 5 of chapter 2 describes it.24) has two solutions (j>(t) — sin t — t cos t and 4>(t) = cos t+t sin t and is unstable. (iii) The 0-solution is unstable if at least one eigenvalue of A has positive real part. Theorem 4.1) are bounded and then use theorem 3. Then the solution of (4.1) is stable if all eigenvalues of A have nonpositive real parts and if every eigenvalue of A which has a zero real part is a simple zero of the characteristic polynomial of A.1). (i) The 0-solution of (4.1) and that its stability can be given in terms of the eigenvalues of A. Without loss of generality. On the other hand. 4.1) is in Jordan canonical form. Stability of linear systems with constant coefficients Suppose that A is an n x n constant matrix and consider the linear autonomous homogeneous system which is a special case of (3. assume that the matrix A of (4. Note that x — 0 is an equilibrium solution of (4.1).1 of the previous section. To establish stability we need to show that the solutions of (4. .66 Differential equations. Although the theorems presented in the preceding section can be used to study the stability properties of (4. the special nature of A allows us to obtain additional results.1) can be written as where J is as (5.1. (ii) The 0-solution is asymptotically stable if all eigenvalues of A have negative real parts.24) has two solutions (f>(t) = t~l sin t and (f>(t) = t~l cos t and is uniformly asymptotically stable. the equation which can also be considered as a perturbation of (3. Proof.

1) have negative real parts is not only sufficient but also necessary for asymptotic stability as well.1. By construction. all eigenvalues of A have negative real parts. . The second part of the theorem follows immediately since.17) of chapter 2 to also conclude that |ej/'|. s. the 0-solution of (4. . . if an eigenvalue of A is simple. . s. Let \l .k. . By hypothesis Re A . . is not only sufficient but also necessary for stability.\k be the diagonal elements of J0 . if at least one eigenvalue of A has positive real part. . .2) is an increasing solution that becomes unbounded and stability does not hold. (f>(t) in (4. note that Re Ak+i <0.. the condition that all eigenvalues of A in (4. stability implies uniform stability and asymptotic stability implies uniform asymptotic stability. . Therefore |ej°'| is bounded. By theorem 3. Markus and Yamabe (1960) give a classic example showing that the eigenvalues of the matrix A(t) cannot be used to determine the asymptotic behavior of the solutions of x = A(t)x. . the solution . Remark 4. that is. Remark 4.1. it is easy to prove that the condition that all eigenvalues of A in (4.1 states sufficient conditions for stability and asymptotic stability for linear systems with constant coefficients.4 the 0-solution is asymptotically stable. there are positive constants K and a such that \QA('~'O}\< K e~ a( '~' o) . Finally.1). . f > f 0 > 0 . . . Use (5. by hypothesis. it appears in block /0. is bounded. i = 1. However. For linear autonomous homogeneous systems such as (4. 5.1.Stability methods: An introduction 67 Consider separately the Jordan blocks J0 and Jf. Ji.1) is time independent. It is important to emphasize that theorem 4. . . If the eigenvalues of a nonconstant matrix A(t) satisfy the conditions of theorem 4. i = l. Finally.1) is stable. i = 1. . . . where The eigenvalues of A(t) are A1(t) = [-1 +iV?]/4 and A 2 ( f ) = [-1 -i>/7]/4. there exists a positive constant K such that e j( '~' o) < K for t > t0>0. . Because (4. Actually. < 0 for i = l.2. . in this case. . Thus. . one cannot deduce stability for x = A(t)x. i = 1. that is. For the other blocks. stability is equivalent to boundedness and asymptotic stability is equivalent to exponential asymptotic stability. and by theorem 3.1) have nonpositive real parts and every eigenvalue of A that has a zero real part is a simple zero. these two eigenvalues have negative real parts. Furthermore. s. .

Remark 4. Therefore. Since (4. If A is positive definite.1 describes the stability or instability of x = Ax in terms of the eigenvalues of A.Ax where Observe that theorem 4. with A as in (4.4).4). p. one need not transform it into a system x = Ax and compute the eigenvalues .6).6) which are obtained by solving the characteristic equation det(A — A / ) = 0 .4).4. If an n x n matrix A is negative definite. it can be shown by induction (see Miller and Michel (1982.4) is transformed into a system x . Remark 4. if an equation is given in the form of (4. 122)) that the characteristic polynomial of A in (4. Suppose that (4.4) and call the roots of p(\) the characteristic roots or eigenvalues of (4.68 Differential equations. the eigenvalues of A in (4. Consider the nth order homogeneous differential equation with constant coefficients given by and define its characteristic polynomial to be Call p ( A ) = 0 the characteristic equation of (4. This means that.4) and x = Ax. stability and chaos in dynamic economics is given by which is not asymptotically stable since it grows exponentially. then its eigenvalues are negative and the 0-solution of x = Ax is asymptotically stable. are the same as the roots of p(\) — 0 in (4.5) which are obtained by solving the characteristic equation of the nth order equation in (4. then its eigenvalues are positive and the 0-solution of x — Ax is unstable. is exactly the characteristic polynomial p(\) in (4.3. that is det(A-A/).5). are equivalent. in practice.6).

Example 4. In view of remark 4. with /?(A) as in (4. = -l and A2 = 2.A . the 0-solution is asymptotically stable. Therefore.4. Determine the stability or instability of the 0-solution of The roots of the characteristic equation of (4. Example 4. Consider the equation Let x.8) in order to compute the eigenvalues of [2 }]. Therefore.Stability methods: An introduction 69 of A in order to determine stability or instability. Consider the system . because Aj =2i and A 2 = —2i. but not asymptotically stable. Example 4.4.5). The 0-solution of is asymptotically stable because the roots are At = -2+ i and \2Example 4.9) given by A2 + 4 A + 4 = 0 are AI = A2 = -2. One can compute the eigenvalues directly from the characteristic equation of (4.2 = 0. then (4. one can directly compute the roots of the characteristic equation p(\) = 0.2.7) given by A 2 . The 0-solution of -2-i.1 to the characteristic roots. the 0-solution is unstable. Example 4.7) can be written as and the eigenvalues of the matrix are A. note that you need not transform (4.3. and apply theorem 4.1. Rather. = x and x2 = Xj.7) into (4.5. is stable.

This eigenvector is of the form for c an arbitrary constant. Unless we put some restrictions on h(x). To do this we need to determine whether there are 2 linearly independent eigenvectors for the eigenvalue 0.Ax. Since zero is an eigenvalue of multiplicity 2. the eigenvalue zero is not a simple zero and the 0-solution is unstable.. Then (i) if the 0-solution of the linearized system x = Ax is asymptotically stable.10) is also asymptotically stable. Theorem 4. . is it possible to deduce stability or instability for the 0-solution of (4. we only have one linearly independent eigenvector associated with A = 0. This means that. Therefore. although A = 0 is of multiplicity 2. Having analyzed in some detail the system x = Ax in (4.1).16) of theorem 3.5 in the previous section. Therefore assume that h(0) = 0 and also that h(x) is very small compared to x.5. A is an n x n constant matrix. x and x are n column vectors and h(x) is an n column vector with each element being a function of x. Theorem 4.1 states conditions for the stability or instability properties of the 0-solution of x . not much could be said about the stability or instability of the 0-solution of (4. we must determine whether or not it is a simple zero.10) from the stability properties of the 0-solution of the linearized system x = Ax! The next theorem gives an answer to this question by specializing theorem 3.10). Note that this latter assumption is motivated by (3. If /i(0) = 0 then 4>(t) = 0 is an equilibrium solution of (4.2.70 Differential equations. Thus. Recall from the previous section that x = Ax is the approximate or linearized equation for (4. A2 = A3 = 0. then the 0-equilibrium solution of (4.10) and suppose that h(x)/\x\ is a continuous function of x which vanishes for x — 0. Solve the equation for A = 0 to find that p} = 3p2/2 and p3 = -3p2. for which we would like to know its stability properties. stability and chaos in dynamic economics and compute the eigenvalues to find that A! = -7.10). Consider h ( x ) of (4.10). the next logical case to consider is the system In (4.10).

the stability of the 0-solution of (4. system Determine the stability of the 0-solution of the nonlinear Write this system as and note that the nonlinear term satisfies the hypotheses of theorem 4. therefore.10) is unstable. by theorem 4. Proof. Theorem 4. We will present a proof after we have developed the Liapunov method in the next chapter. then the 0-equilibrium solution of (4.10) by writing Observe that the 0-solution is an equilibrium solution and that the nonlinear term [ j^] satisfies the conditions of theorem 4. This cannot be claimed for the 0-solution of (4.6.2 is called the Stability Theorem in the First Approximation or the Principle of Small Oscillations. the 0-solution of x = Ax is stable.5 of the previous section. Thus. should all the eigenvalues of A have a nonpositive real part with at least one eigenvalue having a simple zero real part. Remark 4. Example 4. Recall that if the condition just stated holds.10) have a real part that is nonpositive with at least one eigenvalue of A having a zero real part. The eigenvalues of the matrix are ±1.7. Since the eigenvalues of the linear part are -2 and -3. Consider the system which can be expressed as in (4. Note that this theorem does not tell us what happens when all the eigenvalues of A in (4.1(i).Stability methods: An introduction 71 (ii) if the 0-solution of x = Ax is unstable. the 0-equilibrium solution is asymptotically stable.10). . the 0-solution of this system is unstable.10) cannot be determined from the stability of the 0-solution of the linearized system.5.2. Example 4.2. The first part of this theorem can be proved in a way similar to theorem 3.

From (4. 77). Therefore by part (i) of theorem 4.8. but with solution .12) is stable. stability and chaos in dynamic economics Example 4. the system in (4.12). To study the behavior of the nonlinear part of (4. p.14) has the same linearized system as (4. although the linearized part in (4. On the other hand.13) observe that x\(t} + x\(t)->0 as f-»oo and x2l(t) + xl(t) < c.11) is given by and the eigenvalues are ±i. p.11) given by (4.5 is the following presented in Braun (1978.12) is only stable.72 Differential equations. by slightly modifying the nonlinear part. the system can become unstable. Consider Note that (4. The linearized system of (4.11) is asymptotically stable. Therefore.1. 364) and Hahn (1967. the 0-solution of (4.11) observe that Integrate this last equation to conclude that where c = c\+c\. This illustrates that the nonlinear part of the system can influence the stability of the entire system. system The standard example to illustrate remark 4.

12) is stable. Example 4.15) conclude that every solution *i(0. rewrite (4.2. 1) as a unique equilibrium solution.1. In turn. Consider the two dimensional nonlinear system and note that its equilibrium solution is found by solving the system Solving (4.14) is unstable. Therefore. the 0-solution of (4.16) are determined by the properties of the 0-solution of z — Az as presented in theorem 4. presented in theorems 4. with an equilibrium solution x. to the stability analysis of an arbitrary nonlinear system x = f ( x ) . We close this section by connecting the stability results of x = Ax and x = Ax + h ( x ) .18) yields x = ( x 1 . From (4. despite the fact that the linearized system in (4.2 respectively.17) as The last system can be put in matrix form as . set and using (4. Recall from section 3 that given a system x =/(x).14).1 and 4. Taylor's theorem can be used to transform x -f(x) into the system The stability properties of the equilibrium solution x of x=/(x) are equivalent to the stability properties of the 0-solution of z = Az + h(z) as presented in theorem 4.19). the equilibrium properties of the 0-solution of (4. x2) = (1. such that x^(t) + x l ( t ) ^0.Stability methods: An introduction 73 where c — c]+cl is as before. xi(t) of (4. These ideas are illustrated in the next two examples. approaches infinity in finite time. To study the stability properties of x^t) — 1 and x2(t) = 1.9.

Note that A is the Jacobian of partials evaluated at the equilibrium point. is also asymptotically stable. Set and using (4. as The eigenvalues of the matrix A = [2 Q] are ±2 and therefore the 0-equilibrium solution of z = Az is unstable. we combine the analysis on linearizing given in the previous section with the results of the two theorems in this section to study the stability properties of the equilibrium solutions of the nonlinear system Set Xi = x2 = 0 to compute the equilibrium solutions. the 0-solution is asymptotically stable and the equilibrium solution Xi(t) = 1 and x2(t) = 1.20).20) is the Jacobian of partials of (4. This example is slightly more complicated than the previous one.23) rewrite (4. Again. There are four equilibrium solutions: We first study the equilibrium solution x1(f) = 0. A2 = (-3 -iV3)/2.10. Computing the eigenvalues of the linear part of (4.17) evaluated at the equilibrium solution.20) and that the nonlinear term of (4. by theorem 4.21).20) satisfies the hypotheses of theorem 4. Thus.74 Differential equations. Example 4. in matrix form. stability and chaos in dynamic economics Observe that the 2 x 2 constant matrix in (4. More specifically for (4. obtain that Aj = (-3 + iV5)/2.2 the 0-solution of (4. observe that the Jacobian is .24) is unstable and finally the solution x1(t) = 0 and x 2 ( t ) — 1 is unstable. Note also that the 0-solution is an equilibrium solution for (4.21) as or equivalently.2.1. x 2 ( t ) .

the first three equilibrium solutions in (4. (4. More specifically we can state: Theorem 5. A. can be used to determine the stability or instability of the 0-solution of the nth-order equation (5.2) or by finding the roots of the characteristic polynomial of (5. and particularly remark 4.1 to jc = Ax with A as in (5. Therefore. The Routh-Hurwitz criterion describes a method for determining the stability of the nth order equation (5.22) are unstable and the fourth equilibrium solution is stable.25) becomes respectively with corresponding eigenvalues A = ±2.) Consider the nth-order polynomial p(\) with real coefficients given by .1).2) or the roots of the characteristic polynomial of (5.1) by applying theorem 4.1. Using the substitution (9. = A2 = 2 and A.1) without computing the eigenvalues of A in (5. Routh-Hurwitz criterion This subsection briefly describes the Routh-Hurwitz stability criterion which applies to the nth order linear autonomous homogeneous ordinary differential equation with real coefficients of the form where a 0 ^0.22) in (4. (c) and (d).4 in the previous section. 5. (5. We have already completed case (a) and concluded that it is unstable.1). = A2 = -2. For cases (b).25) we can determine the stability properties of the respective equilibria.4) of chapter 1.1) is equivalent to the system x = Ax where A is given by The foregoing analysis. putting the four equilibrium solutions of (4.Stability methods: An introduction 75 Thus. (Routh-Hurwitz criterion.

(2 • 0) = 6>0. stability and chaos in dynamic economics Assume without loss of generality that a0>0.1. pp.5) is asymptotically stable. Routh used Sturm's method to obtain a simple algorithm and independently Hurwitz in 1895 solved the same problem using a method attributed to Hermite.3) have negative real parts was initially solved by Sturm in 1836. Example 5. A unified theory of this classical problem and its variants is found in Coppel (1965. The autonomous nth-order linear equation or the autonomous linear system .1. In 1877. or Gantmacher (1959). Some results of the preceding analysis can be conveniently summarized as follows. Determine the stability or instability of the 0-solution of Using the Routh-Hurwitz criterion note that a1 = 3>0 and al a2 -a0a3 = (3 • 2) . 142-158). It is of some historical interest to note that the problem of determining how many roots of the polynomial p ( A ) in (5. Thus the real parts of the roots of 2A2 + 3 A +2 = 0 are negative and the 0-solution of (5. Solving 2A2 + 3 A + 2 = 0 directly we verify the result since Aj = (-3 + iV7)/4 and A 2 = (-3-iV7)/4.76 Differential equations. pp. A necessary and sufficient condition that all the roots of p ( A ) = 0 have negative real parts is that the following sequence of n determinants are all positive: The proof of this theorem is very technical and can be found in Hahn (1967. 16-22). Remark 5.

this (xl. a solution 0(0 of an ordinary differential equation is a curve whose direction at any point t coincides with the direction of the vector field. x2) plane is the phase space and (0i(0. The path or orbit of a trajectory is the projection of the trajectory into R". Two dimensional linear systems In section 2 of chapter 1 we indicated that. 6. the phase space of a system takes a kinematic interpretation because to every solution of a system of differential equations corresponds not only a trajectory in the (t.x2) plane. 02(0) is the path or orbit of (6.1) can be pictured as curves in the x space with t acting as a parameter. Thus. we define the trajectory associated with this solution as the set in Rn+l given by {(t.2). more importantly. the motion of a point along an orbit in the x space. The Routh-Hurwitz criterion is an algebraic method of determining asymptotic stability without solving for the roots themselves. x) space. x2) plane. x 2 ) and the trajectory is defined by (t. 0(0): t e I}. We also introduced the notion of the phase space for an autonomous differential equation of the form with f: 7?"^ R". geometrically. This kinematic interpretation represented in the phase space is particularly expressive in studying the stability properties of a system's equilibrium. Xi. if 0(0 is a solution of (6.2) traverses in the (x l . oo) and consider the set of points (0i(0> 02(0) m the (xl. Geometrically. More specifically.Stability methods: An introduction 77 is asymptotically stable if and only if every root of the characteristic polynomial or has a negative real part. The x space of dependent variables is called the phase space or the state space. 01(0. when n = 2.On the other hand. Equivalently the path or orbit (0i(0> 02(0) is the locus of points that the solution of (6. the system has solutions 0(0 = (0i(0. 02(0) which are curves in the three-dimensional space (t. For example.1) on an interval /. 02(0). but. the solutions </>(/) of (6. . if we let t take values in the parameter set [0.

</>2(0) = (sin t.with i. x 2 ).5) with the assumption that det A ^ 0. use the linearization method of sections 3 and 4 and recall that . it is possible to give a fairly complete classification of the various representative phase portraits and to illustrate graphically the stability or instability of the 0-equilibrium.-. as t runs from 0 to oo. stability and chaos in dynamic economics Example 6. x2) phase space. Having made the above preliminary remarks. as t runs from 0 to 2n. equivalently. This means that the origin x = 0 is the only equilibrium point of (6. can be reduced to (6. unique if and only if the determinant of A is different from zero.78 Differential equations.1 of this chapter is equivalent to the system obtained by making the substitutions x = x1. The nonlinear case can also be studied using the insights obtained from the linear case.1. The second-order linear equation studied in example 3. 2 and x is a 2-dimensional column vector with elements x1 and x2. Throughout this section. the solution describes a helix. assume that det A ^ 0. This state is.5). while in the (xl. or. Note that x — 0 is always a state of equilibrium of the system (6.5) by translating the coordinates. the solution (sin /. j = 1.4). furthermore. More precisely. The solution 4>\(t} = sin t. cos t) traces out the unit circle x\ + x\=\.1. we now proceed to study the phase portraits of two dimensional linear systems. The apparently more general case where h is a constant two dimensional vector. Remark 6.. For two dimensional systems of the form of (6. Furthermore. Dynamic economic analysis relies heavily on such a phase analysis.5). the solution (</>i(0. </> 2 (0 = cos t is easily verified to satisfy (6.5). It is no loss of generality to study the phase portraits of the homogeneous system (6. X1. More specifically consider the linear system where A is a 2 x 2 matrix with constant coefficients a. x = x2. if both eigenvalues of A are different from zero. In the three-dimensional space (t. cos t) traces out this circle infinitely many times.

. as a third possibility. some line through the origin. or a reflection in a line through the origin. as was done in chapter 2. Note that the phase portrait of the actual system x = Ax may differ from the one indicated below by the fact that the nonsingular transformation P distorts the portrait. the effect of the transformation P is a distortion resulting from two mutually perpendicular expansions or contractions. and to study the stability properties of its solution. we can also obtain important qualitative information by computing the eigenvalues of A and applying theorem 4.7) in the neighborhood of an equilibrium solution are very similar to the phase portraits of linear systems. we assume that the system has already been transformed into canonical form. phase analysis can be used to evaluate the qualitative properties of the model. as is the case with many economic models. Remark 6. Without solving x = Ax explicitly.7) as where A is a constant matrix and h(y) is very small compared to y. However. In discussing the possible shape of the paths of the system x = Ax. the transformation P does not change the character and essential properties of these portraits. Under these assumptions. the phase portraits of nonlinear systems such as (6. For systems that cannot be solved explicitly. phase analysis supplements the methods described previously for solving such systems explicitly. Having made the above three remarks. we can write (6. Thus.5). It can be shown mathematically that the transformation P amounts to. Remark 6. Phase analysis is an additional tool in the study of stability of differential equations that supplements the theorems already stated. In particular. Or. then by letting y = x — 4>(t}. a rotation about the origin. at most.Stability methods: An introduction 79 if (f>(t) is an equilibrium solution of (6.3. This third method is the subject of the remainder of this section.1 of this chapter. One way would be to solve explicitly this system by computing the exponential of the 2x2 matrix A. This reflection is followed by a stretching of the plane away from. or compression toward. suppose that we wish to study the stability or instability properties of the system x = Ax of (6.7).2. which nevertheless preserves the essential properties of the phase diagrams. and possibly another such stretching in a direction perpendicular to the first line. we can compute the eigenvalues of A and refer to the phase portraits presented below. for two dimensional systems. where A is a 2 x 2 constant matrix such that det A ^ 0.

Similarly. If cl — c2 = 0 then (6.80 Differential equations. (i) Suppose A 2 < A ) < 0 : the origin is a stable tangent node.2(a).y^O as f-»oo. From remark 7. then we obtain the y2 axis with the origin deleted and note that y2-* ±00 as t^> oo. If A 2 < 0 < A 1 ? then the orientation of the trajectories in 3.9) as was indicated in section 7 of chapter 2. stability and chaos in dynamic economics Consider x = Ax of (6. In this case A is similar to the matrix (a) in (6. which means that A does not have a zero eigenvalue and that the origin is the unique equilibrium point. If cl = 0 and c2 7= 0 in (6. recall that A is similar to one of the four matrices Therefore. then the trajectories would be tangent to the y2 axis. See figure 3. the motion along an arbitrary trajectory consists of an asymptotic approach of the point toward the origin. . if cl ^ 0 and c2 = 0 we obtain the _y. The solution of this canonical form is Within this case we can further distinguish three subcases.1 of chapter 2. and A2. If cl — 0 and c2 ^ 0 we obtain the y2 axis with the origin deleted and observe that .5) has two real and distinct eigenvalues A. If A. (ii) Suppose 0 < A. The matrix A has a repeated real eigenvalue A. Case 1. axis with the origin deleted and conclude that y} -» 0 as t -> oo. we distinguish the following cases. The matrix A of (6.5) and recall the assumption that det A ^ 0. See figure 3. < A2: the origin is an unstable tangent node. (iii) Suppose At < 0 < A2: the origin is a saddle point.10). This subcase is similar to subcase l(i) with the orientation of the trajectories being reversed. the trajectory in this case becoming tangent to the y^ axis at the origin.2(b).2(b) would be reversed.10) yields the origin. The motion along the positive y^ semiaxis is directed toward the origin and the motion along the positive y2 semiaxis is directed away from the origin. When c^O and c2 ^ 0 then for any point in the first quadrant. < A 2 < 0 . Case 2. This case can be divided into two subcases.

2 .Stability methods: An introduction 81 Figure 3.

11) obtain immediately that y2/yi = ( c 2 / c } ) . then its canonical form is like (c) of (6.12) given by In this subcase.82 Differential equations. Since y2 = c0 eA' then Integrate this last equation to obtain the solution of (6.9) and the solution of this canonical form is given by From (6. see figure 3. This means that. The final case occurs when the matrix A has complex eigenvalues. stability and chaos in dynamic economics (i) Suppose the matrix A is diagonal.9) and the system can be written as .2(d).9) which means that the system is of the form This system can be solved by integrating the second equation and by substituting this y2 solution in the first equation. If A > 0.2(c). If A < 0. Case 3. if A < 0 the origin is called a stable improper (or degenerate or one-tangent) node and the phase portrait looks like 3. then the motion moves towards the origin and the origin is called a stable (stellar or isotropic) node or stable focus.2(d) with the arrows reversed. then the motion moves away from the origin and the origin is called an unstable node or unstable focus. See figure 3. In this case its canonical form is matrix (d) in (6. provided c^O. in this subcase. since from (6.13) y1 and y2 tend to zero as t H> oo. or equivalently. (ii) If the matrix A is not diagonal. the phase portrait consists of straight lines y2 = (c2f c. Then A is similar to matrix (b) in (6. )yl passing through the origin generated as C1 and c2 take arbitrary values. that y2 = (c2/c^yi. then the origin is an unstable improper node. If A > 0 .

2(f) with the arrows reversed. In this subcase.17). to get Substitute (6.2(e). the phase diagram looks like 3.15) with respect to time to obtain Solve this system of equations for r and 0.14) is now given in polar coordinates by the solution of (6. the origin is called a stable focus or a spiral sink since the trajectories are spirals which approach the origin asymptotically as t -» oo. if w > 0 the arrows point in the clockwise direction and if w < 0 .15) to conclude The last system expresses the velocity of a representative point in the polar coordinates system (r. r-> 0 and the phase portrait looks like 3. (ii) If a = 0.14) in (6. then from (6. Let where r>0 and r-Vy2+y2. Differentiate (6.16) using (6. then either a < 0 or a > 0. 6 is the angular velocity about the origin. When a < 0. The solution of (6.Stability methods: An introduction 83 To study system (6.18) as t -> oo. If a > 0 then the origin is called an unstable focus or a source and the phase diagram is like 3. 0) in terms of r and 0.2(f). The latter is Two subcases arise immediately. then r is a constant. The trajectories are circles centered at the origin.14). Observe that in 3.2(f) we assumed that a > 0 and w < 0. the origin is called a center or a focal point. . it is convenient to introduce polar coordinates. Suppose that a < 0. (i) If a = 0. We can summarize the above results and connect them with previous analysis in two remarks. here r is the rate of change of the distance from the origin. Furthermore.

pp. Stable nodes (tangent. oo). 0) = 0 for t e [0. If the nonlinear part satisfies the conditions of theorem 4. The analysis of sections 3 and 4 can naturally be applied here for the study of the stability properties of an equilibrium solution of a two dimensional nonlinear system x=f(x). 0) = 0 for t e [0. o o ) x R n .2. See Hahn (1967.5. An example of such a system is (4) . See Hale (1969. Finally. 191-194) for the analysis of the following example of an autonomous system of differential equations of second order whose 0-solution is attractive but unstable: (1) (3) Consider the system Analyze the stability properties of the 0-solution of this system. centers are stable but not asymptotically stable. t0.2. but also the insights of phase portraits developed in this section. (2) Consider x=f(t. 7. t1 E [0. suppose that the 0-solution is stable at t0. Saddle points and unstable nodes (tangent. The 0-solution is called attractive if there exists a number 60 = 6o(t 0 ) > 0 such that |x0|< 60 implies |o (t.4. Remark 6.84 Differential equations. oo) x Rn -> Rn and f(t. stability and chaos in dynamic economics Remark 6. x) such that f:[0.> R n and consider x=f(t. then the linearized part can be analyzed using not only theorem 4.x) such that f(t. oo). 27). Miscellaneous applications and exercises Suppose f:[0. stellar and improper) and foci are asymptotically stable. oo). p. stellar and improper) and foci are unstable. Furthermore. Show that the 0-solution is also stable at t1 = t0. x0) | -> 0 as t -> oo. The 0-solution is asymptotically stable if it is stable and attractive. Show that the concepts stable and attractive are independent of each other. There are systems that have no equilibrium solutions.

Show that if the linear system x = Ax is stable then the 0-solution of (7. Further remarks and references The stability and asymptotic stability definitions presented in 2. assume that foo r(t) dt < oo. Furthermore.1) is also stable.Ax when A is as follows: (6) Determine the stability or instability of the 0-solution of: (7) Draw the phase diagram for the linear system (8) and determine the stability or instability of the 0-equilibrium solution. They later reappeared in 1907 . Find all the equilibrium solutions of the nonlinear systems and study their stability properties. (10) Consider the system where A is a constant n x n matrix and for x\ < a. Draw the phase diagram for the linear system (9) and determine the stability or instability of the 0-equilibrium solution.Stability methods: An introduction 85 (5) Determine the stability or instability of the 0-solution of the system x .1 were originally introduced by Liapunov in 1893. 8.

See also Lehnigk (1966). This chapter introduces fundamental notions of stability while chapter 4 presents the main results of Liapunov's method. 3-48). Unlike earlier treatises on differential equations which ignored the topic of stability. Recently. stability is studied with respect to changes in initial data. pp. The original 1893 article and some other important subsequent papers of Liapunov have been translated into English and published as Liapunov (1966). One of the earlier books on stability in English is Bellman (1953). or Rouche et al. see Coppel (1965. His second method does not require the knowledge of solutions themselves and is therefore a method of great generality. The topic of stability has also been treated in the mathematical economics literature. exercises and figure 3. For a brief history on the subject of stability. F. The French translation has been reproduced as Liapunov (1949). even modern introductory books on differential equations familiarize the reader with the main concepts of stability. Brauer and Nohel (1969). some current books such as Hartman (1964) and Hale (1969) give to the topic of stability a great deal of attention. Plaat (1971). (1977. The definitions of uniform stability and uniform asymptotic stability. as well as several other definitions of various forms of stability. Sanchez (1968). Hahn (1982) has surveyed the main stability results of general equilibrium. pp. 1983). Actually. such as: Hale (1969). This second method has found great applicability and is known as Liapunov's direct method. Brauer and Nohel (1969). The various examples. 51-53). Takayama (1985). The analysis of this chapter has benefited greatly from several books. were introduced by several mathematicians during the past forty years. Plaat (1971). stability and chaos in dynamic economics in the French translation of the original article.2 presented follow the exposition of books such as Pontryagin (1962). Roxin (1972). Roxin (1972). Hahn (1963) summarizes many important results. Braun (1978) and Hirsch and Smale (1974). One could also study stability with respect to changes in the vector field f ( t . and Miller and Michel (1982). and Hahn (1967) remains one of the standard references on the topic of stability. Coddington and Levinson (1955). We emphasize once again that in this book. In his 1893 paper Liapunov studied stability using two distinct methods.86 Differential equations. x): this is called structural stability and . originally published in Russian. Coppel (1965). Such examples include: Pontryagin (1962). Arnold (1973) and Braun (1978. Murata (1977) and Gandolfo (1980) are the standard references. The first method presupposes a known explicit solution and is only applicable to some special cases.

Finally. pp. chapter 16). 433448) and for proofs see Coddington and Levinson (1955. Kocak (1986) offers a manual and a diskette to help readers learn how to use a program called PHASER which runs on personal computers. pp. In nontechnical language the Poincare-Bendixson Theory describes the behavior of a bounded trajectory and shows that as t -> oo such a trajectory either tends to an equilibrium point or spirals onto a simple closed curve. R. The original ideas may be found in Bendixson (1901). For those interested in the study of differential equations through computer experiments. 242-249) or Gandolfo (1980. Schinasi (1982) gives an application of the Poincare-Bendixson theory in economics. most introductory books on differential equations devote several pages to the Poincare-Bendixson Theory which describes the geometry of phase portraits in two dimensions and could be used to supplement section 6. . chapter 16) or Peixoto (1962). Thom (1975) has applied structural stability to the natural and biological sciences and Fuchs (1975) uses structural stability in economics.Stability methods: An introduction 87 for an introductory survey the reader is referred to Hirsch and Smale (1974. For general details see Plaat (1971.

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for deciding the stability or instability of an equilibrium point of a differential equation. Liapunov gave some very simple geometric theorems . asymptotic stability and instability for initial values in a small neighborhood of the 0-equilibrium solution. the theorems of the Liapunov approach can be classified as local and as global results. A further useful distinction is between autonomous and non-autonomous systems. p. primarily for linear and linearized systems. . The idea is a generalization of the concept of energy and its power and usefulness lie in the fact that the decision is made by investigating the differential equation itself and not by finding solutions of the differential equation. This distinction has already been made on several earlier occasions. we concentrate essentially on the autonomous case because . While the previous chapter presented some elementary stability methods. Local results report on stability. The global results refer to asymptotic stability at large for initial values in the whole of Rn. Preliminaries In this chapter we continue to investigate the stability properties of ordinary differential equations. this chapter exposits the Liapunov approach and some other recently developed mathematical methods that have been found useful by economists. 291) 1. . Hale (1969. In this chapter. For methodological clarity.CHAPTER 4 ADVANCED STABILITY METHODS In his famous memoir.

The first method consisted of expanding analytic solutions in series and studying their stability. In other words.1. The time derivative of such a function can be used to infer whether the distance between a solution and the 0-equilibrium solution decreases or increases and consequently whether stability or instability holds.V(x) is positive definite. A scalar function V(x) is negative semidefinite on D if — V(x) is positive semidefinite.> R n .90 Differential equations. for mathematical completeness and exposure of theoretical economists to new methods. consider an autonomous differential equation x = f ( x ) . Also assume that the 0-solution is the only equilibrium solution in D. f : D < R n . This function measures a distance between a given solution and the 0-equilibrium solution. Finally. The second method does not require any knowledge of the solutions themselves but it does rely heavily on the existence of a certain function. stability and chaos in dynamic economics most economic applications deal with autonomous differential equations. also called Liapunov's direct method. A continuous scalar function V(x) is indefinite if V(0) = 0 and in every neighborhood of the origin it takes both positive and negative values. Definitions 1.1. However. we make the next definitions that allow us to embark on the details of Liapunov's second method. Liapunov in his original 1893 article proposed two distinct methods for studying stability. Further assume that the open set D contains the origin and that f(0) = 0. V(x) > 0 for x = 0 and V(0) = 0. The function . assume that f is continuously differentiable in an open set D. a scalar function V(x) is negative definite if . To begin with. Example 1. For future reference we write Recall from chapter 1. that assuming / to be continuously differentiable implies that a unique solution exists through any initial value. V(x) is positive definite if it is positive semidefinite with V(0) = 0 and V(x) > 0 for x = 0. Let D be an open subset of Rn containing the origin. With this intuitive motivation. A scalar function V(x) is positive definite on D if it is continuous on D. several theorems are also stated for the nonautonomous case. A scalar function V(x):D->R is positive semidefinite on D<Rn if it is continuous on D and V(x) > 0 for x e D.

Let us take one step further. for a positive definite V(x) on D. Thus. such that any continuous curve from the origin to the boundary of U. . x2) = constant. For f as in (1. we assume not only that V(x) is continuous on D but also that its partial derivatives of all arguments exist and are continuous themselves on D. x 0 )= o(t) = x ( t ) be a solution of x = f ( x ) in (1. it has a gradient usually denoted by Vx or V V(x) or grad V.Advanced stability methods 91 is positive definite on R3 and positive semidefinite on R4. take n=2 and assume that V(x l .1) define If we let o(t. x2) is positive definite. Assume that V(x) is positive definite on D < R n and further assume that V(x) is continuously differentiable.1). For concreteness. Recall that such a gradient is defined as a vector valued function of partial derivatives given by A fundamental concept in Liapunov's method is the time derivative of V(x) along solutions of the autonomous differential equation. there is a neighborhood U of the origin x — 0. then use of the chain rule in calculus yields. It is helpful to describe the geometric meaning of the function V(x). denoted by d U. must intersect the level curve described by the set {x: V(x) = c} for 0< c< k. it becomes zero. t0. Since V(x) has continuous partials. The function is positive definite inside the unit circle but indefinite on R2 because it becomes negative for x outside the unit circle. with the closure of U contained in D and a constant k > 0. The function V(x(t)) is called the trajectory derivative or the time derivative along a solution x(t). The curves V(x1. The function is positive semidefinite on R3 because for x1 — 0 and x2 = —x3 = 0. In other words. represent a set of ovals or level curves surrounding the origin.

x e D with a negative semidefinite V(x) is usually called a Liapunov function. To supplement this geometric meaning for n = 2. a positive definite function V(x). We have already given an intuitive geometric meaning of a positive definite V(x).1 . V(x1. . Actually. x2 in D. x2) < 0 for xl. x2) > 0 for x1. x2 in a neighborhood D of the origin and furthermore that V(x1. . put in plain English. be a decreasing sequence of real numbers approaching 0 such that the level Figure 4. y2. How can this help us with issues of the stability of the 0-equilibrium of x = f ( x ) ? To answer this question. The surface y = V(xl.92 Differential equations. x2) has the general shape of a parabolic mirror pointing upward or. stability and chaos in dynamic economics The functions V(x) and V(x) play an important role in Liapunov theory. suppose that V(0) = 0. of a cup on a table. . let y1.

292-299) and LaSalle and Lefschetz (1961. pp. pp.x 0 ) = x ( t ) be a solution of x = f ( x ) in (1. . where D is an open set containing the origin. Define V0 = min V(x). Theorem 2. Furthermore let o(t. 2. . Then if |x0|<6. Proof. as t -» oo. t0. Our analysis follows Hale (1969. since the motion in the phase space along the curve F is toward the origin. x 2 ). in the special case of n = 2.1. For autonomous systems. shrink towards the origin. x0) of x = f ( x ) satisfies | x ( t . y2 = V(x1. We need to show that given an e > 0 and t0 > 0. x 0 )| < e for all t > 0. (Liapunov stability for autonomous systems. t0. 37-40). |x| = E (2. Then the 0-solution of x =/(x) in (1. the hypothesis that V(x)<0 implies that From (2.1) is stable. x 2 ). let {x: |x| < e}c D < Rn. are crossed by the continuous curve F from the exterior and toward the interior. recall that stability of the 0-solution implies. . Therefore. y2 = V(x1. a continuous curve F from the origin to the boundary of a set U containing the origin with U c= D. t0. Since we assume that V(o(t. . exists because V(0) = 0 and V(x) is continuous on D. there is a 5 > 0 such that for |x0|<6 the solution x(t. that is. t0. Local stability and instability for autonomous systems This section collects several local stability and instability theorems for autonomous systems that make the intuitive ideas presented above more precise. .2) conclude that | x ( t . V(x(t)) decreases monotonically and that the level curves y1 = V(x1. . See figure 4. Let e > 0 be given such that the closed ball of radius e is contained in D. Such a curve may represent the path or orbit of the solution x ( t ) in the phase space as t -» oo. x2).) Suppose that there is a continuously differentiable positive definite function V(x):D c= Rn -> R. x 0 )) = V(x(t))<0 for x = 0 and xED it follows that as t -» oo. x 0 )| <e for t >0 and thus the 0-solution is stable. .1) and consider. 0 < 8 < e. .1. we conclude that the 0-equilibrium solution is asymptotically stable. automatically uniform stability and asymptotic stability implies uniform asymptotic stability.1) Choose 8 > 0 such that if |x| < 6 then V(x) < V0. and V(x) is negative semidefinite for x e D. Such a 5.Advanced stability methods 93 curves. y1 — V(x1. t 0 . x2).

x0)|->0 as t-> oo. f ( 0 ) = 0. t0. Then the 0-solution of x=f(x) in (1.1. with D an open set containing the origin. In other words.2. t0. we suppose that V(x(t. If it is true that V ( x ( t ) ) . Consider (3 defined by which upon integration. yields written simply as for all t > 0. x0)| < e for all t > 0. . The key notion of a Liapunov function is that V. Remark 2. Suppose that V(x(t.94 Differential equations. by being positive definite. t0. stability and chaos in dynamic economics Theorem 2. x 0 )) -» V0> 0 as t -> oo. is a generalized measurement of the distance between a solution and the 0-solution. The ingenuity of A. Proof.5) is a contradiction of the hypothesis that V is positive definite because as t becomes large and is multiplied by B < 0 it forces V(x(t))<0. Assume the hypothesis that V is negative definite on D. Observe that (2. Liapunov cannot be overemphasized. without solving such a system. then there is some a > 0 such that for |x| < a it follows that V(x) < V0. The stability of the 0-solution follows from the previous theorem so that for |x0| < 8 we have that | x ( t . x0)) does not approach zero as t-> oo and hope to get a contradiction. The previous two theorems demonstrate the usefulness of Liapunov functions in determining the stability of an autonomous system. x O ) | . The existence of a Liapunov function is sufficient for establishing the stability of the 0-solution of x = f ( x ) . Therefore V0 = 0 and |x(t.) Suppose that there is a continuously differentiable positive definite function V(x): D< Rn -> R.> V0> 0 as t-> oo. M. t0. x 0 ))-»0 as t-» oo. The voluminous literature on this subject is partial evidence of the significance of his method. V by being either negative semidefinite or negative definite. Here. t0. and let V(x) be negative definite for x E D. t0. Furthermore.1) is asymptotically stable. with respect to t. tells us whether such a distance does not increase or whether it strictly decreases as time increases. we need to show that |x(t.» 0 as t-> oo or equivalently that V(x(t. (Liapunov asymptotic stability for autonomous systems.

3) instead of (2. Given 5>0. The topic is addressed later in this section. connected set that contains the origin. that V and V are positive definite on D n U. From the hypothesis we infer that V(x 0 )>0.Advanced stability methods 95 Assuming the existence of a Liapunov function makes the stability and asymptotic stability proofs simple. Proof. The examples in this chapter and the applications in subsequent chapters will familiarize the reader with several useful techniques. partially. a methodology is available to guide us in constructing a Liapunov function. Ultimately. in most of the applications. 293). Then the 0-solution of x=f(x) in (1. Let Observe that a > 0 since d U n S is empty. by having seen many Liapunov functions corresponding to specific systems. t0. Liapunov theory remains valid by assuming that V is only continuous in D instead of continuously differentiable provided that V is defined for x0 e D as Since. the critical question to be answered is how to construct such Liapunov functions. and also that V — 0 on d U n D. this book uses the definition of V in (1.3.1) is unstable. p.2. x0) be a solution which implies that V(x(t))>a for x(t)eS. Let x(t) = x(t. that is on that part of the boundary of U inside D. See Hale (1969. In some special cases. we conclude that . Suppose that V is continuously differentiable on D. such as for linear systems. Theorem 2. constructing Liapunov functions is in general a rare skill that is acquired. (Liapunov instability for autonomous systems. Remark 2. V is continuously differentiable.6). Integrating. Define Note that S is closed and bounded which makes it compact. Let U be an open set which contains in its closure the 0-equilibrium solution. choose x 0 eD 0 nU with 0<|x 0 |<6. However.) Let D <= Rn be an open. Choose an open and bounded set D0 containing the origin such that D0=D.

Since D 0 nU is compact and V is continuous. Therefore.1. stability and chaos in dynamic economics Figure 4.96 Differential equations. Since X0 is chosen arbitrarily close to the origin. since V is continuous and S is compact. However. Some independent possibilities include: . 0) = 0. To discuss the stability properties of this system let and compute To determine the stability properties of the 0-solution we need to make an assumption about f(x. there is a ft such that x ( t ) leaves D0n U at time t1. See figure 4. we conclude that the 0-solution is unstable because no matter how close to the origin we start. But x(t1) cannot be on the part of the boundary of U inside D because by hypothesis V = 0 there. Let X(t1) E d(D 0 nU). solutions escape a bounded set D0 in finite time. V cannot become unbounded for x e 5. Thus x ( t l ) is on the boundary of D0 inside U.2. Consider the system with f(0. Example 2.2 This last equation says that as t increases V(x(t)) eventually becomes unbounded. y). x ( t ) must eventually leave D0n U.

This example illustrates the generality of the Liapunov method in deciding stability or instability.8 of chapter 3 where f(x. V is negative semidefinite on D and by theorem 2. assume that f(x. A special case is reported in example 4. y) = x2 + y2 is positive definite.11). Then. y) = 0 on D. conclude by theorem 2. 6) of zero. In example 4. For example.10) that the nonlinear part f ( x . the 0-solution is stable. For x E (-6. assume that g'(0)>0. then this example reduces to example 2.Advanced stability methods 97 First. However. y) is positive semidefinite on an open neighborhood D c R2 of the origin.5 of chapter 3. the eigenvalues of the linearization of (2. assume that g'(0)<0. stability cannot be decided by examining only the linear system because the nonlinearities of the system may play a critical role in determining the stability of the whole system. It is clear from (2.8) can be computed to be ±i from which we can only conclude the stability of the 0-solution of the linear system. Then V is positive definite on D. in general. The nonlinear system in (2. .1. y) is positive definite on D. y) is negative definite in a neighborhood D of the origin. It is shown there that with f(x.3 that the 0-solution is unstable. To apply theorem 2.8) cannot be studied conclusively by computing the eigenvalues of its linearization. 6) and g ( x ) > 0 for x E (-6. Using (2. The analysis of this chapter illustrates the generality of the Liapunov approach. Consider the autonomous system and make appropriate assumptions to study the stability properties of (2. V is negative definite and by theorem 2.2. V is positive definite. Second. y) = 0 on D. y ) plays a critical role. suppose that f(x. that the 0-solution is stable but it is not asymptotically stable.0). Example 2. Second. the 0-solution need not be asymptotically stable. More specifically. Third. if f(x. First.12) and the assumption that g'(0)>0. y) is positive semidefinite. the three cases discussed here illustrate that.2 the 0-solution is asymptotically stable. Note that if f ( x . assume that f(x. Let g(x) be a continuously differentiable real valued function on a neighborhood D = ( — 6.3 let U = R2 and conclude that the 0-solution is unstable.2 that the 0-solution is asymptotically stable.8 it is shown that the 0-solution is asymptotically stable using a specialized analysis. Let Since g'(0) < 0 and g(0) = 0 it follows that g is decreasing through the origin with g(x)<0 for x E (0. 6) observe that V(x) is positive definite and V(x) is negative definite and conclude from theorem 2.

13) is stable. From the homogeneity assumption obtain (note that the variable t is dropped) where k = K/L is the capital-labor ratio. denoted by K. L). and saving is defined to be sF(K. all at time t. stability and chaos in dynamic economics Example 2.14) where Y(t) denotes units of output. Assume that f(0) = 0. Consider a production function Y(t) = F(K(t). lim k->0 + f'(k) = oo.14) is multiplied by a positive constant A. K ( t ) denotes units of capital stock and L(t) denotes units of labor force.4. Let Then Therefore by theorem 2. In this example we establish the stability of the equilibrium solution of the neoclassical economic growth model. Equilibrium requires that investment must equal saving.3.98 Differential equations. If this property is satisfied.f"(k) < 0. (2. .14) is called homogeneous of degree 1. with 0 < s < l . stability issues of economic growth are presented in greater detail. Example 2. the 0-solution of (2. lim k->oo f'(k) = 0. that is. Consider the second-order equation which can be rewritten in system form as Assume that xf(x) > 0 for x = 0 and f(0) = 0.14) satisfies the property: if each of the independent variables in (2. (2.L(t)).f'(k)> 0. It is assumed that (2.1. Investment is defined to be the time derivative of K(t). then the dependent variable is also multiplied by the same constant. In a later chapter.

Solow (1956) used equations (2. V(x) is negative definite because k * f ' ( k * ) < f ( k * ) . This concludes example 2. Also.Advanced stability methods 99 Assume that labor grows exponentially given by Under the above differentiability and concavity assumptions about (2.18) has been the subject of much research in economics. The next logical step in the study of the Liapunov method is the analysis of the linear autonomous system with constant coefficients.18) to obtain a unique positive equilibrium solution. Compute: In (2.15) through (2. By theorem 2. Consider the system . A useful reference on this subject is the book of Burmeister and Dobell (1970).14). Actually k* is asymptotically stable for k>0. The importance of this system has already been emphasized in the previous two chapters.20) note that the inequality follows from the strict concavity property of f(k). Denote the equilibrium solution by k* and use the Liapunov function where x = k .4.17) to derive the one-sector neoclassical differential equation of economic growth for the certainty case: Equation (2.k*. The purpose of revisiting this topic is to illustrate a method for constructing a Liapunov function for an autonomous linear system with constant coefficients.2 the k*-equilibrium solution is asymptotically stable for k in a neighborhood of k*. Assume that and set k = 0 in (2.

22) is positive definite and V(x) in (2.25). Proof. Therefore.100 Differential equations. Suppose A in (2.21) is a real n x n constant matrix such that det A = 0. stability and chaos in dynamic economics with A being an n x n constant matrix. Lemma 2. by hypothesis. Let C be a positive definite matrix and suppose that B is a positive definite solution of (2.2 and 2. Set where B is some n x n constant positive definite matrix and compute its time derivative The next lemma gives necessary and sufficient conditions for V(x) to be a Liapunov function. 2. B is positive definite because by hypothesis C is positive definite.1. from its definition in (2. so that for any vector y € Rn. the 0-solution of x = Ax is asymptotically stable and from remark 4. by theorem 2. t > 0.1 of chapter 3 we conclude that the eigenvalues of the matrix A have negative real parts. Also. suppose that the eigenvalues of A have negative real parts and let C be a given positive definite matrix.3 we need a Liapunov function. Then V(x) in (2. y = 0.2. A has negative real parts there are positive constants K and a such that |e At | < K e-at.25) converges and thus B is well defined.23) is negative definite. The matrix equation has a positive definite solution B for every positive definite matrix C if and only if all the eigenvalues of the matrix A have negative real parts. To apply theorems 2.1.24). Conversely. Thus the integral in (2. . Recall that AT denotes the transpose of A and define Since.

B in (2.1 of chapter 3. for instance. To apply the Liapunov approach let C = I. consider the Routh-Hurwitz criterion of theorem 5. Therefore. In this example we reviewed two methods exposited in chapter 3 and the Liapunov method.5.Advanced stability methods 101 Finally. for B as above V(x) = xTBx > 0 and V(x) = -xrCx < 0 for x e R2 and x = 0 and by theorem 2. Since a1 = 2>0 and a 1 a 2 -a 0 a 3 . let C be the identity matrix and use (2. Next.24) to solve for B = [b11 b12] Carrying out the two multiplications and the addition in the above equation we get four equations to solve for four unknowns. Consider the linear system which represents the second order homogeneous differential equation To study the stability properties of the 0-solution we have various techniques available. by theorem 4.1 of chapter 3. Note that since I is symmetric. the eigenvalues of the matrix in (2. Consider. B satisfies (2. that is.26).2 the 0-solution is asymptotically stable. The purpose of presenting all three methods is to show that the Liapunov approach is more complicated when applied to linear systems with constant coefficients than either the eigenvalue method or the . = (2 • 1)-(1 • 0) = 2>0 we also conclude that the 0-solution is asymptotically stable. Example 2. They are At = A2 = —1. The solution is Therefore.27) is also symmetric. the 0-solution is asymptotically stable.24) since This completes the proof.

the following analysis is more than an illustration.28) is the same as (4.29) is negative definite we need the following lemma.21).2.28) has continuous first derivatives in Rn with h(0)=0 and 6k(0)/dx = 0.1 to the equation Recall that (2. Suppose that h(x) in (2.2 of the previous chapter. Put V(x) = xTBx and compute V(x) for (2. Then. using the definition in (1. it is a proof for theorem 4. The advantage of the Liapunov method becomes evident when.102 Differential equations. definite matrix B such that ATB + BA = — I. Since Vp(x) is positive definite k > 0 and since Vp(x) is homogeneous of degree p. symmetric. Then is positive definite in a neighborhood of the origin. Lemma 2. instead of considering a linear system as (2.10) of the previous chapter. for any x = 0.28).3) of the previous section To determine that V(x) in (2. Our immediate purpose now is to illustrate the usefulness of the Liapunov method in determining the stability properties of a linearized system such as (2. . stability and chaos in dynamic economics Routh-Hurwitz criterion. From the hypothesis about W(x) for any given e > 0. there is a 6 ( e ) > 0 such that if |x|< 6(e) we have | W ( x ) | < e|x| p .2 is pending. Proof. and also let W(x) = o(|x| p ) as |x|-»0 be continuous. Let Vp(x) be a homogeneous positive definite polynomial of degree p. Let I be the identity matrix which is positive definite and suppose that the eigenvalues of A have negative real parts. recall that a proof of theorem 4.28). we apply the Liapunov method of lemma 2. there is a positive.> 0 as |x|->0. Furthermore. Actually. Let k = min |x|=1 Vp(x). Choose 5(k/2) and for 0<|x| < 6 ( k / 2 ) conclude that Thus V(x) is positive definite in a neighborhood of the origin. Note that W(x) = o(|x| p ) as |x|->0 means that ( W ( x ) / \ x \ p ) .

the 0-solution is asymptotically stable. Consider the autonomous system x = f ( x ) and suppose that f ( x ) is continuously differentiable on a set D containing the origin and also f(0) = 0. V(x) = xTBx is positive definite and V(x) in (2. Then (i) if all the real parts of the eigenvalues of the Jacobian f x (0) are negative. Theorem 2. Example 2.28) establishes theorem 4. with two blocks.1 twice in the following manner. Let B1 be a positive definite solution of ATB1 + B1A1 = -I and let B2 likewise be a positive definite solution of (—AT)B 2 +B 2 (—A 2 ) = —I.28) obtain that By lemma 2. The first block A.28) is unstable. the 0-solution is unstable.29) is negative definite and by theorem 2. V(x) is positive definite in a neighborhood of the 0-solution of (2. the analysis beginning after (2.6.3 the 0-solution is unstable. Therefore for the 0-solution of (2. consists of all the eigenvalues having negative real part and the second block A2 consists of all the eigenvalues having positive real part. Define the Liapunov function where x = (x1. then we conclude. on the other hand.28) arises from the linearization of the nonlinear autonomous system x = f ( x ) . as in section 5 of chapter 2. Consider the nonlinear system .Advanced stability methods 103 With the help of lemma 2.28).28) and by theorem 2. x2) with x1 and x2 having the same dimensions as B1 and B2 respectively. Thus. (ii) if some eigenvalue of the Jacobian fx(0) has positive real part. assume that the matrix A is in Jordan canonical form. Since (2.29) is positive definite in a neighborhood of the 0-solution of (2. as in theorem 4.4.28).2. no eigenvalue of A has a zero real part and an eigenvalue of A has positive real part. If. To establish this result without loss of generality. as follows. that the 0-solution of (2. This way we can apply lemma 2. Computing V(x) of V(x) as in (2.2 the 0-solution is asymptotically stable.2.2 part (ii) of the previous chapter. we conclude that —V(x) in (2.2 of the previous chapter.31) for x as in (2. we can restate theorem 4.2. which has just been proved.

The same example can be worked out using theorem 4.2. 27) uses the concept of significant or noncritical behavior to describe the case when the matrix A of the linear system x — Ax has either all eigenvalues with negative real part or at least one eigenvalue with positive real part.21) or (2.2 of the previous chapter to obtain the eigenvalues of A and to check the properties of h(x).1. Hahn (1963. for system (2.4(i). the Liapunov approach provides the researcher with a second option and indeed it is by the help of the Liapunov approach that theorem 4. Remark 2. Although it is usually easier to compute the eigenvalues of A and use theorem 4. Using this terminology.104 Differential equations.32) is asymptotically stable by theorem 2.32) choose as V(x) the following: To compute V(x) use (2.28) are connected by lemma 2. p. the 0-solution of (2.5 we conclude that we can apply the Liapunov approach with C = I to solve for B given by (2.2 conclude that V(x)<0 for x = O and V(0) = 0.2.4 by saying that if the stability behavior of x = Ax is significant then for h(x) = o(|x|) the stability behavior .1.29) to obtain From lemma 2.32) can be put immediately in the form of (2. Note that (2. both the eigenvalue method and the Liapunov method for systems such as (2. Therefore. by using a Liapunov function obtained from the linearized part of the system via lemma 2.27) is positive definite so that (2. The same conclusion is also obtained from theorem 2. we can rephrase theorem 4. Therefore. Of course. Also from lemma 2.34) is V(x)>0 for x = O and V(0) = 0.1 observe that B in (2. This example illustrates the usefulness of the Liapunov method in determining the stability properties of a nonlinear system.27). stability and chaos in dynamic economics and study its stability properties.2 of the previous chapter or theorem 2.3.28) From the analysis in example 2.2 is proved.

c21]/ [C11C22 . V and V are positive definite and therefore (0. for the equilibrium (0. That is. l/c 22 ). Example 2. often times. x2.36) to obtain four equilibria: (0.7. Then the closure of U contains the origin. y2) are positive on U n D . y2) and V(x1.Advanced stability methods 105 of x = Ax + h(x) is also significant. [c11 . y2) = 0 on the boundary of U inside D. . for (0. l/c 22 ) is unstable. (l/c 1 1 . the equilibrium (0.C 12 C 21 ])- First. Let V(x1. Thus. A has critical behavior when none of its eigenvalues have a positive real part with some having zero real part and some negative real part. (0. for all (x.1 in this section where the nonlinear part plays a critical role in determining the stability properties of the entire system.c22> c12. When the behavior of A is not significant.X1> 0 and also that x2 > 0.0) and ([c 22 -c 12 ]/[c n c 22 -c 12 c 21 ]. y2) = xl. Before we can determine the stability properties of this system we need to find the equilibrium states. Set x1 = x2 = 0 in (2. Recall example 2. (x1. l/c 22 ) apply the translation y 2 = x 2 (l/c 22 ).{0}. 0) consider Note that for small values of xl. We close this section by studying the stability properties of the Lotka-Volterra system which represents population changes for two competing species: Assume that all six constants are positive. cn > c 21 . By assumption x1 >0. 0). x2) = (0. V(x1.y 2 ) sufficiently close to the origin we get that X1 > 0. Second. when A has a critical behavior we cannot automatically deduce the stability properties of x = Ax + h(x). As was pointed out earlier. 0) is unstable.. D is a neighborhood of the origin. therefore. it is called critical. 0< c12< c22. 0). V(x1.

2.1. the only difference being that some attention is required to see that things happen uniformly in the time variable t. solving det(AI-A). Therefore the equilibrium (z1. For the fourth equilibrium point denote and apply the translation Using (2. The proofs are similar to the ones presented earlier.3 of the previous section can be extended easily to nonautonomous systems. Also.0) = 0 for all f>0 and there is a positive definite function . 0). Put (2. A function V(t.0) is unstable using an analysis similar to the second case. x ) . with A being the linear part of this last equation we obtain that the eigenvalues of A have negative real parts. This section collects the appropriate definitions and states theorems on the stability properties of nonautonomous systems. x) is continuous in ( t .1. stability and chaos in dynamic economics Third. the equilibrium (l/c 11 . oo) x D -> R is positive definite if V(t. y2) = (0.106 Differential equations.28) by writing Note that in this last equation the nonlinear term approaches zero as (y1. oo) x Rn -» Rn is continuously differentiable so that solutions exist.38) in matrix form as in (2. Let D be an open subset of Rn that contains the origin. Consider the nonautonomous system where f:[0. 0).37).2 and 2. 3. V(t.y2)->(0. rewrite (2. Several useful definitions are collected below. x):[0. are unique and also depend continuously upon initial data.36) as with equilibrium (y1. z2) is stable. Local stability for nonautonomous systems Theorems 2. Definitions 3.

oo) x D. A continuous function V(t. oo) x D. x) e [0. x) > g(|x|) for all (t. x). x) e [0. x) E [0. oo) x D. oo) x D -» R is positive definite if and only if V(t. we define the time derivative along the trajectories of (3. x) given in (3. . More specifically.1) as Note. Remark 3. r] with g(0) = 0. 0) = 0 for all t ]> 0 and V(t. x): [0. It is helpful in the analysis of the stability properties of a nonautonomous system to have equivalent definitions for positive definite and decrescent. for some real r > 0 let g(x): [0. oo) x D. oo) x D. x) > 0 for U x) e [0. Example 3.2) is computed without having to solve the ordinary differential equation in (3. x) e [0.1. Let D< R2 be a small neighborhood of the origin. A function V(t. 0) = 0 for all t > 0. Finally the function is positive semidefinite but it is not decrescent for (t. x)| < g(|x|) for all (t.> R such that | V ( t . once again.Advanced stability methods 107 W ( x ) : D . the function is positive definite but it is not decrescent for (t. oo) x D-» R is decrescent if and only if | V(t. oo) x D-> R is positive semidefinite if V(t.x)>W(x) for all (t. Also. oo) x D. oo) x D. x) E [0.1). x):[0. a continuous function V(t. oo) x D for some r>0 with D c {x E Rn: |x| < r}. that the time derivative of V(t.1. On the other hand. x):[0. x)| < U(x) for all (t. r] -» [0. Note that D c {x E Rn: |x| < r}. x) and there exists a positive definite function U ( x ) : D . x) e [0. To formulate such equivalent definitions the key idea is the notion of a strictly increasing continuous function. The function is positive definite and decrescent for (t. Assuming that V(t. oo) denote an arbitrary continuous function that is strictly increasing on [0.x) is continuously differentiable so that it has continuous partial derivatives with respect to both (t. x):[0.> R such that V(t. oo) x D -> R is decrescent if it is continuous in (f. x)e [0. and that for some r > 0 it follows that V(t. It is easy to show that a continuous V(f.

The interested reader can find these proofs in Hahn (1967.1. stability and chaos in dynamic economics Next we state theorem 3. x 0 )| < e for all t > t0.1) is stable. Proof. x) > g(|x|) for 0 < | x | < r and t >0.1. Example 3. To illustrate these theorems we present three examples. 198-204).x) positive definite.2. Then the 0-solution of x = f(t. t0) such that if |x0|< d then | x ( t .1 in the preceding section with additional attention paid to the variable t. x(t. x) < 0. x): [0.) Suppose that there is a continuously differentiable decrescent function V(f. oo) x D-> R with -V(t.x 0 )|< e because V(t.) Suppose that there is a continuously differentiable. decrescent function V(t. x 0 )) is nonincreasing with V(t. For 8 thus chosen we conclude that | x ( t . decrescent function V(t. Then the 0-solution of x =f(t. x0))<g(e) for t > t0. (Uniform asymptotic stability. Let £ > 0 and t0 > 0 be given with e < r. let g(x):[0. x ) < 0 so that V(f. oo) be a continuous function that is strictly increasing with g(0) = 0. x) in (3. Theorem 3. We need to show that there is a 8 = 8 ( e . Since V(t.3. x):[0. The proof is similar to the proof of theorem 2. x) < 0.2. Theorem 3. oo) x D -» R such that in every neighborhood of the origin there are points x such that V(t. x):[0.x) in (3. t 0 . oo) x D -> R such that V(t. r] -»[0. Then the 0-solution of x = /(r.4. Proofs are similar to the ones presented in the previous section and are omitted. 0) = 0 for all t > 0 we can choose 6 to be so small that if |x0| < 8 then V(t0. x0) < g ( e ) . pp. positive definite. (Liapunov stability for nonautonomous systems. For the nonautonomous system . t0. x):[0. Theorem 3. positive definite. such that V(t. Then the 0-solution is unstable. oo) x D -» R with V(t.1) is uniformly asymptotically stable. The following three theorems summarize the stability and instability properties of the nonautonomous systems. t 0 . (Instability for nonautonomous systems.1. This completes the proof. x) in (3. Using remark 3. x) is continuous with V(t.) Suppose that there is a continuously differentiable positive definite function V(t.) Suppose that there is a continuously differentiable. Theorem 3. t0. x(t. (Uniform stability.1) is uniformly stable. x ) > 0 with V(t. x ) > 0 .108 Differential equations.

2 to conclude the uniform stability of the 0-solution because V in (3.3) is stable. x2) < 0.2).5) is stable. The linear part of (3. We want to show that the 0-solution of the second order nonlinear equation is stable. It may be instructive to note that the stability of the 0-solution of (3. Furthermore. Suppose that a ( f ) > 0 and d ( f ) > 0 for t E [0. Let and compute Therefore by theorem 3.3) can also be established using exercise 10 of the previous chapter. X1.3.4) is not decrescent. .3) is with eigenvalues A1 = 0 and A2 = —1. Therefore (3. xl. observe that although V>0 and V<0 we cannot use theorem 3. Example 3.x2) in (3. oo). Furthermore since the nonlinear part of (3.4) using (3.4) is positive definite and V(t. It is given by Since V(f.3) is stable. the 0-solution is stable for x in a small neighborhood of the origin.1 that the 0-solution of (3.3) is bounded and foo e-t dt = 1 we conclude by exercise 10 that the 0-solution of (3.Advanced stability methods 109 consider the Liapunov function and compute the time derivative of (3. we conclude by theorem 3.1.

If b ( t ) > 0 then the 0-equilibrium is unstable. As is mentioned elsewhere in this book. If b(t)<0 then the 0-equilibrium is uniformly asymptotically stable. suppose .1 of the previous section. Consider the system reported in Hahn (1967. Actually. 4. unless dynamic economic models are analyzed for the existence. our study of stability is motivated by reasons that go beyond its intrinsic mathematical interest. uniqueness and stability properties of the equilibrium solution. the numerous books that treat stability from a strictly mathematical point of view consider it beyond their scope to express any nonmathematical opinions about the relative appropriateness of the stability notions in applications. Actually. 204) Note that (3.110 Differential equations. In economic applications it is not difficult to find reasons to argue that asymptotic stability is more important than stability. Global asymptotic stability The previous chapter and the preceding sections have presented several theorems on local stability and asymptotic stability for both autonomous and nonautonomous systems.8) of the previous chapter and is related to example 2. Our goal is to illustrate that the analysis of dynamic economic models benefits from the methods of stability theory. The exposition of these theorems has been mathematical in scope and no emphasis has been given to an evaluation of the various stability properties. it is relevant for the economic theorist to reflect on the relative importance of the various stability concepts.7) generalizes example (4. p. stability and chaos in dynamic economics Example 3. Use and compute If b(t)< 0 then the 0-equilibrium is uniformly stable. For example.4. how could such models be helpful in guiding the theorist's deductions and the policy maker's recommendations? Therefore.

If A =0 then (4. t0.1. then a preference may be expressed for the asymptotic stability property of the equilibrium solution. assuming the system starts with an inflation rate close to 5%. x0) also as <f>(t) or x ( t ) by suppressing the initial data.2) that the 0-solution is globally asymptotically stable because for any x0 € R. This notion describes the property of a dynamic system that converges to its equilibrium. . asymptotic stability means that inflation will actually converge to 5%. Usually we take t0 = 0 and global asymptotic stability describes the notion that any solution will converge to the 0-solution independent of the x0 where it starts. independent of its initial state. If A is a negative real number then we conclude from (4. Recall that we denote the solution <£(t.> Rn is assumed to be continuously differentiable with a unique equilibrium at the origin.2) becomes x ( t ) = x0. The desirable notion of stability in such cases is global asymptotic stability. t0. x ( t ) -> 0 as t -» oo. If the goal of economic policy is to reduce inflation fluctuations. t0. This section is devoted to this important kind of stability. x0) exists for t >0 and <f>(t. We first discuss the autonomous case. obtained by integration and given by. it may not be possible to adjust a system initially to be very close to its equilibrium. If A > 0 then the 0-solution is unstable. consider where f ( x ) : R n . The terms asymptotic stability in the large or complete stability are also used by some authors. instead of just closely fluctuating around it. We say that the 0-solution of (4. In practice. it still remains a narrow concept for economic applications.Advanced stability methods 111 that a dynamic macroeconomic model has a unique equilibrium rate of inflation of 5%. x 0 )->0 as f-» oo. Example 4. t > Q and the 0-solution is stable for small x0 but it is not globally asymptotically stable.1) is globally asymptotically stable (also stable in the large or completely stable) if for any x0 E R" the solution <f>(t. Although asymptotic stability may be moderately more important than stability. Stability means that inflation will fluctuate around 5%. As in earlier sections. The simplest example of a globally asymptotically stable 0-solution is the equation which has a solution.

0. in the simple two dimensional space (t. oo).4) will approach zero as f-» oo. local stability does not imply global stability. x 0 )|> e for values of t in some subinterval of [0. However. . then x(t)-> 0 as t-> oo and thus conclude that the 0-solution is asymptotically stable. Consider which upon integration becomes Use the method of partial fractions from the theory of integration in elementary calculus to rewrite the last equation as Integrate this last equation from 0 to t. Here we give an example of an ordinary differential equation in which the 0-solution is locally asymptotically stable but not globally asymptotically stable. For example imagine. This behavior implies that the 0-solution is globally asymptotically stable but not stable. if we choose x0= 1 then it is not true that x(t) in (4. x). Therefore. for example. From (4. to obtain which yields the solution for t .4) observe that as x0 is chosen close to the 0-solution.2. the 0-solution is not globally asymptotically stable. For x0 = 1 obtain from (4.0 and x(0) = x0 From (4. It is also true that global stability need not imply local stability. solution curves that are defined for all x0 E R and f >0 which have the following property: no matter how small x0 is chosen the solution <f>(t.3) conclude that x = 0'and x = 1 are the two equilibrium solutions of that equation.112 Differential equations. the solution | o ( t . because for any given e>0.4) that x ( t ) = 1 as t -> oo. 0. To proceed with various results on global asymptotic stability we need some topological definitions and a lemma about the limit properties of orbits. no matter how small an x0 we choose. x0) grows rapidly before it decays approaching zero as t -» oo. stability and chaos in dynamic economics Example 4.

t0. . p ) of (4. p). We denote y. p) satisfies three properties: 1. p) of (4.Advanced stability methods 113 Definitions 4. Here we review this notion by defining an orbit as the range of the solution o ( t . 2. 2 and 3 hold. we define to be the negative semiorbit through the point p. More specifically. For the purpose of analyzing the global asymptotic stability property of (4. The positive semiorbit through p is denoted by y + ( p ) and defined as and.5) we assume that f: Rn -» Rn satisfies enough conditions to ensure that the solution o(t. oo). p ) in the x-space. For a given point p. Put differently. p ) ) for any real number s on G < Rn+l. there exists a unique solution o (t. the path or orbit associated with it is denoted by y ( p ) and defined as From the uniqueness property of solutions we deduce that for a given p there is a unique orbit y ( p ) going through this point. no two orbits can intersect. p) = p. Consider the autonomous differential system where f ( x ) : D < Rn -> Rn is continuous and D is an open set in Rn. p) which has certain properties. positive semiorbit or negative semiorbit with no reference to a specific point p. similarly.5) going through p at time t0.1. let G be an open subset of (-00. o ( t . o(t + s. The solution o ( t . p) going through p at t0 = 0 is defined for all t E (-oo. 0. 3. o ( s . p) is continuous on G C R n + 1 . Assume that for any point p E D. p) = o(t.5) going through p at t0 = 0 can be viewed as a function of (t. p) as o(t. oo) x Rn and consider the function This function o(t. The reader may recall that the notion of an orbit as trajectory into R" is introduced in section 6 of the previous chapter. o(0. all p e Rn and properties 1. y+ or y the orbit. It is no loss of generality to let t0 = 0 and to write o ( t .

a set M c Rn is called an invariant set for (4.114 Differential equations. Finally. Recall that if x = [x1.5) is denoted by and defined as w(y + ) Similarly. 47). Having introduced the concept of global asymptotic stability and made several essential definitions we are now ready to state and prove a few theorems. 2. Observe from the definitions given that any orbit is an invariant set. if the positive semiorbit. These theorems follow either the Liapunov methodology or state conditions involving the Jacobian matrix J ( x ) of x=f(x) in (4. then the w-limit set is nonempty. connected and the distance between o(t. compact.11) and (4. that a scalar function V(x):D<= Rn -> R. . that is. The theorems that follow the Liapunov methodology rely on the concept of the Liapunov function. y n ] E Rn are n-vectors then the dot . . reduce to conditions involving one of the two inequalities or where a dot in (4. p. J ( x ) = [df(x)/dx] = [ d f i ( x ) / d x j ] . . . .5) is closed and invariant. p). Lemma 4. is bounded. The w-limit set of an orbit y of an autonomous system (4. In other words. p) e M for all t e (-00. . . is a Liapunov function if V(x) is positive definite and its trajectory derivative V(x) is negative semidefinite for x e D. the negative limiting or a-limit set is defined in the same way as (4. n. j = 1. Recall from section 1. 0 E D. oo). stability and chaos in dynamic economics The positive limiting or w-limit set of an orbit of (4. then o(t. Also.5). . y+.10) with the only exception that t is replaced by -t. For a proof see Hale (1969. x n ]e Rn and y = [y1.12) denotes scalar multiplication. .5) if for any p e M. an invariant set M is characterized by the property that if a point p is in M then its whole forward and backward path lies in M. The criteria for global asymptotic stability that make use of the Jacobian. and w ( y + ) approaches 0 as f-»oo. The properties of the w-limit set are summarized in the following lemma.1. . . . where i. For the theorems that state conditions involving the Jacobian of f(x) we note that the Jacobian matrix is the matrix of first-order partial derivatives.

Hartman and Olech (1962).5) for all t > 0 and suppose that x0 is a point of the w-limit set of o ( t ) that lies in D. Let f(x) of (4.1. x0) for 0 < t < e. Thus it is proved that x 0 e{x: V(x) = 0}. this last equation is a contradiction to (4. . Then V(x 0 ) = 0. 537-555). and Markus and Yamabe (1960). pp. However. In particular as o ( t k ) . From the continuity of the Liapunov function obtain that V ( o ( t k ) ) . Since x 0 is an w-limit point there exists a sequence { t k } . e] as k-»oo.> V(xo) as k-»oo and from the fact that V<0 conclude that To show that V(x0) = 0.14) and (4. x 0 )|->0 uniformly for t e [0. Proof. tk->oo. where e > 0 is small.5) be continuously differentiable on an open set D c Rn and let V(x) be a continuously differentiable real valued function on D such that V(x)>0 and V(x)<0 for xeD. with o(t k )->x 0 as k -» oo. Suppose that o(t) is a solution of (4. 56-71).* x0 for k->oo. o ( t k ) ) . then | o ( t .x 0 |->0 as k->oo. pp.15) yield for tk>0. pp. suppose that V(x 0 ) < 0 and consider the solution o ( t . We need to show that if x0 E w ( y + ) then x0 E{x: V(x) = 0}. Hale (1969. 296-299) and LaSalle and Lefschetz (1961. Theorem 4. e].1 of chapter 1 implies that if | ( o ( t k ) . This section draws heavily from Hartman (1964. From the assumption that V(x0) < 0 conclude that The continuity of solutions on initial data theorem 7.o(t. Without loss of generality suppose that tk < t k+1 . From the continuity of the Liapunov function we get that uniformly for t e [0. (4.13).Advanced stability methods 115 product or inner product or scalar multiplication is given by Most of the results that follow are relatively recent and have appeared in Hartman (1961).

and if there exists a unique point x0 such that V(x 0 ) = 0.p)]. (Global asymptotic stability. and the other assumptions about f and V imply that these bounded solutions approach the singleton {x0} as t-»oo. Remark 4. that is. p ) ] < V[o(0. that is. p)-» x0 which proves that x0 is globally asymptotically stable.116 Differential equations. this x0 is globally asymptotically stable. the hypothesis that V(x)-»oo as |x| -»oo for x E Rn implies the boundedness of solutions independent of where they start in Rn. assume that {x0} = {0}. oo) and are bounded. p ) ] exists and because V(x)<0 we conclude that V [ o ( t . by hypothesis there exists only one unique point x0 such that V(x 0 ) = 0.2. V and V in theorem 4. by requiring that V is positive definite instead of positive semi-definite. V(x) < 0 for x e Rn and V(x) -» oo as |x| -> oo. assume that {x0} = {0}. under this added assumption.2) imply local asymptotic stability. Under the stated assumptions about f. p)= o (t.1 is a subset of {x: V(x) = 0}.1.2. that is.3.5) be continuously differentiable on the whole Rn space and let V(x) be a continuously differentiable real-valued function on R" such that V(x)>0. the global asymptotic stability of x0 can be restated using the notion of an invariant set M as follows: if the largest invariant set M consists only of the singleton {x0}. Let o(t. The boundedness of solutions means that there exists an to-limit set in Rn which by the preceding theorem 4. Proof. This is true because as in the proof of theorem 4. we conclude that independent of the initial point p e Rn all solutions o(t. Then we could conclude that the 0-solution is not only globally asymptotically stable but also locally stable from theorem 2. all solutions exist on [0.2. p) be a solution of x = f(x) for p e R". Then all solutions of x =/(x) exist on [0. Remark 4. oo) and are bounded. Furthermore. if M = {x0} then x0 is globally asymptotically stable. Remark 4. and strengthen the hypotheses by assuming that V(x) is a Liapunov function. The hypothesis that V(x)-> oo as |x|-» oo implies that V [ o ( t . f and V are continuously differentiable on the whole R" space and let V ( x ) > 0 .) Let f(x) of (4. However.1 of this chapter. stability and chaos in dynamic economics Theorem 4. In the preceding theorem without loss of generality.2.2. Again with reference to theorem 4. we can also conclude that the 0-solution is locally asymptotically stable because both the local stability (from the assumption that V is a Liapunov function) and the global asymptotic stability (from theorem 4. {x: V(x) = 0} = {x0}. Therefore. Thus. 0.

all together these hypotheses imply that. Remark 4. p.» oo as |x|->oo implies boundedness of solutions. V(0) = 0. pp. x 0 )-»0. .3.> oo as |x|->oo.4. this implies local asymptotic stability and the assumption V ( X ) . the solution o ( t . Example 4.1 as follows: assuming V to be a Liapunov function such that V(x)->oo as |x|-»oo with V(x) < 0. 298) let the Liapunov function V(x. We can also reason in the language of remark 4. and (3) Jo g ( s ) ds -> oo as |x|->oo. Then the 0-solution of x =/(x) is globally asymptotically stable. (2) f ( x ) > 0 for all x = 0. x = 0. y ) . therefore the 0-solution is globally asymptotically stable. imply that all solutions are bounded and converge to the largest invariant singleton set M = {0}. y) be given by and its trajectory derivative is obtained immediately by Assume that (1) xg(x)>0 for all x = 0. independent of the initial condition x0e Rn at t = 0.Advanced stability methods 117 for x = 0. These three assumptions imply that (1) V(x. V(x) < 0 for x = 0 and V(x) -» oo as |x| -» oo. the 0-solution is globally asymptotically stable. Consider the Lienard equation which can be written equivalently in system form as Following LaSalle and Lefschetz (1961. This is true because here we have strengthened the assumption by requiring V to be a Liapunov function with V(x) negative definite for x = 0. 67-68) or Hale (1969. 0. Thus.

Put and observe that such V is positive definite and V ( X ) .) Suppose that f(x) of (4. symmetric. .118 Differential equations.5) is continuously differentiable on the whole Rn space and f(0) = 0. Observe that for V as in (4. If it can be shown that V is negative definite using (4.3.1 we conclude that the 0-solution (x. The next two theorems make use of the Jacobian of f(x) and involve trivial generalizations of conditions (4. from theorem 2. Proof.2 we conclude that the 0-solution is globally asymptotically stable and from remark 4.2. positive definite matrix. Conditions (4.22). stability and chaos in dynamic economics Therefore.19) and (4. real. symmetric positive definite matrix and let the Jacobian matrix J(x) satisfy for all points x = 0 and for all vectors y = 0.> OO as |x|-»oo. or remark 4.12).2 to conclude the global asymptotic stability of the 0-solution of x =/(x).11) and (4. y) = (0. Theorem 4. Specifically.20) in the calculation of V(x) and afterwards appeal to theorem 4.12) can be replaced by or by The theorems below make use of (4. (Global asymptotic stability. 0) is locally stable. Then the 0-solution is globally asymptotically stable.21) we can conclude from theorem 4. real.3 that the 0-solution is globally asymptotically stable. assume that A is a n x n constant.11) and (4. Let A be an n x n constant. from theorem 4.2 we also conclude that the 0solution is locally asymptotically stable.

Since V vanishes at zero then f(0) = 0. real. the 0-solution is also locally asymptotically stable.Advanced stability methods 119 To go from (4.2 the 0-solution is globally asymptotically stable. observe the following: for 0 < s < 1 use the chain rule to write which by integration yields because f(0) = 0. symmetric positive definite matrix and let the Jacobian matrix J(x) satisfy for x = 0 Then f(0) = 0 and the 0-solution is globally asymptotically stable.4.) Suppose that f(x) of (4.21) and the properties of the matrix A to conclude that if x = 0 and V(0) = 0.5) is continuously differentiable on the whole R" space and furthermore suppose that |f(x)| -> oo as |x|-> oo. Let A be an n x n constant. Theorem 4. From (4. .23) to the desired result that V(x) < 0 for x = 0 and V(0) = 0.23) and use the hypothesis (4. (Global asymptotic stability.24) into (4.> OO. Thus the 0-solution is globally asymptotically stable. Proof. Use as a Liapunov function and compute for x = 0 and V(0) = 0. Put (4. and from theorem 4. Actually.26) conclude that V is positive definite and V-»oo as |x|->oo because |/(x)|-»oo as | x | .

pp. Also. Lemma 4. b).2 and theorem 4. means the set of points x0 e D such that the solutions 0(f. x0) exist for t > 0 and o(t. Let u>0 be so small that the set Bu = {x: |x|<u} is in the domain of attraction of the locally asymptotically stable 0-solution. Suppose also that the 0-solution of x = f ( x ) is locally asymptotically stable. s ( b ) ) the following holds For a proof see Hartman (1964. s(0) = 0 and for the right maximal interval of existence of w(t). 550-554).5. Suppose that f(x) of (4. t e [0. Theorem 4. 548-554). stability and chaos in dynamic economics To state the next global asymptotic stability theorems we need a definition and a lemma from Hartman (1964. satisfies d [ o ( t ) .o(0)| < 5 there is an increasing function s ( t ) .120 Differential equations. let Du ={x: | X | > u } and assume that holds for x e Du and all y e Rn. From the continuity of solutions with respect to initial data and the assumed asymptotic stability of the 0-solution we note that the domain of attraction is an open set. . The domain of attraction of the 0-solution of x =/(x). Then there are positive constants 8 and K such that for any solution w ( t ) of x = f ( x ) with |w(0) . x0) -> 0 as t -»oo. pp.5) is continuously differentiable on the whole Rn space with f(0) = 0 and f(x) = 0 if x = 0. 0. b) with the property that there exists a positive number a such that the distance between o(t) and the boundary of E denoted dE.5 have found many applications in capital theory and several results are presented in chapter 9. 0. d E ] > a. The next lemma and the theorem are due to Hartman and Olech (1962) and are reported in Hartman (1964). t E [0. Then the 0-solution is globally asymptotically stable. where / is continuously differentiable on a domain D. Let f(x) = 0 be continuously differentiable on an open and connected set E and suppose that Let 0(t) be a solution of x =/(x) remaining in the set E on its right maximal interval [0. Both lemma 4.2.

that is E* = E . Suppose that the 0-solution is not globally asymptotically stable.2 with E replaced by E* conclude that all solutions w(t) starting at w(0) near o(0) = x0 remain close to o ( t ) in the sense of (4. Let o(f. Markus and Yamabe (1960.28) holds for xeE*. 0. p. Assume that each eigenvalue of is negative and also that there are positive constants cl. c2 such that Then each solution o ( t ) of x=f(x) the critical point as t->oo. 0.4. Example 4. it contains both the set B ( u ) = {x: |X|< u} and also there exists an a >0 such that the set B(u + a) = {x: |x|< u + a} is also contained in the domain of attraction. The proof makes use of lemma 4.29) for (4. Theorem 4. Proof. dE*]> a on the right maximal interval [0. The next theorem is due to Markus and Yamabe (1960). X E E* and (4.5) is continuously differentiable in the whole R" space. Since the domain of attraction of the locally asymptotically stable 0-solution is open. y) E R2.2. To compute (4. Let E* denote the open set obtained by deleting B ( u ) from the set E in lemma 4.32) start with . pp. This is a contradiction of the fact that x0 is on the boundary of the domain of attraction of the 0-solution. x 0 ). Using lemma 4.27). x0) of x =f(x) be such that d [ o ( t . In particular w ( t ) E E* on its right maximal interval of existence.6. is bounded in Rn and it approaches See Markus and Yamabe (1960.6. 310) use the following example to illustrate theorem 4. Consider the system for (x. f ( x ) = 0. Then there exists a point XO E E* on the boundary of the domain of attraction of the 0-solution. From hypothesis. b).2.B ( u ) . Suppose that /(x) of (4. 309-310).Advanced stability methods 121 Proof.

All the results in this section refer to global asymptotic stability of an autonomous system. symmetric matrix B so that (4.6. Hartman (1961) further generalizes JTB + BJ by considering a nonconstant matrix B.35) and apply the Routh-Hurwitz criterion to conclude that the eigenvalues of M are negative. Here we present one typical result that is the direct analogue of theorem 4.31) are satisfied. |det M| > 4. They use a condition more general than (4. Numerous theorems exist that establish the global asymptotic stability of nonautonomous systems. by theorem 4.29) which considers a constant. Barbashin (1970). Actually. .3.30) and (4. Chetaev (1961) and Zubov (1964) summarize these theorems which follow the Liapunov methodology and appeared in Russian journals during the 1950s. Therefore.5. Russian mathematicians such as Krasovskii (1963).33) in (4. y) observe that Use the computations of (4. Remarks 4. positive definite. Economists have used these results as subsequent chapters illustrate.122 Differential equations.33) conclude that |trace M| = 6.29) is generalized to M = JTB + BJ. Markus and Yamabe (1960) state and prove a theorem that is more general than theorem 4. computing the characteristic polynomial of M(x.34) Therefore. (4. For detailed bibliographical references see Hahn (1963).6.2 and remark 4. stability and chaos in dynamic economics and obtain where as before JT denotes transpose of J. Furthermore. From (4. The interested reader is referred to these two papers for further details. there exist constants c1 and c2 so that (4.6 every solution approaches the unique critical point as t -> oo. Remark 4.

1) and suppose that f: [0. oo) x Rn -> R to be radially unbounded if V(t. x) given in (3. x) is radially unbounded to show the boundedness of solutions. Also suppose that there exists a continuously differentiable. assume that one of the four partials f11. y) e R2. From theorem 3. oo) x Rn -> Rn is continuously differentiable. So it remains to be shown that the domain of attraction of the 0-solution is the whole Rn space.2). Theorem 4. decrescent.3 of the previous section we conclude that the 0-solution is locally uniformly asymptotically stable.f 2 are continuously differentiable for all (x. Theorem 4. Then the 0-solution is globally asymptotically stable. use the property that V(t. Then the 0-solution is globally asymptotically stable. We define a continuous function V(t. x) in (3. U(x) > 0 for x = 0.8. we also need the equivalent of V(x)-»oo as |x|-»oo used in this section. U(x) -> oo as |x| -» oo such that V(t. . Suppose that the origin is the unique equilibrium solution and also suppose that the Jacobian has eigenvalues which have negative real parts everywhere in R2. and use the fact that V is negative definite to conclude that bounded solutions converge to the 0-solution. x) =» U(x) for all t > 0 and all x E Rn. and radially unbounded function V(t. x) being positive definite and decrescent. x):[0. To do this.f12. and V(t. positive definite.f21.f22 vanishes identically in R2.7. 0) = 0 for all t > 0 and there exists a continuous function U(x): Rn-> Rn with U(0) = 0. x) is negative definite. x):[0. oo) x Rn -> R such that V(t.Advanced stability methods 123 In addition to the definition given in the previous section about V(t. Consider the two dimensional system and assume that f1. We close this section with two theorems about the global asymptotic stability in the plane. Proof. Suppose that the 0-solution is the only equilibrium of the nonautonomous system x = f(t. The first one is due to Markus and Yamabe (1960) and the second is due to Olech (1963). Finally.

8) and then employs (4. Indeed. For an extension of Olech's theorem see Meisters and Olech (1988). the 0-solution is globally asymptotically stable.38). Olech uses conditions (4. Olech's theorem 4.9.36) and assume that f1. 390-394).41): Thus.40) or (4. y ) in (4.f vanishes for all (x. stability and chaos in dynamic economics Proof. tion of To determine the global asymptotic stability of the 0-solu- compute (4. y) e R 2 . Theorem 4. Example 4. f 2 are continuously differentiable for all (x. Consider the two dimensional system in (4. pp.40) or (4. (4..39) implies (4.124 Differential equations.0) = 0 and also suppose that the Jacobian matrix J ( x .39).36) has. Thus.8 and 4.8 by Markus and Yamabe.f21.9 are closely related. characteristic roots with negative real parts (as assumed in theorem 4.5.y)e R2 as assumed by Markus and Yamabe. assume that either or Then. Together these facts imply global asymptotic stability.37) satisfies Furthermore. See Markus and Yamabe (1960. 311-314). (4. at each point in R2.f12. pp. then this assumption with (4.38) and (4.9 contains theorem 4.0) =f 2 (0.41) to establish that the 0-equilibrium solution is unique.39) to obtain that the Jacobian of (4. .38) and (4. if any of the four partials f11. Proof. See Olech (1963. Observe also that theorems 4. the 0-solution is globally asymptotically stable.40) or (4. Suppose that f1(0.41).

The reader may recall that figure 3. there is an open set U containing x. x):[0. tend to the 0-solution as t -» oo. the system of differential equations considered is given by Note that A is a real n x n matrix that is assumed to be noncritical as described earlier in remark 2.2(b). Recall that this means that the matrix A has either all eigenvalues with negative real part or at least one eigenvalue with positive real part. one could say that solutions. First.0) = 0 for t > 0 and finally. to explain the notion of a manifold we need to define a diffeomorphism. oo) x D. h(t. it may be true that a certain subset of solutions starting from a given subspace converge to this equilibrium. the y2 axis is an unstable manifold because any solution that starts in y2 moves away from the 0-solution as t-> oo. second. a k-dimensional (differentiable) manifold is a space which is locally diffeomorphic to the euclidean k-space. The function h(t. starting in one dimensional linear subspace given by the y1 axis. where D is an open subset of R" containing the origin.Advanced stability methods 125 5. To make these remarks more precise we need to first. and a diffeomorphism h: U -» V such that In other words. To provide a geometric motivation of the theorem to be stated shortly let us refer to the two dimensional portrait 3. Therefore. write the system of differential equations and third. even if it is not true that local stability of an equilibrium holds. given any e > 0. and call the y1 axis the stable manifold of this saddle. x) e [0. then the property of the stable manifold may be worth investigating. state the stable manifold theorem. a differentiable function h: U -> V with a differentiable inverse h-1: V-> U is called a diffeomorphism. . With this pictorial motivation one can understand that if local stability cannot be established for a given system. By implication. an open set V<= Rn. also.2(b) is a saddle and the origin is a saddle point with the motion along the y1 axis being directed towards the origin while the motion along the y2 axis is being directed away from the origin.3. A subset 5 of Rn is called a k-dimensional manifold in Rn if for every point x E S. Second. In other words for a given system. Stable manifold In this section we return to local stability to introduce the reader to the notion of stable manifold. We take these three steps in order. oo) x D-> Rn is assumed to be continuous in both (t. explain the notion of a manifold. If U and V are open sets in R".

See Brauer and Nohel (1969. (Stable manifold. Having assumed A in 5. in a sufficiently small neighborhood of the 0-solution.2(b). 205).1. More specifically the following holds. and Irwin (1980) discuss in detail the stable manifold theory. The analysis is local.126 Differential equations. Guckenheimer and Holmes (1983). the intuition is similar.t0 cannot satisfy | x ( t ) | < n for t > t0. around a small neighborhood of the 0-solution. Then there exists a real k-dimensional manifold S containing the origin and having the following properties: (i) any solution o ( t ) = x ( t ) of (5. (ii) there exists an n > 0. See Coddington and Levinson (1955. The books by Carr (1981).) Suppose that the n x n matrix A and the function h(t. satisfies x ( t ) . Proof. x) space.1) with the assumptions just stated seems more general than the two dimensional phase portrait 3. in the (t. pp. stability and chaos in dynamic economics there exists a 6 >0 and T>0 such that Although the system described by (5.1) starting on S at t = t0 for t0 sufficiently large.1) satisfy the assumptions stated above and let k eigenvalues of A have negative real parts and n — k have positive real parts.k eigenvalues with positive real parts and show that there is a (k + 1)-dimensional stable manifold and an (n — k+ 1)-dimensional unstable manifold. p. 330-333). The special cases k = n or k = 0 refer to asymptotic stability and instability. Theorem 5. real matrix we distinguish between k eigenvalues with negative real parts and n . sufficiently small such that any solution x ( t ) near the origin but not on S at t .1 to be an n x n noncritical.x) of (5. 6. To repeat. .> 0 as t -> oo.x). what we want to show is the existence of stable and unstable manifolds when such manifolds become slightly distorted due to the influence of h(t. Miscellaneous applications and exercises (1) For the system use the Liapunov function V(x) = x2 to determine the stability properties of the 0-solution.

x2) = x2 + x2 is not helpful in deciding the stability properties of the 0-solution. 200).4 to verify your answer? For the system show that the Liapunov function V(x1.x 2 ) = x1 + x2. Can you use theorem 2. Also note that the Jacobian of this system evaluated at the origin is critical and therefore theorem 2.4 cannot be applied. Can you use the theorem 2. p. One way to decide the stability properties of this system is to construct a Liapunov function by taking the ratio of x1 and x2 as follows: or equivalently which upon integration yields Define . Given the system use the Liapunov function (4) to show that the 0-equilibrium solution is stable.Advanced stability methods 127 (2) Consider the system (3) and investigate the stability properties of the 0-solution by using the Liapunov function V(x1.4 to verify your answer? See Brauer and Nohel (1969.

d be real constants and consider the system Use the Liapunov function V(x. p. Finally. x) is decrescent in [0. Let a. See Hahn (1967. Then V(t.x):[0. c.0) = 0 for all t >0 and also V(t.x) has bounded partial derivatives with respect to x. stability and chaos in dynamic economics (5) for x1. oo) x D. ex2 > l + x2. (10) Suppose that there is a positive definite matrix Q such that . x2> —1. V(0)=0and V = 0. V is positive definite because x 1 -ln(l + x 1 )>0 and x 2 -ln(l + x 2 )>0.128 Differential equations.oo) x D-» R satisfies V(t. y) = cx2 + by2 to study the stability properties of the 0-equilibrium solution in each of the cases: (6) Find an appropriate Liapunov function to study the stability properties of (7) (8) when a = 0 and when a = O. Thus the 0-solution is stable. Let D be an open subset that contains the origin and suppose that the function V(f.( 1 + x2)y. Such a V is continuous for x1 and x2 and for e x1 > 1 + x. b. Which of the following V( f. oo) x D -> R are decrescent? (9) Find an appropriate Liapunov function to determine if the 0-solution of the following system is globally asymptotically stable.x 3 . y = . 105). x = y. x): [0.

For example. it is worth mentioning the books of Cesari (1963). Hale (1969) and Harris and Miles (1980).4) implies that the 0-solution of x =f(x). LaSalle (1964. Zubov (1964) and Barbashin (1970). Coppel (1965). The extensive contributions to stability theory made by Russian mathematicians are reported in several books which appeared originally in Russian and later translated into English. some authors use the notion of weakly stable to describe a solution that is stable but not asymptotically stable. Several books discuss Liapunov's method as well as other related methods of stability. Practical stability characterizes a system which may be mathematically unstable and . Liapunov's stability methods have also been reported in review articles. See also Massera (1949.Advanced stability methods 129 is negative definite for all x = 0. Bhatia and Szego (1967. the reader is referred to Antosiewicz (1958). Hartman (1964). Halanay (1966). This book contains most of the material presented in Hahn (1963) with a detailed documentation of Liapunov's original work and the subsequent scientific discoveries up to the late fifties. Lagrange stability describes the notion of boundedness of all solutions. Every serious student of stability is encouraged to consult W. Another book that introduces the reader to the dynamical aspects of the theory of ordinary differential equations with an emphasis on the stability of equilibria in dynamical systems is Hirsch and Smale (1974). Finally. Rouche et al. Hahn (1967). See also the classic book by Nemytskii and Stepanov (1960). (1977) is a rigorous monograph on Liapunov's direct method. Show that (6. where as before J ( x ) is the Jacobian of f(x). 1968) and Bushaw (1969). 1956) and Mangasarian (1963). 7. There exist numerous stability concepts beyond the ones treated in this chapter. Some representative examples are: Chetaev (1961). 1970) use topological methods to present various stability results for dynamical systems first introduced by Birkoff (1927) and recently reviewed by Smale (1967). LaSalle and Lefschetz (1961) describe Liapunov's direct method at a level accessible to persons without an advanced mathematical background. f(0) = 0 is globally asymptotically stable. In this category. A recent book on ordinary differential equations with a major emphasis on stability with engineering applications is Miller and Michel (1982). Further remarks and references The standard reference for Liapunov stability is Hahn (1967). Krasovskii (1963). Among such review articles.

Two economic applications of Olech's theorem are found in Garcia (1972) and Desai (1973). For details about these notions see Hahn (1967). Yoshizawa (1975) and Burton (1985) and the related topic of bifurcation presented in Andronov et al. 395). In addition to the major references on global asymptotic stability given in section 4 we also mention Markus (1954). .130 Differential equations. and Shub (1986). Levhari and Liviatan (1972). Heller (1975). (1973). Burganskaya (1974). p. stochastic stability is presented in Kushner (1967). stability and chaos in dynamic economics yet the system may oscillate sufficiently near its equilibrium that its performance is empirically acceptable. p. Finally. The reader who wishes to go beyond the topics covered in this chapter may consider the topic of orbital stability presented in Halanay (1966). Finally. Unlike orbital stability and bifurcation theory which build on the theory of ordinary differential equations. See also the mathematical papers of Hirsch and Pugh (1970) and Rockafellar (1973. chapter 5) explains both the intuitive meaning and economic interpretation of saddle point equilibrium. Malliaris and Brock (1982) and Ladde and Lakshimkantham (1980). Samuelson (1972a). Martin (1973). a trajectory which is contained in a limit set is called Poisson stable. Benhabib and Nishimura (1979) apply the Hopf bifurcation theory in optimal economic growth. Sattinger (1973). Furthermore. Mufti (1961). Coppel (1978) and Iooss and Joseph (1980). p. 411). and Kuga (1977) among others. 1984). Brauer (1961). Neher (1971. Levin and Nohel (1960). For a discussion of this model and its graphical illustration of the saddle point equilibrium and the existence of a stable manifold see Burmeister and Dobell (1970. stochastic stability requires the methodology of Ito's calculus presented in some length in Malliaris and Brock (1982) or briefly in Malliaris (1983. Michel (1970) and Bushaw (1969). Burmeister (1980. Levin (1960). 228) or Intriligator (1971. The typical example of the existence of a stable manifold in a saddle point equilibrium is the optimal economic growth model of Cass (1965). LaSalle and Lefschetz (1961). 1976). Datko (1966). the saddle-type stability and instability described in section 5 has been treated by economists such as Kurz (1968a).

Introduction This chapter surveys various stability results of optimal control and indicates some possible areas of their application. This raises the question of stability: under a slight perturbation will the system remain near the equilibrium state or not? LaSalle and Lefschetz (1961. The chapter relies on Brock (1977a) and its emphasis is on basic ideas and not on technical details in order for the basic structure of the analysis to remain clear. p. consider the following optimal control problem subject to measurable. 30) 1. this chapter presents results obtained primarily by mathematical economists since the early 1970s. Unlike previous chapters where most of the results reported have been obtained by mathematicians several decades ago.CHAPTER 5 STABILITY OF OPTIMAL CONTROL A real system is subject to perturbations and it is never possible to control its initial state exactly. Without further ado. .

is of the time stationary feedback form.2) and (1.132 Differential equations.1) is chosen as the vehicle of explanation of the results in this chapter because it is described in Arrow and Kurz (1970. stability and chaos in dynamic economics where U is the instantaneous utility. T[ • ] is the technology which relates the rate of change of the state vector x = dx/dt to the state x ( t ) and instruments v(t) at time t. the optimal v ( t ) . and.) and T(. W is independent of t0. To specialize problem (1. ) E 0.1) somewhat. there is a function h(x) such that . v(t) is the instrument vector at time t. let Then. As pointed out by Arrow and Kurz. that is. the technology function and transpose should not cause any difficulty because it is rather standard in the literature.p>Q is the discount in future utility. the problem becomes: subject to Note that sup in (1.5) denotes supremum which is taken over all instrument functions V ( .). which is usually taken to be the set of all measurable v ( • ) or the set of all piece wise continuous v( •). Problem (1. denoted by v * ( t ) . chapter 2). and x0 is the initial position of the state vector at time 0.3) over some set 0 of instrument functions. T is the planning horizon. t is time. under strict concavity assumptions on U(. The choice of T to denote the terminal time. x ( t ) is the state vector at time t. The objective is to maximize subject to equations (1.

and (ii) x* is globally asymptotically stable (G. The cost of obtaining factor services in each instant of time is wTx(t). x = x0. The neoclassical theory of investment as stated by Mortensen (1973) is subject to Here f(x.7) is L. Basic problem (P).A. v) is a generalized production function which depends upon the vector of n factors x(t). We recall the definitions of L.5).S.S.7) with initial condition x(0) = x0.S.A. Find sufficient conditions for the utility function U[ • ]. Call it x* such that (i) x* is locally asymptotically stable (L. x(t. so that the optimal plan . if for all XO E Rn. and the rate of adjustment of the factors v ( t ) . Definition. the technology T[ • ].S.Stability of optimal control 133 Thus optimal paths x*(t) satisfy which is an autonomous set of differential equations.A.S. x 0 )-> x* as t -» OO. The steady state solution x* is G.). if there is e > 0 such that where x(t.S.8).A. The basic problem addressed in this chapter may now be stated.). and G.A. The steady state solution x* of equation (1. and the discount p such that there exists a steady state of equation (1. and the cost of adding to the stock of factors (which may be negative) is g T v ( t ) .7). Put t0 = 0. and suppress t0 in W.A. where WT denotes the transpose of the vector w. It is assumed that a stationary solution x0 = x* exists for equation (1. henceforth. x0) is the solution of equation (1. Here \y\ denotes the norm of vector y defined by It will be useful to write down some specializations of the general problem (1.

x » 0 means that xi > 0 for i = l. which are discussed below.5) to avoid many tangential technicalities and are maintained throughout this chapter. . 2. it is assumed that / is twice continuously differentiable and that the optimal plan is one with piecewise continuous time derivatives. 0). The next few pages summarize the fundamental work of Magill (1977a) on the stability of the linear quadratic approximation around a steady state solution of (1. . The linear quadratic approximation at a steady state (x*. respectively. n) and is interior to any natural boundaries (this means that x f ( t ) > 0 for all t > 0. . v*) for the general problem (1. .5) is presented in the next section. v*) = (x*. . 2. .134 Differential equations. Rockafellar. The linear quadratic approximation of equation (1. and Brock-Scheinkman. . . where The symbols all evaluated at (x*. Furthermore. n). the local results of Magill lead naturally to the global results of Cass-Shell. Furthermore. stability and chaos in dynamic economics exists and is unique for each x0 » 0 (note that for x e R". i = 1. . These results go far beyond the simple checking of eigenvalues that most people associate with a local analysis. These assumptions are placed on problem (1.8) at a steady state x* is subject to measurable.5).

v*). Linear quadratic approximation to general problem (Magill (1977a)) Consider subject to measurable. where are the appropriate matrices of partial derivatives evaluated at (x*. The finite horizon case is studied. for example.5) has not been studied yet.Stability of optimal control 135 2. by putting . Clearly.1) is the time stationary optimal linear regulator problem (OLRP): subject to measurable. A problem studied extensively in the engineering literature and closely related to equation (2. (1963) (see also Magill (1977a)). The validity of the linear quadratic approximation for the infinite horizon problem (1. The quadratic approximation (2.1) can be expected to hold only in the neighborhood of x0. by Breakwell et al.

53). . Second. problem for economic problems with p > 0 for two reasons. This transformation of variables. n(t) may be replaced by in equation (2. The constraint in equation (2.5) if the engineers had focused on the case p>0 instead of the case p < 0. 41)). allows results for the case p = 0 (the bulk of results on the OLRP) to be carried over directly to the case p > 0. provided that the question of sufficient conditions for the validity of the linear quadratic approximation is resolved for problem (1. the paper by Magill (1977a) fills this gap. the minimum from £0 itself (Anderson and Moore (1971.1).136 Differential equations.2) becomes where / denotes the n x n identity matrix. p.S.5) to the L.A. Before plunging into statements of formal theorems.A. stability and chaos in dynamic economics becomes the same problem as equation (2.1) to economic problems. First. The following is based upon Magill (1977a).2). Results on the OLRP are applicable. Such an approach would virtually resolve the local asymptotic stability question for problem (1. viz. p.1) and (2. Assume that the matrix is positive definite in order to reflect the concavity of U(x. used by Magill (1977a) and Anderson and Moore (1971. e(t). leading to the negative definiteness of the matrix in economic problems. The importance of observing that equations (2. but brevity demands that many of his results be passed over.2) are the same problem is that it enables us to carry the extensive set of results derived by engineers on OLRP (see Anderson and Moore (1971) and Kwakernaak and Sivan (1972) for example) to linear quadratic approximations (2. the OLRP suggests an important class of Liapunov functions upon which several theorems below will be based. The minimum is a positive definite quadratic form £oP£0 under general assumptions (see Anderson and Moore (1971)).S. Fortunately. let us use the OLRP to explore the determinants of L. v).

. Following Anderson and Moore (1971.2) with S = 0 becomes subject to Clearly. we see that instability is more likely the larger F is. To sum up in words: why stabilize a highly unstable system (large F) when control input is ineffective (small |G|). For if G < 0. and the larger p is. the system is unstable. If n(0) is administered today. Q. put n2= -n1. R. put S = 0. Note that since the left hand side of (2. The intuition behind this is quite compelling for. However.2) unstable? First.5) to explore when instability may be likely.5) is unstable if and only if equation (2. and stability will not be affected. the smaller |G| is. if F is positive. is small then a lot of input n(t) must be administered in order to have much impact on g(t).Stability of optimal control 137 When is the OLRP equation (2.2) is unstable. the absolute value of G. the smaller Q is. Then in the one dimensional case. Let us use equation (2.4) is positive definite. when control input is expensive (R is large) when deviation of the state from the origin is not very costly (Q is small) and the future is not worth much (p is large)? Now assume that S = 0. But the future is discounted by p. Defining the OLRP (2. and Magill (1977a). Without loss of generality we may assume G > 0.1 S T are all positive definite. Consider the one dimensional case. If |G|. Change units to reduce the problem to the case 5 = 0. p. then £ ( t ) Q e ( t ) will be smaller in the next instant. inputs n(t) cost n T ( t ) R n ( t ) to administer. and Q-SR . 47). equation (2. the larger R is.

1 ST larger and makes smaller. The paper by Magill (1977a) develops a rather complete set of results for all p. For S > 0. Here By the reasoning above from equation (2. still holds.8). because a decrease in S makes F — GR . is intuitive from the existence of a finite value to the integral and the positive definiteness of the matrix Roughly speaking. If S — 0. It is known that instability in the multidimensional case is related to the amount of asymmetry in the underlying system matrix.A. Sufficient conditions for G. This is so because. roughly speaking. stability and chaos in dynamic economics It is clear from equation (2. instability of A which is related to its lack of symmetry makes instability of the optimal path more likely. gained from the OLRP to the linear quadratic approximation (1.-f*vvis large (it is positive by concavity of f in (x.S.138 Differential equations. an increase in S makes the underlying system matrix. G. smaller (a stabilizing force).5). Note that when F = 0 and S = 0. Hence. in the one dimensional case. v*(t)) must converge to 0 as t-»oo.A. the underlying system matrix is not stable. of the OLRP are covered in detail in Anderson and Moore (1971.9) to the neoclassical model of investment (1. instability at x* is likely when p is large.S. . (x*(t). chapter 4) for the case p < 0. In the multidimensional case when p<0. since 0 is not a stable matrix. v)). Let us apply our intuitive understanding of the determinants of G. however.S. or else the integral will blow up. a theorem to be proved below will show that G.5) that when S < 0 a decrease in S is destabilizing. but R--1STbecomes smaller (a destabilizing force). provided that A>0. ambiguity is obtained in this case.A. and -f*xx+f*xvf*-1~f*xv is small (it is positive by concavity of f).A.S.

p. These results are based on two Liapunov functions. to hold it turns out to be convenient to form the current value Hamiltonian (following Arrow and Kurz (1970.48) show that there exists costate variables q*(t). We are now in a position to state the G. such that on each interval of continuity of v*(t). The first is given by where (q*. results of Cass and Shell (1976a).2) and (3. The general nonlinear nonquadratic problem In searching for sufficient conditions on U.Stability of optimal control 139 3. where W(x) is the current value state valuation function.3).5) Let v*( •) be a choice of instruments that maximizes subject to over all measurable v ( . 47)) for equation (1. Rockafellar (1976). p. . x*) is a steady state solution of the system equations (3. T for G. ) . Note further that Wxx exists almost everywhere and is negative and is negative semi-definite when U and T are concave.A.S. 35) have also shown that if Wx exists. This is so because W(x) is concave in this case. 1977a). Then Arrow and Kurz (1970. p. and Brock and Scheinkman (1976.S. expressed in current value.A. where v*(t) solves Arrow and Kurz (1970.

Roughly speaking. is quadratic in £0 and is 0 when £0 = 0.2) and (3.A.140 Differential equations. Thus. stability and chaos in dynamic economics It is important to interpret the meaning of V1 for the OLRP. More specifically.2) and (3. n).3) for the OLRP is given by Thus.S. Kwakernaak and (1977a) for a more complete discussion of why function in the OLRP literature. C(£0) = -W(£0). and asking that V1 > 0 is simply asking that the increases when the minimal cost is calculated Anderson and Moore (1971). given by equation (2. 4. The minimum cost. there is a matrix P such that Also. analysis in economics. Furthermore. and Magill V1 is the basic Liapunov The next two sections report stability results based on these two Liapunov functions. Such a Liapunov function was used earlier by Samuelson (1972a) to eliminate limit cycles in the case p = 0. Stability results based on V. See Sivan (1972). the costate q*(t) in equations (3. Here. Cass and Shell formulate a general class of economic dynamics in price-quantity space which includes both descriptive growth theory and optimal growth theory.3) that satisfy . Here we are concerned only with their stability analysis. since the state-costate equations (3.2). x* = q* = 0. they take the time derivative of V1 along solutions of equations (3. Cass and Shell (1976a) and Rockafellar (1976) were the first to recognize that V1 is of basic importance for G.3) are linear. The second Liapunov function is given by minimal cost fall as time at £*(t) for each t. P is positive semi-definite when the integrand is convex in (£.2) and (3.

in the set of all solutions of equations (3. . See Cass and Shell (1976a). x) is convex in q and concave in x. That is.1) holds.S. T are concave in (x. More precisely: Theorem 4. x) such that (q. v).2) and (3.2) implies Thus. Assume that H°(q. only a slight strengthening of equation (4.) For the case p>0 assume that for every e > 0.A.2) and assumptions sufficient to guarantee that x*(t) is uniformly continuous of [0. Also (S) is the same as Cass and Shell (1976a) also prove the following useful theorem.3).2) and (3.2.Stability of optimal control 141 and interpret the economic meaning of the assumption They show that equation (4.1. Then for any solution ( q ( t ) . (Cass and Shell (1976a). then it is trivial to show that H°(q. x * ( t ) ) solves equations (3. there is a 8 > 0 such that \x — x*\ > e implies Then if (q*(t). oo) allow them to prove that the steady state solution x* is G. x ( t ) ) of equations (3. then Proof.3) and if equation (4. x) is concave in x Convexity in q follows from the very definition of H°.1).3) that satisfy equation (4. It should be noted that (S) is only required to hold on the set of (q. Proof. x * ( t ) ) for some t >0. Theorem 4.2) and (3. See Cass and Shell (1976a).x) = ( q * ( t ) . Note that if U.

that the restriction (x. Then the stationary solution x* is G. then a-convexity is equivalent to: for all x0e C. v) and T(x.S.A. x).A.142 Differential equations. (Rockafellar (1976). v) = v.3.3) starting from any set of initial conditions.3) exists and that optimum paths exist from the initial condition x0.A. however. stability and chaos in dynamic economics regardless of whether U. of the stationary solution x*. Here we give a simple overview of Rockafellar's work. X convex.A. He points out. (2) duality theory of the Hamiltonian function H°(q.S. . and (7) the notion of (a. may be treated by defining U to be equal to -oo when (x.) Assume that H°(q. (q2(t). The proof uses the definition of convexity and the definition of maximum.2) and (3. if the function is convex on C. x) is finite and B-convex-a-concave on Rn x Rn. Also assume that a stationary solution (q*. of the stationary solution x*.S. x)e X. x2(t)) of equations (3. v) is concave in (x. a e R. See Rockafellar (1976) and its references for a systematic development of properties of the function H°. x) is not in X. B) convexity-concavity for the H° function and its relation to G. Definition. (4) theorems on the differentiability of W(x) under assumptions sufficient for G. T are concave. The paper and its references develop the following ideas assuming U(x. (6) theorems on the monotonicity of the expression for any pair of solutions ( q 1 ( t ) . Then h is a-convex. x1(t)). A function g: C -> R is B-concave if — g is B-convex. provided that (R) 4a B > p2. If C is open and h is twice continuously differentiable. must hold.S. Theorem 4. theorem of Rockafellar a definition is needed. Thus a very general class of problems may be treated by his methods. Rockafellar (1976) studies the case in which U(x.2) and (3. (3) existence and uniqueness theory for optimum paths. x*) to equations (3. Let h : C -» R be a finite function on a convex set C <= R". for all w e Rn. Here hxx(x0) is the matrix of second-order partial derivatives of h evaluated at x0. To present the main G. v) to be concave but not necessarily differentiable: (1) a dual problem that the optimal costate q*(t) must solve. (5) relations between W(x) and its analogue for the dual problem.

We will return to some of the Brock and Scheinkman results in the next chapter where their applicability to capital theory is demonstrated.3) that correspond to optimal paths. The basic idea of the proof is just to show that (R) implies along solutions of equations (3.3) to yield where and where / denotes the n x n identity matrix and the matrices of partial derivatives H°gg _ H°xx.2) and (3. The following sequence of theorems summarize the results in Brock and Scheinkman (1976. 5. These results are developed rapidly with primary emphasis on contrasting them with the other theorems reported in this chapter. x*(0)) be a solution of equations (3.1. Theorem 5.3 is given in Rockafellar (1976) who works with a more general system. (which are positive semi-definite since H° is convex in q and concave in x) are evaluated at ( q ( t ) . A more precise statement of theorem 4. Differentiate the Liapunov function V2 = . 1977a).2) and (3.Stability of optimal control 143 Proof. Then Let (q*(0).3).q ( t ) T x ( t ) along solutions of equations (3.2) and (3. x ( t ) ) . See Rockafellar (1976). provided that . 1977a) based on the Liapunov function V2. Stability results based on V2 In this section we summarize the stability results of Brock and Scheinkman (1976.

x*) is the unique stationary solution of equations (3. stability and chaos in dynamic economics where Furthermore. Thus. Put V1(q. Theorem 5.3) that are bounded for t >0 converge to (q*. x) < 0 for (q. Proof. If (a) (q*. implies (c) For all w = 0. Here. Note that theorem 5.2) and (3. and equation (5.3). x*) of (3.2 gives a set of sufficient conditions for the Cass and Shell hypothesis. x*)w>0. x*) as t-»oo. Remark.5) holds automatically.S. given a function y( •): [0. by means of Liapunov functions. oo) -> R.1).2) and (3. x*( •)) is bounded independently of t or if then there is a stationary solution (q*.3) such that Proof. The rest is a standard Liapunov function stability exercise. The second part of the theorem is just a standard application of results on G.5) is quite natural for optimal paths because if Wxx( •) exists it will be negative semidefinite since W( •) is concave for U and T concave. x) = (q*. wTB(q*. if (q*( •). Then all solutions of (3.2. Assumption (5. Inequality (5. x*). x*). lim sup y ( t ) denotes the largest cluster point of the function values y ( t ) as t -»oo. x) = (q*. x) = -(q -q*)T(x-x*) and use (b) and (c) to show that V1(q.3) is obvious from equation (5.144 Differential equations.A.2) and (3. . (b) For all (q.

x * ( t ) ) may be dispensed with provided that one assumes and refines the Liapunov analysis or one assumes that W x ( .3. x * ( t ) ) where 4aB > p2.S.7) holds for optimal paths.1 and 5.) in the last line exposes why the Liapunov function. ) exists.x*). Then (g*.x * ) is natural. complementary since each asks that Q be positive definite in directions which are transversal to each other. This is an adaptation of Hartman-Olech's theorem in Hartman (1964. Assume that W x x ( . x*) is the unique stationary solution of (3. Also note that boundedness of ( q * ( t ) . to be locally B-quasi-concave at XO E Rn if for all w e Rn. Proof. we have for all w such that g: Rn -> R is locally a-quasi-convex at x0e Rn if —g is locally a-quasiconcave at x0.q * ) T ( x .2 are.2) and (3. and (e) H°(q. p.Stability of optimal control 145 to hold.8) with their G( •) = .3). We define a twice continuously differentiable function f: Rn-> R.x)-pqx is B-quasi-concave along ( q * ( t ) .Wxx( •). w = 0. For if W( •) is concave and W x ( . ) exists and is negative definite on Rn+. x*(f)) be a solution of equations (3. Let (q*(t). in some sense. x*) is G.x) is locally a-quasi-convex and H°(q. . Assume (a) H° is twice continuously differentiable. Theorems 5.3) that corresponds to an optimal path.x) is locally a-convex-B-concave at (q*. .A. ) exists. Benveniste and Scheinkman (1979) provide a set of very general conditions on equation (1.5) that imply that Wx exists and that (5.2) and (3.( q . (b) (q*. 548) to the system equation (5. Theorem 5. (c) x* is a locally asymptotically stable solution of the reduced form system (d) H°(q. then The use of W x ( .

) is negative definite which implies a form of long run decreasing returns.3 is in an unsatisfactory state of affairs at the moment since it requires Wxx( •) to exist and to be negative definite. This we do in the next section.A. we record here the Hamiltonians for OLRP obtained by converting the OLRP into a maximization problem.A. the Hamiltonian function H°(q. To sharpen our understanding of functions U and T that satisfy the hypotheses of the preceding G.1). For B-quasi-concavity in x of the imputed profit function. Note that concavity of W does not imply concavity of U or T.10). p. In particular. 224) derives in detail equation (5.A. is likely when H°(q.x) — pqx amounts to allowing increasing returns to x provided that the isoquants for each fixed q have enough curvature. They are Brock (1977a.3 allows a weak form of increasing returns to the state variable. The last six theorems are all unified by the fact that they represent results that can be obtained from the Liapunov functions. the Rockafellar condition.S. it is useful to look at the OLRP or the linear quadratic approximation to problem (1.S. or its analogues. are sufficient for G. stability and chaos in dynamic economics Theorem 5. x) has a lot of convexity in q and a lot of concavity in x relative to the discount rate p. but we do not have a useful set of sufficient conditions on U and T for this to happen.3 allows a weak form of increasing returns because we assume W x x ( . We say that theorem 5. See next chapter. theorems.5) as given in equation (2. . Both this question and the question of stability analysis under increasing returns seem to be wide open and important fields of research.146 Differential equations.S. Systematic study of economic dynamics under increasing returns is likely to change our view of how a dynamic economy functions. and their analogues. These results lead us intuitively to expect that G. Theorem 5. More specifically. the state valuation function is concave. However.

A. x*) = (0.S. x.A. The Cass and Shell test requires that for all q. Linear quadratic approximation Let the Hamiltonians be given by Substitute the formula to obtain the system Similarly. Note the existence of the stationary solution (q*.5) where which is the negative of the Magill (1977a) Kp matrix. and to obtain at the same time some of the Magill (1977a) G. Let us use these formulas to build some understanding of the meaning of the G.10) and (6.S.S.Stability of optimal control 147 6. Thus in the case of the OLRP. 0) for the OLRP. results for the OLRP. . all five G.A. This will not be true for nonquadratic problems. tests developed in the first five theorems of this chapter amount to the same thing. From equations (5. Now it is easy to see that the Rockafellar condition (R) is basically the same as B positive definite. tests in the first five theorems.

x) means a equals the smallest eigenvalues of H°qq and. However. there are two state variable examples in which the underlying system matrix is stable. one source of stability or instability is ignored by equation (6. That is the matrix F. We shall say more about F later. for the OLRP. but it is optimal to administer control to destabilize the system! See problem 7 in section 9 for an outline of how to construct such an example. This seems plausible because it costs vTRv to administer control.S.A.concavity. Similarly for B. A test needs to be developed that uses information on F. we require Inequality equation (6. Then in the one dimensional case. and one would think that in view of the cost xTQx of x being away from zero it would be sensible to use v to speed up the movement of x to zero when F is a stable matrix. that is.8) and indeed by all six theorems. However. it is pointed out by Magill (1977a) that a fruitful way to view G. R is small and p is small. That is to count the eigenvalues of the linear system . Return now to the role of the matrix F. stability and chaos in dynamic economics When is B positive definite? To get some understanding for this put G = /. This is in accord with our earlier heuristic discussion of the stability of the OLRP. for intuition suggests that.S. as is easy to see.8) holds if Q is large.148 Differential equations.9) is the same as (R) since a-convexity of H°(q. if F has all eigenvalues with negative real parts. which is the very law of motion of the system. Now there is one test for G.A. B will be positive definite when where A ( A ) is the smallest eigenvalue of (A + AT)/2. Indeed. Inequality (6. Any information on F is wasted by the last six theorems.A. no matter how stable or unstable the matrix F. of the OLRP that wastes no information at all. in this case. tests based on the six theorems is that they give sufficient conditions for G. In general. then it seems odd that it would be optimal to destabilize the system.S. F is a stable matrix. S — 0.

Results based upon the Liapunov function V3 Brock and Scheinkman (1977a) consider the class of Liapunov functions where the matrix G(q. tests on U and T that work for nonlinear.A.S. but the problem appears to be in developing a test that is efficient in the use of the structure of (L). which is the famous no discounting case in optimal growth theory. This sort of test has not been generalized in an interesting and useful way to nonquadratic problems. follows from just convexo-concavity of H° for the case p = 0. The objective of the work being surveyed in this chapter is to develop G. 4.S. Then.S. x) is positive definite. However. they indicate that G. Brock and Majumdar (1978) and also Chang (1982) develop stochastic analogues of theorems 4.Stability of optimal control 149 and check whether half of them have negative real parts. nonquadratic problems.A. 4.2. 5. Let us call this kind of test the ideal OLRP test.2). 7. One obtains Here G(q. holds. G.S.1. Turn now to the development of a test that uses information on F. This is another research problem of some importance.1 and 5. provided that the corresponding eigenvectors in (q. there are Routh-Hurwitz-type tests for k< n of the eigenvalues to have negative real parts.A. wasteful relative to the ideal test for the OLRP though they may be. for half of the eigenvalues of (L) to have negative real parts and for the projection property to hold seems to be open. The problem posed by Had Ryder of finding a neat set of conditions on (L). x) space generate a linear space whose projection on x space is all of Rn.3. The tests proposed in the six theorems. making full use of its structure. Look at Evaluate V3 along solutions of equation (7. however. results for a highly nonlinear multisector model under uncertainty. and that generalize easily to uncertainty. is defined by . the trajectory derivative of G. provide adequate results for nonlinear problems and generalize easily to the case of uncertainty.A. For example. x).2 and obtain G.

2) and (3. Recall from chapter 4 that M is future invariant under x = f(x) if for each x0e M the solution x(t. the G.3) that correspond to optimal paths. but the production function is not necessarily quadratic. We may now state the following theorem.7) to the OLRP.1.) exists. Theorem 7.1 would be very nice if the term H°qq did not appear.3) suggests choosing Thus.3) such that Assume along x ( .2.1. 4. stability and chaos in dynamic economics Assuming Wxx( •) exists and is negative semi-definite.1 and 5. x) arise in neoclassical investment models in which the adjustment cost function is quadratic. and especially for problems where H°qq is independent of (q. so that qTx < 0 along solutions of equations (3. Many times the special structure of the Liapunov function V and the law of motion f can be used to show that the largest future invariant set contained in {x0: V(x0) = 0} is a point. ) . 5. x0) starting from x0 stays in M for t > 0.A. Here .2) and (3.Also assume that W x ( . test (7.3.S. See Brock and Scheinkman (1977a) for details and some extensions of theorem 7.7) is applicable. Problems where H°qq is independent of (q.7) is useful. See Brock and Scheinkman (1977a) for a wide class of investment models where equation (7.2 may be sharpened in this way. equation (7. Let q( •). x). This term is hard to grasp. However. theorems 4. Obviously.1. x( •) be a solution of equations (3. Let us apply equation (7.150 Differential equations. Theorem 7. for quadratic problems. 4. Then x ( t ) converges to the largest future invariant set contained in The proof is just a standard application of Liapunov theory to the function V3.

then the OLRP should be G. we see that F<0 implies G. . by theorem 7.1. independently of p. tests mentioned above make use of H°xx in a way that parallels H°qq in theorem 7. (Magill (1977a).A.S. This is in accord with our intuition that.A. The Liapunov function V4 Consider the Liapunov function.A.A.) Assume that are negative definite. if F is a stable matrix. then since R > 0 by convexity of the objective.8) put G = I. None of the G.S. Proof. Magill (1977a) shows that implies the following The rest is standard. Put Then. We state it for the case of certainty only. S = 0. This brings us to one of Magill's (1977a) nice results for the OLRP.S. assume that is nonpositive definite.1 regardless of the size of p and Q.2. since under Magill's hypotheses. Theorem 7.S. Then If R and F are one dimensional. holds for the OLRP. Furthermore. Then G. 8.Stability of optimal control 151 To get some understanding for negative quasi-definiteness of equation (7.

3).x) such that V 4 <0 holds along ( q ( t ) . just put 6 = 0.2) and (3. x ( t ) ) and if we assume that q T x<0 along optimal paths. Relationship (8. x ( t ) ) . choose a < 0. if A = H 0 . x ( t ) ) to equations (3.1) is derived by differentiating V4 along solutions to equations (3. which is equation (8. The only case where we can get a new theorem. we then get V4 < 0 for all t > 0 by putting a = 0. Grouping the terms common to qTx in V4.1 H 0 q x + (H 0-1 qq H 0 qx ) T +(H 0-1 qq ) is negative definite along ( q ( t ) . Therefore. t E [0.2) is nonpositive provided that However. oo). for t > 0. stability and chaos in dynamic economics which leads to the following: find sufficient conditions on H°(q. One useful sufficient condition for V4 < 0 that emerges from this approach is holds along the solution ( q ( t ) . is when B is not positive semi-definite and A is not negative quasi semi-definite for all t > 0. .1). for particular choices of a. Suppose that A ( A ) > 0 .2) and (3. Here A(A) denotes the largest eigenvalue of (A + A T )/2 and A the smallest.3). therefore. Similarly. x ( t ) ) . Note that the first line of V4 is just so if B is positive semi-definite along ( q ( t ) . a<0 to get V4< 0 for all t > 0. b > 0.152 Differential equations. The right hand side of (8. b > 0 such that 2b + ap > 0. Then since qTx< 0. b E R.

2) and (3.A.A.A. that is. in particular.then Scheinkman (1978) shows that G. in discrete time.A. 1977b) has formulated a linear quadratic approximation to a continuous time stochastic process versions of problem (P). x) is separable. to G. This establishes. Thus loo continuity is not an assumption to be taken lightly. See also Brock and Magill (1979) or Chang and Malliaris (1987) for the continuous time stochastic case. This is a promising area for future research that is largely undeveloped. Note that stability does not depend on the size of p. Separable Hamiltonians arise in adjustment cost models where the cost of adjustment is solely a function of net investment. Magill's stability result is the first one for the multisector optimal growth model driven by a continuous time stochastic process.A. is true.A.A.A.).A. Brock and Majumdar (1978) treat the discrete time stochastic case. then loo differentiability of the optimal paths with respect to both initial conditions and discount factor must hold.S.Stability of optimal control 153 9. Miscellaneous applications and exercises (1) If the Hamiltonian H°(q. Burmeister and Graham (1973) present the first set of G. (2) Araujo and Scheinkman (1977) have developed notions of dominant diagonal and block dominant diagonal that take into account the saddle point character of equations (3. (4) Scheinkman (1976) shows the important result that G. They show that loo continuity plus L.S.S.S. results for multisector models .S. F 2 (. is a continuous property in p > 0 at p = 0. holds. (3) Magill (1972. and using qTx < 0 to show that V5 < 0 along optimal paths. namely the minimal expected value of the objective as a function of the initial condition x0. that both the policy function and the value function are differentiable if G.S.S.S. and has established the stochastic stability of this approximation. holds under convexo-concavity of H° by setting V5 = F1(q). Scheinkman has also generalized the above result to discrete time.3).S.). and have obtained interesting G. His paper (1972) was the first to point out the correct Liapunov function to use. They also show the converse result that if G. of a steady state x* implies G. The Araujo and Scheinkman paper also relates 1oo continuity of the optimal path in its initial condition. for some pair of functions -F1(. of that steady state. results. Malliaris (1987a) discusses some modelling issues in continuous uncertainty. This result was generalized for any p>0 in Araujo and Scheinkman (1977).

What additional assumptions are needed on the Hamiltonian to ensure G.S.S. x0) of . (1.5). arguing heuristically. is not well understood at this point. Here xt(t)e Rn denotes the vector of state variables under the control of player i. stability and chaos in dynamic economics (5) under adaptive expectations. In particular. p-»oo.2).A. then the optimal solution of equation (9.S.S. and G. vi(f) e Rm denotes the vector of instrument variables under control by i. suppose that equations (1.A. This looks like a promising area for future investigation. Vi(t) denote the state and instrument variables under control by all players but i. The relationship between L. For example. if we let |G|-»0. should converge to the solution x(t. x0).? A nonlinear version of the OLRP suggests that this problem may be difficult. A discussion of the economic basis for these games and some very preliminary results is given in Brock (1977b).154 Differential equations.7) had only one rest point x* and assume it is L. |Q|-»0. Now. consider the problem (6) subject to Note that only F(x) is nonlinear. call it x(t.6) and (1.A. and x i ( t ) . |R|-»oo. Another particularly promising area of research is to apply the program of results surveyed in this chapter to noncooperative equilibria generated by N-player differential games. where the objective of player i is to solve subject to measurable.A.

2). t -> oo for all E0. In economic applications more information on F is available. the matrix equation See Magill (1977a) for this easy derivation and a discussion of the properties of the Riccati quadratic matrix equation (9.S.S. rest point but are not G. The Hamilton-Jacobi equation generates. T. and unique. Without loss of generality.A. to get G.3) for F concave is possible. An obvious example in the plane is concentric limit cycles surrounding a unique L.A. it is fairly easy to show that F < 0 implies e(t. We may assume F(x) is concave in x.A. Thus.2).A. Now the system .2). letting W(x 0 ) = xTWx 0 be the state valuation function of equation (2.5).2) that generates optimum paths that lie arbitrarily close to the solution trajectories of equation (9.3) we should be able to construct a problem (9. £0) denotes the optimum solution of equation (2. rest point. it appears that strong additional hypotheses must be placed on the Hamiltonian.S.3) can be generated by optimum paths to problems of the form (9. above and beyond convexo-concavity.Stability of optimal control 155 (7) Here |A| denotes a norm of the matrix A. An important research project would be to classify the class of optimal paths generated by problem (1.S. even when the rest point is L. for example.2) starting from £0. The heuristic argument given above suggests that anything generated by equation (9. Still. This suggests that any behavior that can be generated by systems of the form (9. G. n = q to ease the notation. For the one dimensional case.A. assume that S = 0 in equation (2. The uniqueness of rest points is comprehensively studied in Brock (1973) and Brock and Burmeister (1976).S. given any differential equation system (9. Put £ = x. In other words.A.5) for all concave U. where g(t. There are many systems x = F ( x ) that possess a unique L.3). £o) -> 0.S. a lot of phenomena may be generated by systems of the form x = F ( x ) with F concave.A. Thus we must go to the two dimensional case in order to construct a counter-example.S: Obviously. cannot hold when there is more than one rest point. It should be pointed out that there is a close relationship between uniqueness of the rest point and G.

B. Pick stable F and positive diagonal B so that the determinant of F-B is negative: To do this set FU + F 11 <Q. The easiest way to do this is to divide both sides of (9.8) is negative. where Q is a fixed positive definite matrix. Obviously. Put so that BQ = B and A = F . W is approximately given by W=-Q and Our task now is to construct a stable matrix F and two positive definite matrices so that A is unstable. Thus for p large. stability and chaos in dynamic economics becomes using and the formula for the optimal control. This ends the sketch of the counterexample.5) by p. The task is to construct a matrix F that has all eigenvalues with negative real parts and to construct p. if b1 is large enough and b2 is small enough.156 Differential equations. let p-»oo. Q. R. and change Q so that Q/ p = Q. . then the right hand side of (9. G so that F+ GR -1 G T W is unstable.

a high discount on the future. let us call the control gain. this area is well covered in the papers by Cass and . R. the discount p is high on the future. But —F 1 2 F 2 1 >0 in order that F11<0. A first area is the neoclassical theory of investment associated with the names of Eisner-Strotz. F 22 >0.Stability of optimal control 157 What causes this odd possibility that it may be optimal to destabilize a stable system when more than one dimension is present? To explain. It is large when control cost. In brief. is small and Gu is effective in moving x. But if bt is large and b2 is small. The paper by Mortensen (1973) obtains a set of empirical restrictions on dynamic interrelated factor demand functions derived from the neoclassical theory of investment provided that the stability hypothesis is satisfied. Therefore. Mortensen. and differential control gains or differential state costs. Now. 2. Jorgenson. Lucas. A version of this theory was used by Nadiri and Rosen (1969) in a well-known article on estimating interrelated factor demand functions. Further remarks and references It is appropriate to discuss why the results reported in this chapter are useful. 10. then control gain is larger for x1 than for x2. there is no doubt that stability results are of great importance to the neoclassical theory of investment. Mortensen's paper can be viewed as Samuelson's Correspondence Principle done right in the context of the neoclassical theory of investment. A second area of applications of stability results is economic growth theory. their usefulness depends on their applicability in several areas of economic analysis as was indicated in section 9. The Nadiri-Rosen work culminated in their book (1973) which ended with a plea for useful results on problem (P). the optimizer administers more control to x1 relative to x2. The economic content of our example shows that optimal stabilization policy may be destabilizing when there is a high cost of state disequilibrium. and others. More on this topic is presented in chapter 7. Treadway. Thus the optimizer is led to destabilize the system. For i = 1. Thus. the cost of xi disequilibrium is weighted equally by Q. but the state disequilibrium cost Q — pI is large. so that the sign of the impact of an increase of x2 on X1 is opposite to the sign of the impact of an increase of x1 on x2. |F| > 0. Fortunately.

Bensoussan (1982) and LaSalle (1986) give a rigorous mathematical presentation of deterministic and stochastic optimal control. These games represent important new efforts to dynamize the field of industrial organization. Gale. Radner.7) is discussed in Benveniste and Scheinkman (1982) and Araujo and Scheinkman (1983). For an illustration of the importance of stability in economic growth see chapter 9. and the integral convex cost problem of operations research discussed in Lee and Markus (1967. Brock (1987a) and Malliaris (1987b) offer a brief introduction to the deterministic and stochastic optimal control in economics respectively. Samuelson. Indeed. Fleming and Rishel (1975).1) or (5. 1976b). A fourth area of applications is the optimal regulator problem of engineering reported in Anderson and Moore (1971). so we will not spend time on it here. the optimal filtering problem reported in Kwakernaak and Sivan (1972). The specialized topic of the stability of optimal control is treated mathematically in Lefschetz (1965) and Roxin (1965a. 1965b). Friedman (1971). and others to the case p > 0. This application is developed by Magill (1977a). The mathematical analysis of deterministic optimal control with numerous applications in economics is presented in Kamien and Schwartz (1981) or Seierstad and Sydsaeter (1987). No doubt there are many more applications.158 Differential equations. Finally. . and others. It is. but this should be enough to convince the reader that the stability problem is of basic importance in a number of areas. chapter 3). basically. this area is wide open for new researchers. stability and chaos in dynamic economics Shell (1976a. the role of the transversality condition given in (4. the extension of the well-known turnpike theory of McKenzie. A third area of applications of the results reported here is the dynamic oligopoly games of J. Prescott (1973).

Introduction The previous chapter studies the question of locating sufficient conditions on the Hamiltonian of an infinite horizon optimal control problem for the optimal dynamics to be globally asymptotically stable. Increasing returns in the state variable are allowed. Brock and Dechert (1985). the mathematical problem already takes on some sophistication. This leads to hard mathematical problems. The hypothesis of joint concavity of the Hamiltonian in the state and the control factor was maintained throughout chapter 5. 1987). Romer (1986a. Smale (1976. 1986b.CHAPTER 6 MICROECONOMIC DYNAMICS When one considers the equation. The reader is forewarned that we are entering unchartered terrain. we conduct the exposition in the context of a two sector economy. For recent work on increasing returns see Majumdar and Mitra (1982). the gaps in this chapter will stimulate badly needed research in the area of increasing returns. This chapter is written to make three points. The concavity hypothesis does not allow increasing returns. p. Dechert (1983). Perhaps. 288) 1. supply equals demand for several interdependent markets. First an infinite horizon two sector economy in which one sector is decreasing returns and the other is increasing returns may fail to achieve Pareto optimum. under decentralized . To keep the analysis tractable and to focus on important economic issues of decentralization and stability that arise when increasing returns are present. In this chapter we relax the hypothesis of concavity of the Hamiltonian. Dechert and Nishimura (1983). and Mitra (1987).

Inputs are capital goods and energy. we illustrate the nature of stability analysis when increasing returns are present.S. intended to capture the main features of regulation of public utilities in the U. Imagine that production of goods takes place in a large number of regions.S. Consider a two sector economy. Skiba shows that there are two trajectories I. In the U.S. Skiba shows that there is xs such that VI(X 0 ) > V II (x 0 ).160 Differential equations. Capital is shiftable across the two sectors. The chapter also provides an analytically tractable framework where the impact of different modes of regulation upon economic development paths may be studied. one input increasing returns production function. Each region is inhabited by a large number of identical neoclassical firms who all buy energy from one energy . Welfare is measured by the discounted sum of utility of consumption over time. This may occur even when the increasing returns sector is regulated in a first best fashion. efficient markets prevail. We come to our subject. Consider the following parable. II for each level of capital stock x0. To study of decentralized regulatory institutions in the framework laid out above becomes a parable. Capital goods are input to the energy sector. National commissions such as the Federal Communications Commission regulate interstate business. capital market that they treat the cost of capital as parametric. It seems reasonable to assume that all of these commissions are so small relative to the U. there is a tendency for the increasing returns sector to overexpand although this is not always the case. The assumption of price taking public utilities and price taking commissions in the capital market is the key assumption that drives our results.. Conditions may be located on the technologies so that the Pareto optimum problem is equivalent to the problem of one sector optimal growth under a convexo-concave technology treated by Skiba (1978). It provides consumption goods and capital goods which are perfect substitutes. Hahn (1966) type problems. Third. V11(x0) along I. The economy stagnates along II and grows along I. for x0 > xs and vice versa for X0 < xs. Energy is produced by a one output. The framework presented here leads one to decompose the dynamic decentralization problem into a sequence of static decentralization problems. Sector one is described by a one output. a state commission regulates public utilities in the state. II that satisfy the Euler equations and transversality conditions at infinity. rational expectations obtain. and the necessity of the transversality condition at infinity for identical infinitely lived agents eliminate F. Second. The optimum is found by calculating value functions V1(x0). two input neoclassical production function. stability and chaos in dynamic economics institutions.

First. necessity of identical consumers' transversality condition at infinity. The conclusions of the analysis are fourfold. II. Since there are a lot of regions.) of an a-competitive equilibrium are not satisfied by a rest point or one of Skiba's trajectories I. first best a-competitive equilibrium may not exist when Pareto optimum is II. In other words suppose one accepts the decentralized institutions described above as reasonable abstractions of observed regulatory institutions. this state of affairs occurs when the output elasticities of capital and energy in the neoclassical sector are relatively small and economies of scale in energy production are not too large. each commission also acts like a price taker in the capital market. Neoclassical firms are price takers in the goods market. concavity of the aggregate production function as a function of raw capital input is sufficient. II. In general.N. Each region has a regulatory commission that regulates its natural monopoly. . such as an efficient multipart tariff. the economy as a whole may follow I when II yields more welfare.C. Then perfect capital markets. of an a-competitive equilibrium are satisfied by two trajectories I. Moreover. Energy firms are price takers in the capital market. Each firm buys capital input in the interregional capital market. if mode a is a first best mode of regulation then the first order necessary conditions (F.C. Trajectory II cannot be supported by an a-competitive equilibrium. Second best modes impose a wedge between price and marginal cost. Second. Capital is mobile across regions and firms. We define an a-competitive equilibrium to be a decentralized regulatory competitive equilibrium where all commissions use mode a of regulation. Third.O. and there are a large number of identical price taking consumers in each region. In the examples. Call such an economy a decentralized regulated economy. Energy production is a natural monopoly in each region. then under general conditions on technology the F. we exhibit a class of examples where static first best regulatory institutions realize a social optimum even though commissions and their firms act as price takers in the capital market. First best modes set the price of the last unit sold equal to the marginal cost of the last unit sold of energy at each point in time. We will examine two classes of modes of regulation of energy firms. and rational expectations are not enough market forces to achieve a Pareto optimum contrary to the case in which both sectors are neoclassical as in Brock (1982) or Prescott and Mehra (1980). if all commissions follow a second best mode of regulation such as Ramsey (maximize surplus subject to breakeven constraint). Fourth. the energy market and the capital market.O.Microeconomic dynamics 161 company.N.

Function g2 produces power which is needed as input into gt. g(0) = 0. The economy's freely shiftable capital stock x is allocated between power production and capital goods-consumption goods production.C.N. Even though the equilibrium interaction between interest rates and increasing returns generates F.162 Differential equations. g(x) is convexo-concave. overlapping generations. g'(oo) < 0. economic actors must engage in some type of joint centralized approach to the control of investment in order to achieve a Pareto optimum. Power production is convex increasing. 2. g'(0) = 0. Put We assume A2. They must coordinate their planned paths of investment. that is. We analyze a two sector abstraction that is analytically tractable and generates a Skiba-like phase diagram under plausible assumptions.O. is likely to remain in more complicated setups with heterogeneous consumers. It is the assumption that commissions and their firms face interest rates parametrically. multiproducts and uncertainty since these complications require even more markets to achieve the same degree of coordination. increasing in both arguments and satisfying right and left hand Inada conditions. it is jointly concave.1. stability and chaos in dynamic economics The central finding that the decentralized regulatory institutions fail to generate Pareto optimal competitive equilibria. The central cause of the failure of decentralized institutions is easy to explain. But this requires a degree of centralized planning that does not prevail in mixed economies. g'(x) > 0 for x> 0. satisfied by the same two trajectories and rest points as the optimum planning problem. it does not generate the correct mechanism for choosing between them. First best regulatory modes in a two sector model This section proceeds rapidly because we reinterpret existing literature. that is. The function g1 is neoclassical. The optimum planning problem is Here. g1 is output of capital and consumables. Hence. . increasing returns prevail in the power industry. and g is twice differentiable.

1.1) may be restated thus: put The Euler equation and material balance equation are given by Figure 6.3) the optimal planning problem (2.) is graphed in figure 6. Obviously the planning problem is a Skiba problem. 2. Digression on optimal growth under convexo-concave technology Using the definition of g(x) given in (2.1.1 .Microeconomic dynamics 163 Function g(. We digress to describe Skiba's results. Hence the Skiba (1978) results on optimal one sector growth under a convexo-concave production function may be applied to our problem.

AP(x). The phase diagram is depicted in figure 6. 536). Steady states of (2.6).2. (2. stability and chaos in dynamic economics Let x0 denote the value of x1 that solves (2.6). Then g' is given by where subscripts denote partial derivatives. Define average product.3 .3). x. p. (2. Figure 6.3.164 Differential equations. and marginal product MP(x) by The convexo-concavity of g implies the relationship between AP and MP which is depicted in figure 6. The system (2.7) is phase diagrammed as in Skiba (1978.7) are given by the two points x.2 Figure 6.

1 and suppose that trajectory II cuts x = 0 at x*. VII denote the discounted sum of utility along two trajectories I. and such that II is optimal for x0 < xs and I is optimal for x0> xs.1.Microeconomic dynamics 165 Skiba's result is: Theorem 2.) Assume p < max AP(x). Proof.) Let VI.2. and Dechert and Nishimura (1983) prove this result also for discrete time. Majumdar and Mitra (1982). (Skiba (1978. II satisfy the transversality condition at infinity (TVCoo). A useful tool in comparing values along different trajectories is Lemma 2. Assume A2. See Skiba (1978) and Dechert and Nishimura (1983) for continuous time. (Nondegeneracy.2. 537). II and the steady states x. as well as the Euler equation. p. .10a). Notice that both trajectories I. In order to avoid concern with technical tangentialities we will assume A2. x are the only trajectories that satisfy the Euler equation and the TVCoo (2.) The Skiba trajectories I. (Skiba (1978). Then there is a cutoff point xs such that x < xs < x. II starting at x0 that satisfy the Euler equation and Then VII> VI provided that or.

4. tory then (Dechert and Nishimura (1983). Skiba shows that (2. Let x be the smallest positive solution of the equation g(x) = px. by putting Ci(0)= c. respectively. VII(x0) denote values computed at the steady state x. Proof.10c) to write.2. Corollary 2. The inequality follows from concavity of u and application of (i) or (ii).166 Differential equations. Apply lemma 2.10b) implies Apply (2. Lemma 2.3. along I starting at x0.) If x ( . This ends the proof. and along II starting at x0. II are defined.) is an optimal trajec- . VI(x0). Let V. stability and chaos in dynamic economics Proof. Then x* < xs < x* and If there is no point x* where II cuts x = 0 then for all x0 where both I. One can show that x s < x by using a lemma of Dechert and Nishimura (1983).

Therefore along II since x0<x*<x.) If x0 > x. We find a contradiction to (DN) if II is optimal. > This contradicts (DN) and the proof is finished. then I is optimal. Notice that x <0 along II. This contradiction to the optimality of x(. we know that . we have Multiply both sides of (a) by e -pt and integrate to get (g(x0)-px0)/p foo (g(x) . t >0 generates more utility. x*] is the common domain of definition of Vi. Theorem 2. The interval [x*.3 we need only to examine the case x0<x*.x 0 . Proof.) completes the proof.px) e . To understand the Skiba-Dechert-Nishimura results look at figure 6. In view of corollary 2. the constant path defined by x ( t ) = x 0 .x ) e . (Dechert and Nishimura (1983). Hence.4.5. Look at Skiba's phase diagram to see that Furthermore. By Jensen's inequality Suppose by way of contradiction that Hence.p t d t . II.i = I. The slope of Vi is given by the corresponding value of ph i = I. where x is the smallest positive solution of g(x) = px.Microeconomic dynamics 167 Proof. II..p t d t = f o o ( g ( x ) .

The phase diagram for this case is obtained from figure 6. First best decentralization in a regulated economy Let there be a large finite number of identical price taking consumers that act as if they are infinitely long-lived and let there be a large number of . stability and chaos in dynamic economics Figure 6. Notice that if x0 < xs it is still optimal to stagnate and run the capital stock down to the origin. x*] follows. Doing this we obtain the standard phase diagram of the neoclassical growth model.3 by pushing the large steady state x off to +00.4 still describes the qualitative features of the solution.2. Take the convex case first. Turn now to the concave case. The phase diagram is qualitatively the same as that obtained from figure 6.3 by pushing x to zero. Figure 6.168 Differential equations. 2. The cases where g is convex increasing and concave increasing are easy to analyze given the above background.4 The conclusion that there is a unique cutoff point XSE [ x * .

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regions. Each region is populated by a large number of consumers, one public utility firm which produces power using technology g2, one regulatory commission, and a large number of identical price taking firms who produce consumer-capital goods using technology g1 Each consumer lives off income from equity in firms. In order to avoid notational clutter we will assume there is one region, one consumer and one firm of each type. Due care will be taken to differentiate between the individual and the aggregate. The representative consumer solves (for the all equity financed, no tax case):

Here q1, q2, E1, E2, d1, d2 denote price of an equity share in firm i, quantity of equity held in firm i, and dividends per share in firm i, respectively. The consumer faces ql, q2, dl, d2 parametrically and chooses E1, E2, c to solve (2.11). Firm 1 will denote the representative consumer goods producer and firm 2 will denote the representative power producer. Turn now to describing the firm side of the economy. Firms of both types are assumed to be initial equity value maximizers that face the cost of capital parametrically. Valuation formulae are developed below. The cost of capital is generated by the consumer's first order necessary conditions of optimality as in chapter 8. Put p = u'(c). Then the consumer's first order conditions for optimality are given by Here r is the cost of capital. Following the analysis in chapter 8, apply the Benveniste and Scheinkman (1982) theorem to conclude that the following transversality condition at infinity (TVCoo) is necessary for the consumer optimum: Here denotes the equity value of firm i. The accounting identities

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may be written in terms of equity value as Here P2 denotes the price, possibly nonlinear, of good 2 in terms of good 1 as numeraire. Unlike chapter 8 there are no tax issues here that may effect the firm's policy of issuing shares. Therefore, we shall put Ei = 1. This simplification makes the asset pricing side of our model equivalent to the model of Lucas (1978). Integrate (2.16) from 0 to T to get the valuation formulae

where

It is easy to show as in chapter 8 that (2.13) implies

In other words, the necessity of the consumer's TVCoo prevents divergence between equity value and capitalized value of earnings in equilibrium. Integrate the first term of (2.17) by parts to obtain

where

In order to insure well defined optima for firms we place the following restriction on paths of capital acquisition,

Here lim denotes limit inferior - the smallest cluster point of the sequence {Xi(T)}ooT=O- Condition (2.22) is needed to prevent the firm from choosing borrowing strategies that asymptotically never pay off the loan.

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In view of (2.19) we shall postulate that firms face r ( - ) parametrically and solve

Notice that (2.21) defines static profit maximization problems from static microeconomic theory. If g2 were concave we could just postulate static profit maximization and calculate a static general equilibrium of the static economy (2.21) at each point of time. The path of the interest rate would be determined via (2.21) by the additional requirement that the consumption the consumers are willing to forego add up to the total capital demanded by firms via (2.21). We will assume that the economy starts off in equilibrium. Namely the values of xi(0) are compatible with the values dictated by (2.21). But g2 is not concave. If firm 2 faces P2 parametrically no optimum x2 will exist since g2 is convex. If firm 2 is regulated by the commission in its region so that, facing r parametrically, the static first best problem

is solved then firms of type 2 fail to break even with linear pricing schedules. Here D2(y, r) denotes the demand curve generated by firms of type 1, facing P2, r parametrically via (2.21). The demand curve D2(y, r) is just the marginal product schedule of power derived from TT 1 , that is, D2(y, r) = dTT1/dy. Let us explain the breakeven problem. The first order necessary conditions for (2.24) are

But profits are

because g2 is convex. Hence, the firm will always run a deficit charging P2 per unit. Later, we show that the firm may even run a deficit if it is allowed to extract the entire surplus (2.24). The breakeven problem is well known and exhaustively studied in the literature on public utility pricing. First best modes of solving it are, for

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example, (i) lump sum taxes, (ii) appropriately designed multipart tariffs, (iii) contractual bidding for the market a la Demsetz (1968) where a contract is a multipart tariff schedule. Assume that the static problem is solved in a first best manner for this section. Next we define the notion of first best decentralized regulatory competitive equilibrium. Definition 2.1. A first best decentralized regulatory competitive equilibrium is an allocation ( x 1 ( t ) , x2(t), y 1 ( t ) , c ( t ) ) , an interest rate function r ( t ) , a possibly multipart tariff schedule T ( y 1 , r), stock price functions q 1 ( t ) , q 2 ( t ) such that (i) The solution of:

(ii) The solution of:

(iii) The solution functions c(.), E 1 ( . ) , E 2 ( . ) of (2.11) facing

parametrically and initial conditions

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(v) The last unit of energy is sold at the demand price, that is, the multipart tariff schedule T is such that the solutions of (i), (ii), y 1 ( t ) = g 2 ( x 2 ( t ) , satisfy

where II° is the maximum of the function TT1 in (2.21) over x1. Theorem 2.6. (First order equivalence.)

(i) Both of Skiba's trajectories I, II and x, x may be realized as the first order necessary conditions (F.O.N.C.) for a first best regulatory mode competitive equilibrium. (ii) The F.O.N.C. for first best mode competitive equilibrium are the same as the F.O.N.C. for Skiba's trajectories I, II, x, or x Proof. In order to prove part (i) define r(.) by the formula

where the right hand side is calculated along one of Skiba's trajectories, say I. It is easy to check that the Skiba values x1 ( t ) , y1 (t) satisfy the F.O.N.C. for (2.21) and (2.24). Notice that a solution of the F.O.N.C. may not be a maximum. With respect to consumers, since there is one perfectly divisible equity share outstanding for each firm, the consumer's budget constraint (2.11) becomes Consumers face qh yi, parametrically and choose Ei to solve (2.11). We have placed bars over yi because the F.O.N.C. for equity value maximization by firms facing r( •) are satisfied by yi values equal to their Skiba values yi. The values of qi are determined as in Lucas (1978). Specifically, they are determined by the requirement that the demand for equity in firm i be equal to the supply of equity in firm i which is unity. Hence, for each t,

This ends the proof of part (i).

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For part (ii) let q 1 ( - ) , q2(•), x1( - ), x 2 (.), c ( - ) satisfy the F.O.N.C. of a first best regulated competitive equilibrium. We claim that an equilibrium satisfies the same Euler equations and TVCoo as the Skiba paths I, II. The Euler equations and the necessity ofTVCoofor the consumer imply (dropping upper bars to ease notation)

Equilibrium requires

Look at the firm side. Firms face r ( - ) parametrically and maximize (2.23) subject to (2.22). Matching up the firms' first order necessary conditions, the budget equation of the consumer, and the accounting identities of the firms, with (2.31) generates the same Euler equation and material balance equation as a Skiba trajectory I, II. The TVCoo remains. If firm 2 runs deficits we assume that either stockholders have unlimited liability or lump sum taxes are imposed on consumers to remove the deficits. If lump sum taxes render each T T 2 ( t ) > 0 in (2.20) then (2.34) is valid. If the capitalized value of TT 2 (t) is negative then the argument given in the text for necessity of (2.35) breaks down. In this case we simply assume (2.35) in order to bypass more complicated arguments concerning necessity of transversality conditions at infinity. Since gt is concave and if firm 2 is regulated at each point in time so that it breaks even, Ei = 1 and (2.20) implies

Therefore (2.32) implies

which is the TVCoo satisfied by a Skiba trajectory I, II. Application of the nondegeneracy assumption A2.2 finishes the proof. The main conclusion of this section is: more market and regulatory institutions are needed to get the economy onto the optimal Skiba trajectory. The problem seems basic for two reasons. First, F. Hahn (1966) type problems have been eliminated by necessity of the consumer's TVCoo. Second, distortions between marginal cost and price have been eliminated

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by first best regulatory institutions that seem operational under ideal conditions. Yet there is still not enough coordination to get a Pareto optimum. It is known from Guesnerie (1975) and Brown and Heal (1980) that nonconvexities cause problems for decentralized markets in achieving Pareto optimality. Their framework is a finite dimensional commodity space Arrow-Debreu economy with nonconvex production sets. Our framework has an infinite dimensional commodity space but only one consumer type and a recursive structure. The work of Brown and Heal (1980) suggests searching for a general Brown and Heal marginal cost pricing equilibrium. This necessitates abandoning our institutional framework of decentralized commissions facing interest rates parametrically. The intent of this chapter is to show how static first best regulation schemes like theories used in practice can go awry when interest rates are treated parametrically. Therefore, it is not appropriate to use the Brown and Heal concept in this context. What may be surprising to public utility economists is the failure of the imposition of static Brown-Heal-Guesnerie first best decentralization schemes at each point in time together with imposition of TVCoo to correct the problem. Notice however, if g(x) defined by (2.3) is concave and increasing in x then there is no problem. That is to sayTT1+TT2>0 even thoughTT2may be negative. Hence, a multipart tariff like that of (2.24) can be designed to price the last unit of energy at marginal cost but yet assure both firms non-negative profits at a given interest rate. Thus one can show that a first best competitive equilibrium is Pareto Optimum and vice versa when g is concave. The problem of supporting the socially optimal trajectory I or II with a first best decentralized regulatory competitive equilibrium may be easily explained with the aid of figures 6.1 and 6.2. Four points may be made. First, it is easy to see that

in any equilibrium. This requirement is the heart of the problem. Let us see why. Suppose for example that the stagnation trajectory II is socially optimal. Look at the line r1(t)x drawn in figure 6.1. Interest rates r(t) = g ' ( x ( t ) ) eventually fall on II. But a small interest rate like r 1 ( t ) in figure 6.1 causes each commission and its firm to select the large root of the equation f ( t ) = g ' ( x ) rather than the correct small root. Hence, no trajectory which, at some point of time, satisfies g"(x1(t)) > 0 can be supported by a first best decentralized regulatory competitive equilibrium (FBCE).

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Second, any part x2(t) of a trajectory such that x 2 ( t ) e (x, x), that is, such that

can be supported by a FBCE. This is so because for interest rate r 2 ( t ) the natural monopoly runs a deficit even though it captures all the surplus from the firms to which it sells. Third, even though all points of Skiba's trajectories I, II satisfy the F.O.N.C. of a FBCE only the part of I that lies in the interval [x, oo) may be supported by a FBCE. Fourth, in the case where g(x) is globally concave with [x, oo) = [0, oo), the amount of coordination necessary to correct the problem seems to require that the government choose the correct path of the rate base, x2. In any event the problem of two trajectories persist when we turn to second best modes of regulation.

3. Second best modes of regulation The Ramsey and the rate of return on rate base model of Averch and Johnson (1962) are analyzed as two second best modes of regulation. In our framework the Ramsey problem is: Choose x2 to solve

Refer to (2.24) for the construction of demand curve D2. Here the regulator is treated as facing r parametrically. Recall the parable in which each identical region contains a public utility commission that treats r as beyond its control because there are a large number of regions. Hence, each region is a small part of the capital market which is interregional. The solution is given by

Compare this with first best marginal cost pricing

The solutions are graphed below.

We assume that v is small enough that the AJ constraint is binding. one output production process for the familiar input distortions of AJ type to appear. the solution is given by It is clear from figure 6. Therefore.Microeconomic dynamics 177 Notice that convexity of g2 implies MC < AC for any level of r. Figure 6. In our framework rate of return regulation solves the problem Here v >0 is the premium allowed on the rate base x2.5 that for the case as drawn we may parameterize different AJ(v) modes of regulation by v with Ramsey being the limiting case v = 0.5 . marginal cost pricing induces a deficit which is removed by Ramsey pricing at the social cost of surplus foregone. Turn now to rate of return on rate base regulation. There is no room in a one input. We call this type of regulation A J ( v ) after Averch and Johnson (1962). Hence.

12) is given by Notice that Since x1 is the optimal choice of xt given x. g 2 ( x .6).16) and bypass the routine job of locating sufficient conditions for (3.16) captures the idea that the marginal product of capital in the consumer-capital goods sector falls as the wedge between the second and first best allocations of capital across sectors widens. The only thing that is changed from the decentralization in section 2 is equation (2. x) denotes the solution of It is straightforward to locate assumptions on g1[x1.25). Inequality (3. Recall that x1 denotes the solution to The first order condition for (3. the dynamics are given by Here X1(P. A3. stability and chaos in dynamic economics Next. We assume (3. X 1 v ) ) and MP1(x.1.178 Differential equations.16) is assumed to hold. for mode v. . it follows that Sufficient conditions on gt and g2 are needed so that the relationship between MP1(x. x1) satisfies the natural condition Inequality (3.x 1 ) ] that will enable us to compare steady states. Let us phase diagram the second best dynamics and compare them with the first best (see figure 6. Therefore.16) to hold. This becomes. we analyze the dynamics for each mode of regulation v.

6 Figure 6.7 .Microeconomic dynamics 179 Figure 6.

2 that is so useful in comparing values along I. p ( i > ) ) .1 a smaller input of power causes a drop in MP1 at each level of total capital stock x. and (iii) the trajectory II. The vertical lines p — 0 are pushed closer together as v increases. heterogeneous consumer extensions of our model. multi-input. stability and chaos in dynamic economics It is easy to explain intuitively what happens to the dynamics as we move from first best (marginal cost pricing of power) to second best (a form of average cost pricing of power) (see figure 6. p.N. No apparent mechanism other than central coordination will suffice to get the economy onto the welfare maximizing equilibrium. The conclusion is that the fine tuning suggested by the RamseyBaumol-Bradford-Diamond-Mirrlees optimal tax theory may be self defeating unless the economy is on the correct development path in the first place. This corresponds to MP 1 (x. v>0 where Another choice appears when X0 = X(v). his lemma 2. at any level of total capital stock. then the curve x = 0 rises. x0).7). x 1 (v. Skiba's argument (1978. Third. There are three trajectories that satisfy the F. II and steady states is no longer valid. Second. First. x)) falling below the horizontal line p — p in figure 6. 533) that there is no limit cycle around the steady state ( x ( v ) . Since marginal cost lies below average cost then. however. Furthermore. Analysis of the second best dynamics is not easy. This problem is much more difficult to solve and operationalize than the original partial equilibrium Klevorick problem.O. with respect to the steady state (x( v). the steady states move toward each other with x ( v ) rising and x ( v ) falling as v rises. the fundamental problem of steering the economy onto the welfare maximizing path still remains. We may still. the Klevorick problem (1971) of the optimal choice of v may be posed for each x0 as maximize W(v. the problem of multiple equilibrium paths of development is surely worse in multiproduct. Under A3. They may pass in which case only II remains. (ii) the trajectory I. of regulatory equilibria: (i) the steady state ( x ( v ) . too little power is produced in second best.180 Differential equations. Since output of consumables drops. . p(v)) is no longer valid.C.6. p( v)). Furthermore. draw three conclusions.

Turn now to determination of the optimum.Microeconomic dynamics 181 4. a stage of economic growth.9. II. and 6. Call a zone of convexo-concavity a development stage. The model analyzed below has only two for ease of exposition. it is useful to state the Figure 6.2 will allow us to determine the optimum. IV as well as the four rest points satisfy the F. The model of the previous two sections has only one development stage. The analysis of first best follows section two and is embodied in figures 6. In order to focus attention we assume the relationship between MP and p that is depicted in figure 6.8. Multiple optimal paths Here we analyze cases where the aggregate production function g has multiple zones of convexo-concavity.C. The difficulty in decentralization discovered in section two emerges with a vengeance when there are multiple development stages.O. that is. The same decentralization analysis developed in section two may be used to show that each trajectory a.10. We see from figure 6. of first best regulatory institutions.N. Since there are so many possibilities to screen out.8 . The terminology is motivated by Rostow's famous metaphor. 6. III.10 that there are several trajectories that satisfy the Euler equation and the TVCco. a = I. Judicious use of Skiba's lemma 2.9.

9 Figure 6.182 Differential equations.10 . stability and chaos in dynamic economics Figure 6.

IV> III.x 1 ]. Since there is no point in discussing two development phases when one is dominant. V.*.10. Hence. i = I . Hence.oo).x 0 e[x l s . II> I. we assume that there is x* such that IV cuts x = 0 at x*.x 0 e[jc 2 . I I > ( x 1 . Notice that initial investment on ft is positive in case (i) and negative in case (ii). B where (i) initial investment on a is nonnegative and the initial price of investment (u'(c B (0))) on B is bigger than on a.P 2 ) at x 2 . or (ii) initial investment on a is nonpositive and the initial price of investment on ft is smaller than on a then Hence. on (x2*. (ii) V°(xo)=V I (x 0 ).x 2 s ]. (iii) V°(x0) = V I V (x 0 ). Suppose that II follows the dotted path in figure 6. then the chain of inequalities derived above shows that II > i. IV> 111 = V at x2. In order to avoid this degeneracy we assume II cuts x = 0 at x*i as depicted in figure 6. V. xf. p1). and IV> III at x2*. xf. x0e [x2s. . As in the analysis of II. II > I = IV at x1. we ignore x 1 . x1s). x 0 e(0. . . oo). x2]. We need to dispose of some degenerate cases. . .*. III. x* such that I. Then (i) There are cutoff points x ls e (x^. Definition 4. II > III at x2*. x2*.1. x* respectively. Skiba's lemma implies IV > V at x0 > x2. x2s E (x2*.10 regular. at X1 and III. pi(0). at x. Skiba's lemma immediately implies that II > V at x 0 >x 2 . (iv) V°(x Q ) = Vni(xo).x 0 e[x 1 . II. We may now prove Theorem 4. ft > a at x0 means the value of the discounted sum of consumption along ft is bigger than a starting at x0. that is.10 as follows: Let V°(x 0 ) be the optimum value starting at x0. x1*).2 intuitively.1. Call the case depicted in continuous lines in figure 6. II > III = V at x2. If at x0 you have two trajectories a. (v) V°(xo)= Vv(x 0 ). Turn to the dotted portion of IV. IV cut x = 0 at x t *. x 2 . there is no x1* > 0 such that II cuts x = 0. II > IV at x2*. IV>(x 2 . The dynamics are said to be regular if there exist points x. Since the initial price.10. x2*)such that V°(x0) = Vn(xo). x2*. If the dynamics are regular then the optimum is constructed from figure 6.Microeconomic dynamics 183 basic principle of Skiba's lemma 2. Skiba's lemma shows that I. satisfies Pi(0) = V'i(*x0)» at x0.

2 are represented by open circles. In the n stage regular case there will be cutoff values xis E (x. . The method of construction outlined above may be applied to economies with any number of stages of growth. . xi*).11. xf. stability and chaos in dynamic economics Proof. . .11. 2 may be realized by first best decentralization schemes.11. . Skiba's lemma shows that they are dominated as shown in figure 6. for all i. 2 is as depicted. Furthermore. the steady state xi E (xi*. The values at steady states xi.-*. The logic of the proof is contained in figure 6. We conclude that all of the possibilities depicted in figure 6. Then use pi(0) = V'i(x0) to fill in the rest of the values of Vi as graphed in figure 6. The problem of the possible inefficiency of the first best mode regulatory equilibrium is worse. Recall that in this model the rate base is just x2.184 Differential equations. i = 1. i = 1. including the steady states xi. n that determine when to switch from one trajectory to another. xi*) will be dominated by both choices.11. This ends the proof. i = 1. 2 .*. Apply Skiba's lemma to verify that the relationship between the value functions at x. The upper envelope will not be attained unless some centralized authority coordinates rate bases. = l.

find the inverse demand curve P2= D2(yi. r) by solving the F.1 the planning problem (2.1) is a standard textbook Ramsey optimal growth problem with concave production function.Microeconomic dynamics 185 5. Examples It is useful to have some worked examples to illustrate the phenomena presented. Let Then Notice that g(x) may be convex or concave.C.O.21). Doing so we obtain where Put .N. For the decentralization case. that is. of (2. In order to have a solution to the optimum planning problem we assume concavity of g. Under assumption 3.

X 1 ) Since l — al>ftl. therefore. Let us look at decentralization. In this case there is no equilibrium.1) becomes. .27).186 Differential equations.13) with equality.5) becomes The conclusion is that the much maligned AJ(v} regulation performs better than Ramsey and first best in this general equilibrium economy in a certain sense.20). Define r(t) by as in (2. The main point is that B is concave in x2 when the exponent is less than unity and B is convex when /3 is greater than unity. y i ( t ) solve the optimum planning problem (2. The marginal incentive to expand x2 is v.3) is equivalent to 13 < 1. regulated utilities will expand their rate bases x 2 to infinity facing any interest rate r ( t ) parametrically.7) social benefits B falls in r and rises in x2. For the Ramsey regulation problem (3. in the case /3 > 1 the Ramsey problem is unbounded and x2 = +00 is the solution. stability and chaos in dynamic economics From (5.24) and (2.Johnson effect has not been theoretically justified under the assumptions that are relevant in regulation. To explain. Since ft > 1 the marginal incentive rises with the rate base for Ramsey and first best. For the AJ(v) regulation problem (3. The conclusion is that the global social optimum may be realized by regulated utilities and atomistic firms solving (2. (2. let x2 denote the positive rate base that solves (5. The reader is encouraged to reflect on this problem and to read Dechert (1984) which shows that the Averch. If B>1.24) when B>1. recalling that B denotes a 2 B l / ( l .1). Notice that (5. Let X i ( t ) . From facing r(t) parametrically it follows that x 2 ( t ) is the unique solution of (2. In the case B < 1.24) when B < 1 and x2(t) = +oo is the solution of (2. AJ(v) regulation induces choice of x2 nearer to the social optimum than private profit maximizing monopoly.21) facing r ( t ) parametrically provided that B<1.

p is the output price and w is the real wage. C"(I)>0. and a — aw/p((3 — 1). at the rate of gross investment I. K denotes capital units.2). since the last section continues the discussion on what has been said so far. C ' ( I ) < 0 as 7<0. we turn to several microeconomic applications before we conclude the chapter with further remarks. B<1. Miscellaneous application and exercises (1) Following Gaudet (1977). The first and second derivatives of C(7) are denoted by C'(I) and C"(I) respectively. That is. The firm maximizes the sum of discounted future net cash flows subject to where 5>0 denotes rate of depreciation. Let (K. . I) denote an arbitrary equilibrium of (6. The Euler-Lagrange equations for this problem are Note that L has been solved as a function of K and the real wage from the marginal productivity of labor.Microeconomic dynamics 187 Next. L denotes labor units. are ql + p C ( I ) . C'(I)>0 as I>0. it can be read before section 6. Let E = a + B take on any positive value. Actually.1)-(6. suppose that a competitive firm's production function is of the Cobb-Douglas form where 0<x. where pC(I) represents adjustment costs and q is the supply price of investment goods. 6. Investment expenditures.

X ( f ) = t h e level of expected net earnings available to all equity owners. Gaudet (1977) concludes that although an unstable equilibrium can occur only with increasing returns to scale. = the stock of debt capital. stability and chaos in dynamic economics Linearizing system (6.e) and therefore we may have a saddle point stable equilibrium even with increasing returns to scale. Denote by W(r) B(t) E(t) kj(B/E) — the value of the firm to its equity holders at r.188 Differential equations. I) is locally unstable. notice that (6. Assume that capital markets are purely competitive. I) is a saddle point equilibrium. If (6. investors prefer more wealth to less and the investment decision process leaves the firm's business risk-class unchanged.3) imposes no restriction on the sign of (1 . the existence of increasing returns does not rule out the possibility of a saddle point stability. If then both roots are real and of opposite signs and (K. 6(0 = the net change in debt financing. hold then inequality (6.2) around (K.1)-(6. =the stock of equity capital. then the roots are either real and both positive or complex with positive real parts and (K. (2) A fundamental problem in corporate finance is the optimal determination of the amount and mix of equity and debt capital to allocate to net investment. we find that its characteristic roots are where 6 = [2(l-B)-a]/(B-l). . e = 1.'I). For a stability analysis under increasing returns see Brock and Dechert (1985).3) is satisfied and as already noted saddle point stability holds and the optimal investment path is the stable manifold of the saddle equilibrium. Furthermore. I) note that if decreasing returns. and the subsequent decision concerning the firm's growth and divident policy. To study the role of returns to scale on the stability of the equilibrium (K. e < 1.3) does not hold. or constant returns. e > 1. -the equity investors' market-determined opportunity rate for a dollar of expected return of a firm in risk-class j as a function of the firm's financial risk or debt-to-equity ratio.

z = constant interest rate and corporate tax rates. y. states necessary and sufficient conditions for the firm's optimal earnings and dividend time sequences and determines conditions for the existence and stability of the firm's equilibrium paths. (ii) the price elasticity of demand. dividend and growth decision model can be stated as Senchack (1975). Senchack (1975. 4> = earnings functions. For details see Turnovsky et al. 6. The desirability of price instability increases with the magnitudes of the two elasticities. o ( s ) — the average per dollar flotation costs of new equity as a function of the dollar amount of external equity issued. For a brief review of the literature on the topic of price instability and . who develops this problem in detail. The firm's investment financing. p. it decreases with the degree of risk aversion and its response to an increase in the budget share is indeterminate. and (iv) the coefficient of relative risk aversion.Microeconomic dynamics 189 i(t) = the net change in internal equity financing. the firm's path will be locally stable. (1980) and Baye (1985). (3) Turnovsky et al. (iii) the share of the budget spent on the commodity in question. s(t) = the net change in external equity financing. They show that the consumer's preference for price instability depends upon four parameters: (i) the income elasticity of demand for the commodity. the equilibrium growth path will be locally unstable while in the declining growth period when 6X < 0. (1980) study the question of whether or not consumers benefit from price stability using a more general utility criterion than the concept of consumer surplus. when 6X > 0. 551) concludes that in the initial high-growth stage of a firm's life cycle.

According to Hicks. has recently shown. a competitive equilibrium is imperfectly stable if excess demand for any commodity is negative when its price is above equilibrium. For an extensive analysis of the stability of oligopoly see Okuguchi (1976). that these results of price stability and economic welfare disappear once general equilibrium feedback facts are taken into account. We refer the reader to Craine (1987) for an understanding of the relationship between relative price stability and economic welfare. (4) The stability properties of the Cournot model of oligopoly have been studied by several economists. Samuelson (1947. Oi (1961). 261) defines the general competitive equilibrium to have perfect stability of the first kind if from any initial conditions all the variables approach their equilibrium values in the limit as time approaches infinity. given that any arbitrary set of prices may be adjusted. the others being held fixed. Hahn (1962) states two sufficient conditions for stability under the standard adjustment system.190 Differential equations. (1986). Massel (1969). F. Seade (1980) extends the analysis of these two conditions for local instability. stability and chaos in dynamic economics economic welfare see Waugh (1944). Hicks and Samuelson have made important contributions to the stability of general competitive equilibrium. p. Hicks (1946) extended the stability analysis to the multi-market economy by distinguishing two types of stability: imperfect stability and perfect stability. and Samuelson (1972b). given that all other prices are adjusted so that the markets for all other commodities are cleared. Craine (1987). as long as the markets for those commodities whose prices are adjusted are cleared. at given output of his. Cartel stability is studied by Donsimoni et al. Walras (1954) as early as 1874 analyzed the problem of stability for the two-commodity exchange economy. Hicks shows that the only source of instability of a competitive equilibrium is asymmetric income effects. (5) Walras. These are (i) the marginal cost curve for individual firms should not fall faster than market demand and. Note that this is the same definition as global asymptotic stability. Al-Nowaihi and Levine (1985) study local and global stability conditions and correct the well known proof of Hahn (1962). (ii) marginal revenue of each producer should fall. 261) also defines stability of the first kind in the small . in the context of general equilibrium models of asset pricing with production. Samuelson (1947. were the remaining producers to expand their collective output. p. A competitive equilibrium is perfectly stable or Hicksian stable if excess demand for any commodity is negative when its price is above the equilibrium level.

Note that an n X n matrix A is quasidominant diagonal if there exist . Hahn (1982) gives a comprehensive survey of both local and global stability of competitive equilibrium up to 1982.. One such dynamic adjustment process is the one in which the instantaneous rate of change of the price of any good is proportional to its excess demand with excess demand being expressed as a function of all prices.j = 1. Recall that a matrix D is positive diagonal if its elements dii > 0 for all i and dij = 0 for i = j. that is. But at the same time. i. The interested reader can review these ideas in Hicks (1946) and Samuelson (1947) or in books such as Quirk and Saposnik (1968)..n. will illustrate how the stability methods in this book are put to use. the revised version of Samuelson's Correspondence Principle. He formulates the problem as a set of ordinary differential equations and gives conditions for the convergence to its equilibrium. Samuelson approximates linearly the excess demand equations at equilibrium and sets the speeds of adjustment equal to one to conclude that stability holds if the real part of all the characteristic roots of the matrix of the linear approximation are negative. This condition is neither necessary nor sufficient for stability in Hicks' sense. Metzler (1945) shows that if a matrix A is totally stable then A is a Hicksian matrix.. then A is totally stable. Arrow and Hahn (1971). Negishi (1962) surveys the main stability results up to 1962 while F. In chapter 7.Microeconomic dynamics 191 to hold if for sufficiently small displacements the equilibrium is stable and investigates this stability for the general competitive equilibrium and its relationships to perfect and imperfect stability in Hicks' sense. every even order principal minor of A is positive and every odd order principal minor of A is negative.. (6) Of particular importance in economic theory is the notion of D stability and total stability. In a little more detail. McKenzie (1960) shows that if a real nxn matrix A — [fly]. A real nxn matrix A is said to be totally stable if every submatrix of A whose determinant is a principal minor of A is D stable. A real n x n matrix A is said to be D stable if the product DA is a matrix having characteristic roots with negative real parts for any positive diagonal matrix D. has a negative diagonal and is quasi-dominant diagonal. Samuelson (1947) observes that one cannot consider the stability problem of the general competitive equilibrium without specifying a dynamic adjustment process. we shall provide a revised version of Samuelson's Correspondence Principle that attempts to deal with some of the criticism of Samuelson's previous version. Arrow and McManus (1958) give sufficient conditions for D stability. or Takayama (1985). Related to D stable matrices are totally stable matrices.

the traditional view that the phenomenon of instability is due either to the income effect or to the complementarity of goods. one of which is a numeraire both in a one-individual and the n-individual case. The mathematical theory of such matrices is presented in Gantmacher (1959). if positive weights can be found so that the absolute value of every weighted diagonal element exceeds the weighted sum of the absolute values of the off diagonal elements in the same column or same row. n. (7) The two classic papers of Arrow and Hurwicz (1958) and Arrow et al.. (1959) investigate systematically for the first time the problem of stability of a competitive general equilibrium. . Hirota (1981) studies whether or not the instability of Scarf's system is robust against changes in the assignment .. ... stability and chaos in dynamic economics positive numbers c1. if the price of one commodity goes up while all other prices remain the same.b2. In the first paper.2. Two kinds of the dynamic adjustment process called tatonnement are considered: instantaneous and lagged. 2 .|aii| > Tij^ibjlcijil for every i = l. 1970) and Murata (1977) discuss the stability properties of various matrices that arise in economics and give examples from competitive general equilibrium and the dynamic Leontief model..192 Differential equations. they show that local stability holds.| > |Ej=i cj|aij| for every i = 1. then there will be an increase in demand for every commodity whose price has remained constant. Scarf states that his instability example does not depend on a delicate assignment of values of initial stocks... The overall conclusion of this paper is that in none of the cases studied has the system been found to be unstable under the perfectly competitive adjustment process whether instantaneous or lagged. Scarf's instability example makes full use of the perfect complementarity case and supports. Nikaido (1968. c n such that ci|a. that is. (8) Scarf (1960) and Gale (1963) indicate some limitations to the scope of stability of the tatonnement mechanism in competitive general equilibrium by constructing examples of global instability. three specific cases of the model are analyzed: (i) no trade at equilibrium. Arrow and Hurwicz (1958) construct a dynamic economic model described by differential equations whose characteristics reflect the general nature of the competitive process and examine its stability properties under certain assumptions.. In words an n x n matrix A is quasidominant.n. . and (iii) all goods are gross substitutes at all prices that is.. Takayama (1985). . in general..c 2 . . Khalil (1980) gives a new test for D stability. Also. The second paper extends the results of the first by establishing global stability when all goods are gross substitutes. .bn such that b. . (ii) case of two commodities. or if there exist positive numbers bl.

for a class of economies which includes Scarf's instability example as a limiting case. that demand is determined by constancy of the marginal utility of money. More specifically. roughly.1975). They show that in a continuous time general competitive economic equilibrium model if all commodities. This formulation of the permanent income hypothesis leads to a definition of demand functions different from the usual one appearing in general competitive economic equilibrium. Tarr also gives a counterexample to illustrate that the Arrow and Nerlove result does not hold in general and that the choice of adaptive versus static expectations can affect stability. That is. a consumer spends money on a good up to the point at which the utility derived from the marginal purchase equals the utility of the money spent on it. 1976) which lead to the conclusion that almost any market excess demand function is possible also suggest that there is a large class of economies which have unstable equilibria under the tatonnement price adjustment process. then stability with static expectations is equivalent to stability with adaptive expectations. By perturbing the assignment of initial holdings. Hirota (1981) shows that most assignment patterns are stable. Keenan (1982) and Hirota (1985). The results of Sonnenschein (1972. 1980b) studies the role of the permanent income hypothesis on short run and long run stability. See also Burmeister and Graham (1973. Bewley defines the permanent income hypothesis to be. Such a modification of demand function eliminates the income effects which can cause the tatonnement price adjustment process to be unstable.1973). Hirota (1985) gives an estimate of the fraction of initial endowment distributions which result in global stability of a tatonnement process. See also Scarf (1981) who points out the significance of Hirota's example.Microeconomic dynamics 193 of initial stocks. (9) Arrow and Nerlove (1958) study the role of expectations on stability. fits into the Morishima (1952) matrix pattern. (10) In two papers. See also Balasko (1975). both present and future are gross substitutes. while the globally unstable case emerges only in an extreme limited situation. Tarr (1978) extends the Arrow and Nerlove analysis by showing that the stability property of the system is unaffected by the selection of the more sophisticated adaptive expectations over static expectations. This marginal utility of money is approximately independent of current income and prices provided that the planning horizon is large and the variability of the uncertainty is small relative to the size of the initial holdings of cash. Since the permanent income hypothesis makes sense only in the short run Bewley (1980b) shows that short run global stability . Debreu (1974) and Mantel (1974.1974. provided the substitute-complement relationship of commodities. Bewley (1980a. both present and future.

However. the current price must decrease along the demand curve. Similar reasoning suggests that if prices are expected to grow faster than the interest rate r. (12) Urban economics is a fertile field for the application of the methods of dynamic analysis and stability. the price of an exhaustible resource must grow at a rate equal to the rate of interest. The intuition behind the Hotelling rule is simple.194 Differential equations. when consumers' notions of their average real income vary over the long run and Bewley (1980a) shows that the long run adjustment process may be unstable. But as production increases. If we denote by p(0) the initial period price and by p ( t ) the price at period t we can write that where r is the rate of interest. or price net of extraction cost. Bewley (1980a) shows that an analogue of the results of Sonnenschein (1972. initial pessimistic price expectations lead to current price decreases. both along an efficient extraction path and in a competitive resource industry equilibrium. For an introductory survey of the . stability and chaos in dynamic economics holds for the tatonnement process. (11) According to the now famous Hotelling rule established in Hotelling (1931). Hotelling showed that the competitive resource owner would deplete at the socially optimal rate. is expected by producers to be rising too slowly. then the value of resource deposits would grow faster than any other form of wealth which may cause speculative withholding of production and higher current prices. The present value of a unit of resource extracted must be the same in all periods if there is to be no gain from shifting extraction among periods. suppose that price. the undiscounted value must be growing at precisely the rate of interest. Put differently. perverse income effects reappear as a source of instability. Then resource deposit is not a good way to hold wealth. Thus. There is an extensive literature on this subject and it would be interesting to use the stability methods of this book to analyze appropriate dynamic models of exhaustible resources. For an introduction to the economics of exhaustible resources see DasGupta and Heal (1979) and their references. 1976) applies to the long run adjustment process assuming the permanent income hypothesis. For the present value of price. Producers will try to liquidate their resource deposits by increasing current production and by investing their revenues at the higher r%. 1973). say below the interest rate r. to be the same in all periods. or price net of extraction cost. Debreu (1974) and Mantel (1974. If we assume that this interest rate r is equal to society's optimal discount rate between future and present. In fact.

as interest rates have become more volatile and have climbed to unprecedented levels. residential location. (14) One of the more controversial notions in the economics of information is the concept of informational equilibrium. the institution experiences a gain when interest rates decline unexpectedly. The more quickly an asset or liability adjusts to market rate changes. reliable management of this risk is not possible. urban growth and unemployment and rural-urban migration see the book of T. And. the more interest sensitive it is said to be. Miyao (1981) and its references. Riley (1979) explores the viability of such signaling or informational equilibria and discusses the instability of informationally consistent price functions. This differential change in market values occurs if the institution's assets are more price sensitive but less interest sensitive than its deposits. Under the same balance sheet condition. Miller and Rock (1985) extend the standard finance model of the firm's dividend-investment-financing decisions by allowing the firm's managers to know more than outside investors about the true state of the firm's current earnings. yield valuable information to worse informed agents. In a world of incomplete markets an informational equilibrium is one where. . Malliaris and Kaufman (1984) also present a dynamic notion of duration in continuous time models both for the deterministic and the stochastic case. either the observed actions of better informed agents or the resulting equilibrium prices. and develop simple hypothetical examples to demonstrate the implications of various interest rate changes for depository institutions. Interest sensitivity means that the coupon or contract interest rates change with market rates of interest. Institutions expose themselves to interest rate risk whenever the interest sensitivity of the two sides of their balance sheet is not equal. See also their numerous bibliographical references. but accurate measurement of risk exposure is not easy. The problems of interest rate risk are well known.Microeconomic dynamics 195 numerous dynamic urban economics models on industrial location. Such losses occur when unexpected increases in interest rates decrease the market value of an institution's assets more quickly than the market value of its liabilities. without such measurements. Malliaris and Kaufman (1984) describe the use of duration as a technique for measuring in one number the degree of risk exposure an institution assumes. dynamic stability of the interaction between industrial and residential locations. (13) Losses from unexpected changes in interest rates have become an increasing problem at depository institutions over the past decade. instability of a mixed city.

The problem uncovered here seems to be economic rather than mathematical because we have imposed so much structure that if any of it is relaxed the difficulty would become worse. It is disturbing that the difficulty emerges in a model with so much plausible structure. g(x) has a convex zone then utilities and their commissions have an incentive to expand beyond the socially optimum level for certain initial stocks. The paucity of structure of such models naturally leads to few restrictions on the set of equilibria.x 1 ) ) = g(x) is concave increasing in x If. 7. Such recommendations may be counterproductive if the economy follows a suboptimal path of development. The piece meal recommendations to commissions made by devotees of Ramsey pricing are stimulated by partial equilibrium analysis. . We designed our abstract model to show what may happen to development paths in an economy where decentralized commissions regulated natural monopolies in an attempt to efficiently resolve the break even problem but facing interest rates or the cost of capital parametrically.196 Differential equations. g 2 ( x . How might such a situation reveal itself in practice? Take the case of g(x) everywhere convex which is worked out in the examples. Malliaris (1988a) presents three approaches to this problem and surveys numerous references. stability and chaos in dynamic economics (15) The cash balances problem of the firm concerns the management of the timing of cash receipts and payments. Let us attempt to explain what we think the relevance of this exercise is to practical problems of regulatory policy. It seems that only control of rate bases will correct the problem. To the extent our abstraction captures aspects of reality we have shown there is serious danger that the system will follow the wrong path. however. Further remarks and references This chapter formulates an analytically tractable model that captures the striving of independent regional regulatory commissions to achieve first or second best regulation of regional natural monopolies in a rational expectations economy with perfect capital markets. We found that no problem emerges when the aggregate production function maximum g1(x1. This problem has been an active area of research during the past few decades and numerous techniques have been used to solve numerous variations of this microeconomic problem. There would be less cause for concern if we had to go to a heterogeneous consumer multigoods general equilibrium model to generate the difficulty.

It plans to do this by exploiting scale economies to get the unit cost of energy down to a low level but use multipart tariffs to scoop ever increasing revenue from the firms in its domain. As more and more resources are drawn from consumption into capital formation the interest rate that consumers demand to forego current consumption continues to rise. But what one region can do. The process continues. Hence neoclassical firms keep favoring more expansion. Perhaps an adaptation of a Brown and Heal (1980) equilibrium using the recursive structure present in our type of model may be fruitful. It convinces both the commission that regulates it and the neoclassical firms in its domain to accept this plan because (i) the multipart tariff can be designed so that the profits of the neoclassical firms and the utility both increase.Microeconomic dynamics 197 Suppose that r(t) is the current interest rate. The cost of capital rises. (ii) the commission sees higher utility stock prices. If the problem is found to be present under plausible assumptions then future research should look into decentralized schemes with low information requirements and nice incentive properties to fix the problem. lower unit costs of energy. One might think that ever rising interest rates would choke off the profits of neoclassical firms and this would put a brake on the runaway process of expansion that is under scrutiny. The expansion occurring in all regions puts upward pressure on the cost of capital. A regional natural monopoly sees that if it can charge a multipart tariff to capture most of the potential surplus from the firms in its region then it can turn an ever increasing profit from expansion. in the case where g(x) is convex the economies of scale in g 2 (0 allow energy to be produced so much cheaper that the combined positive effects of productivity of energy and scale economies outweigh the negative effect on the profits of neoclassical firms. all can do. Future research should investigate the seriousness of the difficulty uncovered here in more disaggregated models. . and higher profits to energy using firms. However. Hence everyone is happier in the region under discussion. This causes each utility in each region to push for even more expansion of its rate base to produce energy at the same or even lower unit cost as before.

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to show how the problem of stability of equilibrium is intimately tied up with the problem of deriving fruitful theorems in comparative statics. This duality constitutes what I have called the Correspondence Principle. In this section we formulate a general class of optimal control problems which have found many applications in economics as has already been demonstrated in chapter 5. Samuelson (1947. is the main concern of this chapter. This chapter relies on Brock (1986b). The problem of comparing long run equilibria.. Introduction The purpose of this chapter is to show how some recent results on the global and local asymptotic stability of optimal control problems may be used in comparing long run equilibria in various economic models with emphasis in investment theory. Consider the problem . 258) 1.. a revised version of Samuelson's famous Correspondence Principle plays an important role. known by most economists as comparative statics or comparative dynamics.CHAPTER 7 STABILITY IN INVESTMENT THEORY It is the central task. The various definitions and results which are needed are stated next. p. In such an exercise.

whose existence is claimed by the maximum principle in Hestenes (1966) and Pontryagin et al. If an optimum exists for each (XQ.) is absolutely continuous if dx/dt exists almost everywhere. where x(t. When the Hamiltonian of (1. then there exists a function h: R" x Rm -» Rn. As in Rockafellar (1976). h does not depend upon x0 or on t because (1.a) is the optimal path corresponding to x0 and a. the rate of change of the state. If TT( •.1) is time independent. Using (1. x). such that Furthermore.5) and (1. dx/dt = x(t). a)->x(a) as f-»oo. x(t).1) is taken over the set of absolutely continuous functions x ( t ) such that x(0) = x 0 . x ( t ) . and a vector of parameters a. the maximum in (1. that is. aeRm and p>0 with p being the discount rate.200 Differential equations. then there is at most one optimal path x(t. x(t.2) is evaluated at the optimum we use the notation H°. a) for each x0 and a.x0. also called a costate variable. called the optimal policy function. x0. In this chapter we discuss a set of sufficient conditions on TT and p which imply that there is a unique steady state x ( a ) such that for all x0. Chapter 5 surveys various sufficient conditions on the instantaneous payoff function TT and the discount rate p of (1. stability and chaos in dynamic economics Here i i ( x ( t ) . a ) is instantaneous payoff at time t which is assumed to be a function of the state of the system at time t. denoted by x(a). a).x0. (1962). Observe that x(t)ER". H. a) is strictly concave in (x. •.6) is used to obtain an important abstract result in comparing optimal steady states.4) we write down the necessary conditions for an optimal solution In section 2 the system of differential equations (1. As before superscript T denotes the transpose of a vector or a matrix.1) such that there exists a steady state solution. which is locally asymptotically stable . as where q is an auxiliary variable. x ( t ) e R n . Recall that a function x ( . Define the Hamiltonian function.

x0. a) impose on dx(a)/da? To provide some answers to this important problem we proceed as follows. Chapter 5 reports that any of these three hypotheses is sufficient for the G. This duality .A.S.S.Stability in investment theory 201 (L. where q is the costate variable at steady state x.S.S. it follows that x(t.A. was the first economist to recognize the importance of relating the problem of stability of equilibrium to the problem of comparative statics. where H°qx. where x(t.3) together with the natural structure of TT(X.A. 1947).A. Let (x. Also. H°xx is the usual notation for second order partial derivatives and /„ denotes the n x n identity matrix. we say that x(a) is G. In the remainder of this section we state some recent results on G.S. x.) or globally asymptotically stable (G. of x = x(a). 6 and 7.x0. x 0 . Recall that an n x n matrix A is negative quasi-definite if x T Ax<0 for all x 7* 0. Consider the three hypotheses. of a steady state solution x(a) of (1. or G. XX] (iii) R = (H°CICI)~lHqx is negative quasi-definite at (q.S. x0. and give some additional definitions. a) = x0. in two articles and in his Foundations. if for all x0e Rn. 1942. These three hypotheses-will be used in this chapter along with some structural assumptions to obtain results on 8x/8a.A.A. We are now in a position to state our Problem: What restrictions do the various sufficient conditions for L.x). We use the terms negative definite for the case when A is symmetric and x T Ax<0 for all x ^ 0.S. «)->• Jc(a) as f H>OO.S.a) is an optimal solution with x(0. H°qq.A. q) be a steady state of (1.A. if there is an e >0 such that | x ( a ) — x 0| <e implies x(t. Samuelson's Correspondence Principle Samuelson (1941.a)-*x(a) as f-»oo. In section 2 we discuss Samuelson's Correspondence Principle and offer a reformulation motivated by our problem. It is worth repeating that x(a) is L. Section 3 states an abstract result which is subsequently applied to economic models in section 4.3).). 5. We denote by A"1 the inverse of a matrix A which we assume exists. 2.

assume g i ( E i ) = E i . ... > 0.2) together with sign information on dE /da to get comparative statics information on 3E/3a. . . p. Differentiate (2.2) Samuelson studied its asymptotic stability and enunciated his Correspondence Principle: the hypothesis of asymptotic stability of (2. For example. . Mechanism (2. The n + 1 good is the numeraire.2) corresponds to the intuitive idea that price increases when excess demand is positive and vice versa. See Samuelson (1947. 257). Note that the essence of this principle is. . pn) and the parameter vector ( < * ! . stability and chaos in dynamic economics was called by Samuelson the Correspondence Principle and its main purpose is to provide useful empirical information "concerning the way in which equilibrium quantities will change as a result of changes in the parameters taken as independent data". After introducing (2. Research reported in Quirk and Saposnik (1968) shows that it is not possible in general to use the hypothesis of asymptotic stability of (2. how to infer its qualitative changes analytically.(0) = 0. i = 1 .1) describes competitive equilibrium where excess demand equals zero. #. .1) tells us what the equilibrium price is but does not tell us how the economic system arrives at equilibrium. where g. look at the case where a is one dimensional. We have deliberately stated the Correspondence Principle as a methodological principle rather than as a precise theorem in order to capture Samuelson's basic idea. Samuelson proposed the adjustment mechanism such that p i (Q)=p i o ) given.2) together with a priori information on d E / d a gives rise to useful restrictions on dp /da. given a complex system with certain properties. for Ei < 0. .. n. Samuelson applied his principle to other problems as well as general equilibrium but we shall concentrate on the equilibrium problem here for illustrative purposes. am). for £. 2 .(£. and gi(£. Equation (2.. Note that there are only n independent equations by Walras Law. assuming there are no free goods. . The hypothesis that all eigenvalues of 3E/dp have negative real parts . Equation (2. Without loss of generality. where p(x) is the equilibrium price as a function of a which is assumed locally unique.1) totally with respect to a and solve for dp /da. Samuelson (1947) considered the system of equations where E : R" x Rm -» R" is a system of excess demand functions for n + 1 goods as a function of the price vector (pl.)> 0.) < 0.202 Differential equations.

(1970) was published. Phelps and Winter (1970) develop the beginnings of an alternative disequilibrium dynamics. Shortly after Arrow and Hahn (1971) was published.2) but no consensus seems in sight. a priori sign restrictions on dE/da contain n more restrictions. p. there were several attempts in the literature to rationalize mechanisms of type (2. But there are n2 elements in BE /dp. Arrow and Hahn (1971) in their chapter on comparing equilibria gave little credence to the hope that the .3) if this system is either one dimensional or if dE/dp has a lot of zeroes in it. the Sonnenschein (1972)-Mantel (1974)-Debreu (1974) theorem appeared. Hence. Yet. Since Sonnenschein's theorem (1972) shows that the axioms of Arrow-Debreu-McKenzie general equilibrium theory are general enough to allow any continuous function from R" H» R" to be an excess demand function for some n + 1 goods general equilibrium system. Turn now to a closely related idea.Stability in investment theory 203 contains n restrictions. and also. BE /dp is a stable matrix and dE/da has a priori sign restrictions. they also ask.2) came under attack as a description of an adjustment process.2). 321) in their chapter on comparing equilibria. Nevertheless. "Whose maximizing behavior does such a mechanism describe?" They remark that it is mechanical and not based on rational behavior. This was discouraging enough but while this type of research was going on the very mechanism (2. then it comes as no surprise that examples of higher dimensional systems satisfying all of the restrictions listed above could be created that give arbitrary sign to dp/da. the epitaph of the Correspondence Principle was written by Arrow and Hahn (1971. These findings led to a lot of research on the Correspondence Principle. In view of the Sonnenschein-Mantel-Debreu result. This result shows that any continuous function E ( p ) could be an excess demand function for some economy populated by people with perfectly well-behaved utility functions. this principle in some form lurks in the underworld of economists of a more practical bent. Gordon and Hynes (1970) argue that speculative activity would destroy any such mechanism as (2. After Phelps et al. The papers by Gordon and Hynes (1970) and Phelps and Winter (1970) come to mind. it seems certain that the Correspondence Principle will fail to be of much use if one insists on the generality of abstract general equilibrium theory. with the conclusion that a priori sign information on dE/da plus stability assumed on dE/dp give sign restrictions on dp/da from (2. in such examples. reported in Quirk and Saposnik (1968).

stability and chaos in dynamic economics hypothesis of L. .1) together with the dynamics of the solution (1. of (2.4) with respect to (1. x. can be fit into (1.204 Differential equations. the hypotheses of stability of the solution x(a) of (2. Return now to the optimal control problem (1. that is.2) in the Correspondence Principle. We have a Revised Correspondence Principle.1) and let (1.A. A version of the Correspondence Principle is offered below which is somewhat immune to the cirticisms listed above.3).A.S. a) lead to useful comparative statics information on dx/da.2) alone would yield useful restrictions on dp/da.1). or G. This is some kind of a Correspondence Principle in that stability hypotheses are closely linked to the problem of getting useful restrictions on dp/da. and Lucas and Prescott (1971) and Brock (1972) on perfect foresight models.1).A. Lucas (1967). They did show. Abstract results on comparing optimal steady states Here we develop some mathematical results which are used in economic applications in later sections.2) such as all goods are gross substitutes yield useful restrictions on dp/da.S.1).3).S. Treadway (1971) and Mortensen (1973) on adjustment cost models in the neoclassical theory of investment. Many intertemporal equilibrium systems studied in the literature.3) play the role of (2. however. Consider the system mentioned in the introduction. whose solution generates the equilibrium-disequilibrium adjustment process (1. 3. By the device of describing general intertemporal equilibrium as the solution to a problem of maximizing a discounted sum of consumer surplus an economically interesting class of equilibrium models in modern capital theory is covered by (1. of equilibria of (2. such as Cass and Shell (1976a) on optimal economic growth. For problems of type (1.3) together with a priori structural assumptions which are economically meaningful on TT(X. how sufficient conditions for L. Let play the role of (2. Observe that the Revised Correspondence Principle is stated as a methodological notion unlike Burmeister and Long's (1977) Correspondence Principle which is a theorem. to name a few.

Hence equations (3.8) pxlqa to get for a e Rm. This can be seen immediately by premultiplying and postmultiplying the right hand side of (3. Add to both sides of (3.1) and (3. and Brock and Scheinkman (1976) as reported . The transversality condition has been shown by Benveniste and Scheinkman (1982) to be necessary as well as sufficient for a general class of problems.3) is automatically satisfied at a steady state.2) are necessary for optimality in a large class of problems. we define The matrix Q(a) plays a central role in the stability hypotheses of Magill (1977a). we obtain The right hand side of (3.4) and (3.8) is nonnegative quasi-definite because H° is convex in q and concave in x. for notational convenience. Totally differentiate both sides of (3. A steady state x(a) with its associated costate q ( a ) must solve the equations below The transversality condition (3.5) characterize optimal steady states. The differential equations (3.5) with respect to a and drop upper bars to ease the notation. Rockafellar (1976). and the cross product terms cancel.4) and (3. Recall that a e Rm.Stability in investment theory 205 with initial condition x(0) = x0.8) by a vector a e Rm. where.

when H°xq . Solve (3. x)TQ(a)(q. that is.1. then x(a0) is locally asymptotically stable. g(«o).9). Next we present another abstract result. This will be presented in the next section.12) and (3. q(a0)). Hence the global positive definiteness of Q implies G. shows that if Q(a) is positive definite at the steady state (x(a 0 ).H°qx .1) and (1. Insert (3.A.7) for qa in terms of xa. stability and chaos in dynamic economics in chapter 5.2) to obtain V = (q.13) become . Also.6) to obtain Equation (3.206 Differential equations. then for all ytRm.S. Note that for the interesting special case when the Hamiltonian is separable in q and x.12) into (3. for example. The proof follows immediately from (3. This theorem will be useful when we turn to a problem where a enters the Hamiltonian with a specific structure. x). so that the positive definiteness of Q(a) implies that V acts like a Liapunov function. Proof.0. In the spirit of the Correspondence Principle we have an abstract comparative statics result: Theorem 3. If Q(a) is positive semidefinite at x(a 0 ). equations (3. In chapter 5 the function V = qTx is differentiated with respect to / along solutions of (1. Magill (1977a).13) plays a central role in the comparative dynamics analysis of the Lucas-Treadway-Mortensen model of optimal accumulation of capital by a profit maximizing firm under adjustment cost. note that except for hairline cases Q(a) is always positive definite when p = 0.

Treadway (1971) and Mortensen (1973) among others. we obtain immediately that From these equations the formulae below follow quickly. x).2) and note that u° does not depend upon a. In this application we need to calculate the quantities H°qq. for this model. Applications to adjustment cost models Consider a model of the type (1. This model was studied by Lucas (1967).13) here for convenience and analyze it first.1) where with x(0) = xc0 given. etc. u°) = a2-q defines u°.. a 2 ) an d define Let u°(q.Stability in investment theory 207 4. H°qx. We record (3. .. Let a = (a. Let us examine some of the abstract results obtained in the previous section. and all optimum paths are assumed to be interior to all natural boundaries. The original literature includes Eisner and Strotz (1963) and Treadway (1969) who show that the existence of a demand function for investment goods can be explained in terms of costs of adjustment. concave in (x. Since fu(x. x. a2) denote the optimum choice of u in (4. H°xx. The function TT is assumed to be twice continuously differentiable..

16) are nonnegative by convexity of H° in q and concavity of H° in x Hence yTxlly<Q. If p > 0 and ( H ° q q } .15) by the n x 1 vector y to get Notice that we used (H°qx)T . hypothesis.8) and (4.13) for a = al. It was noted in the introduction that this is a sufficient condition for G. Theorem 4.208 Differential equations.S.12) we get Premultiply both sides of (4. and calculate . The signs in parentheses are the signs of each term in equation (4.and postmultiply (4. as shown in Brock and Scheinkman (1977a) and Magill (1977a). The other two terms of (4. Brock and Scheinkman (1977a) use as a Liapunov function V-xTGx. But (x a 1 y) T (H° q q r l H° q x (x a i y)<0 by hypothesis.A. By (4. We now arrive at Theorem 4.S. We digress in order to sketch how R negative quasi-definite implies L.1.14) by *«. with G=(H°qq)~l. We must show that for all vectors y. y T x a1 y<0.A.H°xq. Proof.15) is an n x n matrix equation.1 is a typical example of a comparative statics result derived from a G. then xai is negative quasi-semidefinite. Consider the quantity and assume that R is negative quasi-definite.16).1 H°qx is negative quasi-semidefinite at the steady state x(a).A. and manipulate to get Since xai is an n x n matrix equation (4. But which completes the proof.S. To verify this claim. Pre. stability and chaos in dynamic economics Examine (4.

(4.11).Stability in investment theory 209 Note that V<0 because G = 0 at steady states and qrx<0. We return to discuss xa. that is.20).12) to obtain But by (4.10).S.A.13) and use (4.17) says that the long run factor demand curve x(a) is downward sloping in a generalized sense. It turns out to be very powerful in analyzing a large class of adjustment cost models reported in Brock and Scheinkman (1977a). Hence by (4. therefore. Thus.18) simplifies down to .19) and (4. We conclude that (4. for all yeR". Since ar is the vector of wage rates for x. Thus V <0 and. V is a Liapunov function. x). Replace a by a2 in (4.8) and (4. Notice that the n x n matrix xai is not necessarily symmetric but our result gives sufficient conditions for it to be negative gMasj-semidefinite. (/C)'1 = -/„„ so that Also. by (4. The latter follows from the fact that where such that x(0) = x0 is concave in x0 because we assumed that TT is concave in (x. the negative quasi-definiteness of R plays a central role as a sufficient condition for L. Hence if it exists. Turn now for similar results on xa2.

2 in a different manner. q. xa. a. then xai. Turn now to the comparative statics implications of the separability of the Hamiltonian in (q. From these last three equations we obtain that the steady state x must satisfy Put ft .16) utilize the special structure of H° as a function of a to force the discovery of (H°qq)~lH°qx as the central quantity to determine the sign of yTxaiy.pa2+a\ and differentiate totally with respect to B to get Now obviously.2.2. It is worthwhile and instructive to verify theorem 4. . x). It is fascinating to note that the negative quasi-definiteness of (H°qq]~l H°qx is a very expeditious G. If p > 0 and H°xq = 0 for all x.A.S.14)-(4. If p > 0 and (H°qq) lH°qx is negative quasi-semidefinite then xa2 is negative quasi-semidefinite. then so is xa2 which gives another verification of theorem 4. stability and chaos in dynamic economics Follow the same argument which leads from equation (4.15). are all negative quasi-semidefinite and symmetric..210 Differential equations. Look at the steady state equations.1 to obtain Theorem 4. We close this discussion of the implications of the negative quasi-definiteness of (H°qq)~lH°qx with the problem of comparing long run equilibria in the Lucas-Treadway-Mortensen model. Hence if xaj is negative quasi-semidefinite and p > 0.8) and (4. Separability of H° occurs when H0xq = 0=H°qx for all (q. x) and a. in (3. Replace a by a. use (4. hypothesis for the Lucas-Treadway-Mortensen model as well as playing a central role in determining the sign of xaj and xa2.14) to theorem 4.3. Xp. Notice how equations (4.12) to obtain Hence we have Theorem 4.

10). we use the abstract results of section 3.A. That Xp and xa.A. The separability of the Hamiltonian is Scheinkman's (1978) G.S. (i) The matrix xlj + p T x . .33) by y e R" to obtain Notice that the cross product terms cancel to give the right-hand side of (4.29).8) and (4. then xai. From (4.35) and the hypothesis that Q(a) is positive semidefinite. With xa} negative quasi-semidefinite and (4. We can now state Theorem 4. Use equations (3. are negative quasi-semidefinite follows from (4.32).12) for the Lucas-Mortensen-Treadway model to obtain Pre. The theorem follows because xai is negative quasi-semidefinite and symmetric from (4. Before we complete the analysis in this section.30). xB and jca.4. use H°xai = -In. q^] and rearrange terms to get Replace a by a. .Stability in investment theory 211 Proof. hypothesis. Part (ii) follows from (4.6) and (3. x q 1^ (ii) if Q(a) is positive semidefinite.31) by [x^. Part (i) follows from (4. is negative quasi-semidefinite.S.34).34) where Q(a) is defined in (3. //J a . in (4. are all negative quasi-semidefinite. Proof.7) to write them in matrix form Premultiply (4. hypothesis and strong comparative statics results.and postmultiply both sides of (4. = 0 from (4. Again we see a close connection between a G.29) we get the other results.34) because H° is convex in q and concave in x.

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Differential equations, stability and chaos in dynamic economics

Once again we see that a G.A.S. hypothesis, that is Q(a) being positive semidefinite, yields strong comparative statics results. Furthermore, when p = 0, theorem 4.4 (ii) shows that xai,Xp,xa2 are all negative quasisemidefinite. Remark. When TT = pf(x, x) - a^x - a Jx, where p is product price, we may obtain comparative statics results on p by noticing that the choice of optimum path is homogeneous of degree 0 in (p, 0:1,0:2). Put alp - l a ^ , a2 = p l &2. Then use the results obtained above to deduce qualitative results for dx/dp. Next examine the impact on steady state x when the discount p is increased. 5. Generalized capital deepening Consider the steady state equations

Burmeister and Turnovsky (1972) introduce the measure of capital deepening B(p) = qTxp where xp is the derivative of the steady state with respect to p: an economy is called regular at p0 if B(po)<Q. The motivation for introducing B(p) is discussed in detail in Burmeister and Turnovsky (1972). It is a measure in a growth model for the impact of the interest rate p changes on the steady state capital stock constellation. It turns out that the following theorem holds. Theorem 5.1. All of the following G.A.S. hypotheses at q(p0), x(p0) are sufficient for fi(p)<0 at p = pQ>0: (i) Q is positive semidefinite, (ii) ( H ® q ) - l H ° q x is negative quasi-semidefinite, or (iii) H°xq = Q. Proof. We demonstrate (i) first. Differentiate totally (5.1)-(5.2), with respect to p, to obtain

Premultiply (5.3) by xj to get

Stability in investment theory

213

Premultiply (5.4) by ql to get Combine (5.5) and (5.6) to get

It follows immediately from (5.7) that (i) implies In order to derive the second result solve (5.4) for qp in terms of xp and insert the solution into (5.3) to get

Premultiply both sides of (5.9) by x^ to obtain

Now,

since H is convex in q. Also —x^H°xxxp>Q because H is concave in x. Hence from (5.10) either (ii) or (iii) is sufficient for <j T x p <0. Remark. Parts (i) and (ii) of this theorem are due to Brock and Burmeister (1976) and Magill (1977a) respectively. As we note in the last section of this chapter a fascinating discussion of the implications of the L.A.S. hypothesis in comparing equilibria when p changes and the relation of this problem to the Cambridge Controversy and the Hahn Problem is contained in Burmeister and Long (1977). This concludes the presentation of results we have obtained on the implications of sufficient conditions on TT(X, x, a) and p for the G.A.S. of optimal paths for qualitative results on steady states. Notice that all of the results are of the following character: A G.A.S. hypothesis and a hypothesis about how a enters H° is placed upon the Hamiltonian H°(q, x, a) of the system to obtain results on comparing steady states. This suggests that a general theory of comparing steady states is waiting to be discovered. This

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Differential equations, stability and chaos in dynamic economics

is so because Hamiltonian constructs are very general. For example, such a construct can be invented for dynamic games in which some arguments enter in a passive way and are determined by equilibrium forces in much the same way as competitive prices are determined; and, other arguments enter in an active way and are determined in much the same way as Cournot oligopoly models determine output levels. See Brock (1977b) for a development of games in terms of a general Hamiltonian approach. Dechert (1978) locates sufficient conditions for dynamic games to be represented by the Euler equation of some variational problem. Furthermore, the analysis of Cass and Shell (1976a) succinctly develops the Hamiltonian formalism of modern growth theory for both descriptive and optimal growth models. A Hamiltonian formalism underlies virtually any dynamic model that has a recursive structure. Hence results such as those obtained in this chapter which depend upon hypotheses placed upon the Hamiltonian alone should extend to more general models. Turn now to the development of results on comparing equilibria that depend only on the L.A.S. hypothesis of the steady state x. 6. More on the adjustment cost model This section presents a simplified proof of a theorem of Mortensen (1973). Return to the adjustment cost model of Lucas, Treadway and Mortensen.

subject to x(0) = x0 with x = u. Assume that p, al and a2 are time independent. Write the necessary conditions for optimality in Euler equation form,

Let x be a steady state and let x0 = x + Ax0. Under very general conditions stated in Magill (1977a), equation (6.2) may be approximated for small AxQ as

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Here (6.3) was obtained from (6.2) by expansion in a Taylor series at (x, 0) and using the equations of steady state to cancel out the first order terms. All second derivatives are evaluated at the steady state (x, u) = (x, 0). Now if/ is strictly concave in (x, x), there is a policy function h(x,p, a) such that optimum trajectories satisfy

Linearize h around the steady state x to get Equations (6.3), (6.4) and (6.6) describe the same trajectory and, therefore, the matrix M = hx(x; p, a) must solve a quadratic matrix equation that is generated by (6.3). That is, where B=fuu, C=fux, CT=fxll and A-fxx. Equation (6.7) is obtained by putting Ax = MAx and Ax = MAx = M2Ax into (6.3) and equating coefficients. Equation (6.7) is difficult to solve for the optimal adjustment matrix M except in the one dimensional case. Nonetheless, we can say a good deal about M in terms of A, B, C, p. For instance, we know that for f(x, x) strictly concave there is only one steady state x and it is G.A.S. for the case p = 0 where the maximum is interpreted in the sense of the overtaking ordering as in Brock and Haurie (1976). Scheinkman's (1976) result tells us that, except for hairline cases, if p > 0 and p is small enough, then G.A.S. will hold. Hence we know, except for hairline cases, that M is a stable matrix when p is small. We also may employ the G.A.S. hypotheses listed above to find conditions on A, B, C, p that guarantee that M is a stable matrix. In this section we are interested in the following: What restrictions does the stability of M imply on the comparison of steady states? This question is more in the spirit of the original Samuelson Correspondence Principle which asserted that stability of M would generate comparative statics results. This brings us to Mortensen's theorem. Theorem 6.1. (Mortensen (1973).) Assume that B is negative definite. If M is a stable matrix, then Xp and (dh/d(3)(x; p, alf a2), where ft = al + pa2, are both symmetric and negative definite if and only if C is symmetric. Moreover, the characteristic roots of M are all real if C is symmetric. For a proof see Mortensen (1973).

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We next develop formulae for later use. First, by direct use of the steady state equations, obtain

Second, we need a lemma. Lemma 6.1. At any steady state, if the quadratic approximation (6.3) is valid, then

Proof. To prove this lemma note that equation (6.10) follows directly from (6.9) and (6.7). So we need establish (6.9) only. Write the necessary conditions of optimality in Hamiltonian form,

In order to see that (6.13) is necessary for optimality and is the correct transversality condition in general, see Benveniste and Scheinkman (1982). Following Magill (1977a), look at the necessary conditions for optimality of the linear quadratic approximation to (1.1) written in Hamiltonian form.

The matrices in (6.14) and (6.15) are evaluated at steady state (q, x) and Ax, Aq denote deviations from the steady state. Now, suppose that for some matrix W. The intuition behind this is compelling. If

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subject to x(0) = x0, x = u, and if R is twice continuously differentiable at x0 = x, then (6.17) holds where W= (d2R/dx2)(x). This is so because by definition q = 8R/dx and hence, Aq = (82R/dx2)Ax = WAx for the linear approximation. Turn back to (6.15) and get Hence M = H°gx + H°qtl W. Next calculate MT5 - BM to obtain

But,

from (4.9)-(4.11). Thus

This ends the proof of the lemma. Observe that the proof of the lemma did not assume that x is L.A.S. or G.A.S. What is needed for the proof of the lemma is that the linear quadratic approximation to (1.1) be valid and that R(x) be twice continuously differentiable. A sufficient condition for both is that/(x, x) be quadratic in (x, x). Magill (1977a) discusses the linear quadratic approximation. Hence, in particular, equation (6.20) holds for all problems, where/(x, x) is quadratic and concave in (x, x). Mortensen does not need to assume that x is L.A.S. to obtain (6.20) when /(x, x) is quadratic in (x, x). Examine the following quantities obtained directly from (6.10)

Notice that by (6.10), both A + pC and (A + pC)M l are symmetric, provided that C = CT. Hence by (6.8) it follows that Xp and dh/dfi are both symmetric since the inverse of a symmetric matrix is symmetric. It is important to note that the only part of Mortensen's theorem that needs the L.A.S. of x is the negative definiteness of x^ and d h / d B . The symmetry of x and d h / D B as well as the characteristic roots of M being real require the symmetry of C alone. Mortensen's theorem is a good example of how the structure of the adjustment cost model interplays with the L.A.S. hypothesis to produce strong qualitative results.

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Corollary 6.1. (i) (H0qq)~lH°qx=fux = CT and (ii) if C is negative quasidefinite, then x is L.A.S. and both Xp, (dh/d(3)(x; p, a1, a2) are negative quasi-definite. Proof. from To prove this corollary note that the first formula follows directly

and C=fxu. Here equation (6.23) is recorded from (4.10) and (4.11) for convenience. Now C is negative quasi-definite if and only if CT is. Hence the negative quasi-definiteness of C is simply the sufficient condition for G.A.S. reported in Brock and Scheinkman (1976) and Magill (1977a). Turn now to the task of showing that Xp and dh/d(3 are negative quasi-definite. Look at (6.21) and (6.22). Since for any yeR",

and Xp, dh/dfi are negative quasi-definite if and only if A + pC and -(A + p C ) M - l are negative quasi-definite; therefore, by (6.21) and (6.22) we need only show that BM is positive quasi-definite in order to finish the proof. Recall that In order to see that BM is positive quasi-definite calculate

**The first equality follows from (6.23) and the second follows because
**

Juu

\*~* qq)

Now, W is negative semidefinite by concavity of the state valuation function of the associated linear quadratic approximation of the original problem around the steady state x. See Magill (1977a). Hence the right-hand side of (6.14) is positive quasi-definite. This ends the proof. We close this section by remarking that some additional structure on the problem above and beyond the stability of M is needed in order to get the negative quasi-semidefiniteness of Xp. This is so because Mortensen (1973, p. 663) provides a two dimensional example where M is stable, C is not symmetric, and djJc 2 /d/3 2 >0. The reader is advised to look at Magill and Scheinkman (1979) where for the case of (6.1) a complete characterization of the local behavior of

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(6.5) near steady states is given under the assumption that the matrix/« is symmetric. Furthermore if p, a1, a2 in (6.1) were determined endogenously by the device of maximizing a discounted sum of consumer net producer surplus, the revised correspondence principle could be developed in price space rather than in quantity space as is done here. In that way an equilibriumdisequilibrium price adjustment process is derived that replaces the ad hoc Walrasian tatonnement. The methods developed in this chapter can be used to show how structural properties of the Hamiltonian of the discounted consumer net producer surplus problem translates into a correspondence principle for the equilibrium price adjustment process. This question has been studied by Magill-Scheinkman (1979), and Magill (1979).

7. Miscellaneous applications and exercises (1) Rational expectations. In this application we illustrate once again the Correspondence Principle and we contrast the comparative statics results obtained by the static theory of the firm versus the dynamic cost of adjustment theory of Lucas, Treadway and Mortensen. Furthermore, to partially differentiate the analysis from the one in the preceding section, we assume rational expectations and we use the technique of consumer surplus employed by Lucas and Prescott (1971). Consider an industry with N > 1 firms, each producing the same industry good by employing K > 1 capital goods, x, and investing x. Each firm forms identical expectations about the product price path denoted by p ( t ) with p ( t ) : [0, oo)^ R+. The instantaneous flow of profit of the /th representative firm is the difference between its revenue p ( t ) f ( x ( t ) , x ( t ) ) and its costs a^x(t) + a^x(t). The firm's problem may be stated as

subject to x(Q) = x0eR+, which is identical to (6.1). Denote by Qs(t) the market supply which is defined by

There is no loss of generality to assume that JV = 1. The market supply depends on p ( t ) , which in turn depends on the solution of the maximum

This result is useful because it reduces the study of problem (7.1). Brock and Magill (1979) show sufficient conditions under which the price path p ( t ) is a rational expectations equilibrium. The integral of the demand function.6). that is. stability and chaos in dynamic economics problem in (7.1) to an analysis of (7.6) in the consumer surplus form and let us check to discover sufficient conditions so that . Write the integrand in (7. is given by for Q > 0. Next. oo). with d ( Q ) > O a n d d'(Q)< O for < > 0 . t e [0. The problem of finding a continuous vector function x(t) such that is called the extended integrand problem.220 Differential equations. Note that the firm's expectations are rational in Muth's (1961) sense. to actual price. so that D'(Q) = d(Q). oo)-» R+ such that for almost all t e [0. the latter being determined by the market. for almost all times. anticipated price is equal. we define a rational expectations equilibrium for the product market of the industry as a price path p(t): [0.oo). denoted by D(Q). D"(Q) = d'(Q) < 0. The market demand also depends on p ( t ) and we denote it by f o r P ( t ) > 0 .

10) we conclude that if fxx=fxx.6) and suppose that x is L. Samuelson (1947) and later made popular by Henderson and Quandt (1971). Then both dx/d(al + pa2) and d x / d ( a l + pa2) are symmetric and negative definite.7) we compute From (7. then (7.8) will hold.9) and (7. we conclude that d x / d ( a 1 + pa2) is symmetric and negative definite. the usefulness of the Correspondence Principle in obtaining comparative statics results in the cost of adjustment theory with rational expectations. Although this application is similar to the one in the preceding section.1 shows and are obtained easily because of the powerful technique of consumer surplus. The reader. let x be the optimal path of the extended integrand problem in (7. Then by Mortensen's theorem we conclude that both d x / d ( a l + pa2) and d x / d ( a l + pa2) are symmetric and negative definite.1 to the results of static theory. . and that the matrix C is symmetric. fx = Q with no meaningful information available about d x / d ( a l +pa2). pp. once again.Stability in investment theory 221 From (7. The above result illustrates. it differs in one significant aspect.S. or equivalently. we obtain the necessary conditions andfxx(x) is negative quasi-definite. It might be informative to compare the results in theorem 7. theorem 7. suppose that the matrix C of section 6 is symmetric.1. comparative statics results hold as theorem 7. that is. p ( t ) here is a rational expectations equilibrium instead of a constant vector as Lucas. Treadway and Mortensen assume. Thus we have sketched a proof of Theorem 7. (2) Static vs dynamic theory. Reducing (4.A. Note that in the static case. Suppose thatj^x =fxx.A.S.1 is a generalization of the early literature on the subject as presented by Hicks (1946). Therefore.1) to the static case we want to maximize Carrying out the maximization. 320-323). Furthermore. Despite this extension. Assume that the optimal path of the extended integrand problem is L. Following Hicks (1946.

13) we get From (7.14) and (7. . Substitution between inputs is possible but it could not prevail. Treadway (1971) and Mortensen (1973) show that the dynamic theory yields results that are dissimilar to those of the static theory. x2) as the output vector and a . our comparative statics results of the dynamic theory of the firm are consistent with the results of the Hicksian static analysis. denoted by Aat>Q. yields While carrying out the multiplication in (7. When C is not symmetric as we have assumed. stability and chaos in dynamic economics however. Consider the simple case with x = (x1.1.1 yields which means that an increase in the input price causes a decrease in the output production due to a decrease in the quantity of the input employed. for an increase in the input price i.(a 1? a2) as the parameter vector denoting input prices. then What is the economic content of (7.222 Differential equations. 98) points out.13)? The negative definiteness of dx/da. More generally. and for factors jointly employed in the same firm to be complementary". Then. must be cautioned that the dynamic theory is not just a straightforward generalization of the static theory of the firm. Hicks (1946. which in our special case is the 2x2 matrix in (7. where i = 1 or 2. p.15) we conclude that complementarity is likely to be dominant in the production process. if Aa1 = Aa2 > 0. (3) We close this section with an illustration of the usefulness of our comparative statics results in theorem 7.13). Therefore. "there is a tendency for products jointly produced in the same firm to be complementary. theorem 7.

We continue to be interested . per capita consumption.5)-(1. Magill and Scheinkman (1979) are able. Mortensen (1973) and Burmeister and Long (1977) are the first to explicitly formulate questions of the type: What are the implications of the L. their Correspondence Principle proves to be a useful tool in studying these two important issues in capital theory. Their results depend upon an assumption of symmetry on the integrand of the variational problem and their technique involves the use of an equilibrium potential function. of regular steady states for a class of optimal control problems similar to ours. namely. Burmeister and Long (1977) note a similarity between the Cambridge Controversy and the Hahn problem and they conjecture a Correspondence Principle to study these issues. Further remarks and references In this section we offer a few comments on the literature related to this chapter. namely. they conjecture that a paradoxical steady state is in some sense unstable. Magill (1979) and McKenzie (1983). under the assumption of symmetry and L.A.Stability in investment theory 223 8..6) and the extension of Samuelson's Correspondence Principle to such mechanisms. which originated in F. Another unresolved issue in capital theory is the Hahn problem. The behavior is paradoxical because if the interest rate is above the exogenous rate of labor growth. hypothesis on the optimal steady states of a control problem for the question of comparing steady states? Burmeister and Long (1977) are interested in studying the basic aspect of the Cambridge Controversy in capital theory. Their conclusion is that the Conjecture Correspondence Principle holds only in some very special cases. then it is possible that a decrease in the interest rate will decrease. and which is concerned with whether or not a general equilibrium model of capital theory is stable. Hahn's (1966) paper. Indeed. to obtain comparative statics results by means of the equilibrium potential function. instead of increase. Burmeister and Long (1977).S. and vice versa. Araujo and Scheinkman (1979). Magill and Scheinkman (1979) present a complete characterization of the L. we focus on the formulation of equilibriumdisequilibrium mechanisms (1.A. Some of the relevant papers are Mortensen (1973). The Correspondence Principle of section 2 is different but the purpose is the same. In the spirit of Samuelson's Correspondence Principle. to be used as a methodological tool to get comparative statics results. Magill and Scheinkman (1979).S. the paradoxical consumption behavior associated with alternative steady states when the interest rate changes as an exogenous parameter. However. Furthermore.A.S. In particular.

Brecher and Hatta (1987) have generalized Samuelson's (1971) Global Correspondence Principle with an application to international trade. Recently. We note that Magill and Scheinkman (1979) is extended to the asymmetric case in Magill (1979). stability and chaos in dynamic economics in similar questions with more emphasis on G. and using different techniques.A. Araujo and Scheinkman (1979) and McKenzie (1983) present important results on comparative statics and dynamics for a discrete time optimal model and Epstein (1982) reports comparative dynamics results in the adjustment cost model of the firm. Furthermore.224 Differential equations. .S. Bhagwati. An effort to rehabilitate Samuelson's Correspondence Principle was implicit in Lucas (1967) and Mortensen (1973) in the context of an adjustment cost model of the dynamic investment theory of the firm and also in Liviatan and Samuelson (1969) in the context of an aggregate one-sector growth model with joint production.

For example. there is no optimal control problem that describes the equilibrium dynamics of the system. Smale (1980. due to tax distortions. and more particularly the long-run effects of various government policies. Yet the methods discussed in this book can still be applied. like most of macroeconomic theory which precedes it. Turn now to the substance of the chapter. equilibrium dynamics can be phased diagrammed and stability analysis conducted. suffers from two major deficiencies. Introduction This book stresses the theme that the stability analysis of optimal control is a useful tool in economics. 113) 1. p. insofar as this is feasible. that is. This literature. the dynamics arising from the creation of assets required to finance certain current activities. Chapter 8 shows how to analyze economic models where. Blinder and Solow (1973). . as well as. Tobin and Buiter (1976). on considering the transitional dynamic adjustments in response to such policies. Several developments in macroeconomic theory have stressed what one might call the intrinsic dynamics of the system. Turnovsky (1977) and others have placed an emphasis on analyzing the short-run.CHAPTER 8 MACROECONOMIC POLICIES Let me start by posing what I like to call "the fundamental problem of equilibrium theory": how is economic equilibrium attained ? A dual question more commonly raised is: why is economic equilibrium stable*? Behind these questions lie the problem of modeling economic processes and introducing dynamics into equilibrium theory.

Recent attempts to differentiate explicitly between physical capital and the corresponding paper claims in a macroeconomic context are contained in Turnovsky (1977. The second major shortcoming is that these analyses are all based on arbitrary behavioral relationships. Physical capital on the one hand. embedding it in an explicit optimizing framework. Despite the increasing awareness by economists of the need to ground macroeconomic theory on the firm microeconomic foundations. The traditional textbook macro model typically assumes that all private investment is financed through borrowing. (c) all markets are continually cleared. The deficiencies of following this procedure become particularly severe when one wishes to augment the model to include a corporate sector embodying rational behavior. which in turn is a function of the tax structure and the differential tax treatments of different securities. The earlier Brock analysis essentially abstracted from the government and corporate sectors and it is these aspects (particularly the latter) which . 1975) and follows Brock and Turnovsky (1981). More recently. and the paper claims to these physical assets on the other. 1978). It includes the following key features: (a) all demand and supply functions of households and firms are derived from maximizing behavior. To incorporate this aspect adequately requires an explicit model of optimizing behavior. the relative prices of which are continually changing. Under these conditions. authors such as Tobin (1969) and Mussa (1976) have introduced very crude stocks markets into their models by identifying one unit of equity with one unit of physical capital. are distinct entities. Yet this typically is not how real world stock markets operate.226 Differential equations. Indeed. Moreover. all expectations will be self-fulfilling and for this reason an equilibrium characterized by (a). The approach we shall adopt is an extension of the general equilibrium framework developed by Brock (1974. the policy implications derived from models based on ad hoc behavioral relationships may be misleading. stability and chaos in dynamic economics The first is its simplistic treatment of the corporate sector. the purpose of this chapter is to introduce a more complete corporate sector into a contemporary dynamic macro model. (b) and (c) has been termed a perfect foresight equilibrium. thereby invalidating the one-to-one relationship assumed by these authors and others. as will become clear below. although his analysis is based on the extreme case of all-equity financing. in practice in many cases they don't and thus the underlying behavioral relationships remain arbitrarily specified. the effects of alternative government policies depend critically upon the capital structure employed by firms. Accordingly. (b) expectations are determined simultaneously with perfect foresight continually holding.

real productive decisions may then be made to maximize discounted net after tax cash flow. Similarly. The approach taken here is to derive the appropriate cost of capital facing firms and hence determining their decisions.Macroeconomic policies 221 we wish to emphasize here. following Brock and Turnovsky (1981) for the derivation of the cost of capital from underlying consumer behavior and within an intertemporal general equilibrium framework. This equation is then manipulated to determine a cost of capital for firms.1974). While the conclusions of this methodology are not particularly novel. or equities. Feldstein et al. a differential equation determining the market value of firms may be derived. Government bonds and both types of private securities are assumed to be perfect substitutes for one another. (1979) and Auerbach (1979). we shall specify the tax rates so as to approximate what might be considered to be real world tax structures as in Feldstein. from the optimizing decisions of households. or out of retained earnings. Except for special circumstances in which the debt to equity ratio is indeterminate. beginning with the budget constraint for firms. expressed in terms of market yields. These taxes impinge on the firm primarily through the cost of capital and hence it is important to make sure that this is defined appropriately. The implications of our approach turn out to be fully consistent with the existing treatments of taxes in the corporate finance literature such as Modigliani and Miller (1958) and Miller (1977). We shall introduce corporate and personal taxes on various forms of income. the optimal financial structure will consist of all bond financing or all equity financing depending upon relevant tax rates. financial decisions are made to minimize the cost of capital. having determined the minimized cost of capital. these market yields can be related to consumers' rate of return on consumption and the various tax parameters. The basic idea is that. firms may finance their investment plans by issuing debt. does appear to be new and in any event seems to be particularly . The expression for the cost of capital thereby obtained embodies the underlying optimizing behavior of consumers. It would not be entirely unfair to say that traditionally the literature has been less than fully lucid on the appropriate definition of the cost of capital in the presence of taxes. The resulting objective function for firms separates into two parts. second. First. In doing so. More specifically we shall assume that the government can finance its deficit either by issuing bonds or by the creation of money. Using the optimality conditions for consumers. and Sheshinski (1979) and Auerbach (1979). Green. The question of the impact of various corporate and personal taxes on real and financial decisions of the firm continues to be widely discussed in the literature such as Stiglitz (1973.

The objective of this composite unit is to choose its consumption demand. We should emphasize that our primary objective is the development of an integrated framework. stability and chaos in dynamic economics instructive. firms. its supply of labor.all of which are interrelated through their respective budget constraints. government bonds. the rates at which it wishes to add to its real holdings of money balances. rather than any detailed manipulations of such a model. While this is obviously a restriction. it seems that the construction of a consistent and more complete macro model under certainty is a necessary prerequisite for proceeding further to an analysis in a world characterized by uncertainty. The macroeconomic structure The model contains three basic sectors .1. To do this. in all cases expressing their behavioral constraints directly in real terms.households. and the government . 2. We shall consider these sectors in turn. and equities. corporate bonds. we shall assume that perfect certainty holds throughout. 2. Household sector We assume that households can be aggregated into a single consolidated unit.228 Differential equations. to maximize the intertemporal utility functions subject to .

rg = nominal interest rate on government bonds.Macroecbnomic policies 229 where c = real private consumption plans by households. /. Is = real supply of labor by households. md = Md/P = demand for real money balances. one can justify the inclusion of money in the utility function by means of transactions costs arguments. Th — personal income tax in real terms. /. rp = nominal interest rate on private bonds. and m. D = real dividends. g. g = real government expenditure. to be determined endogenously below. w = real wage rate. At appropriate places below. taken to be parametrically given to the household sector. p* = instantaneous anticipated rate of inflation. q — relative price of equities in terms of current output. bdp = demand for real corporate bonds. the marginal utility of money balances satisfies . E = number of shares outstanding. Bp = nominal stock of corporate bonds. As Brock (1974) has shown. fog = demand for real government bonds. Labor affects utility of leisure. / = D/qE = dividend yield. M = nominal stock of money. The introduction of real money balances into the utility function is a convenient device for capturing the reasons for holding money in a certainty world. g£d = real stock demand for equities. The introduction of c and g as separate arguments reflects the assumption that consumers view private and public goods as imperfect substitutes. taken to be fixed exogenously. specified more fully below. g. (3 = consumers' rate of time preference. This corresponds to the assumption of ultrarationality in the sense discussed by Buiter (1977). 6(s] = instantaneous rate of return on consumption at time s. it is convenient to focus on the case where they are perfect substitutes. Note that lower case letters denote partial derivatives. Bg = nominal stock of government bonds. P = nominal price of output. in which case they enter additively as c + g. We assume that for given values of c. The utility function is assumed to be concave in its four arguments c.

the restraints (2. at a real wage rate w. government bonds. they receive dividend payments at a rate i on their holding of equities. the marginal utility of money is positive. This rate is taken as parametrically given to households. it is first necessary to solve the optimization problem for the household sector. stability and chaos in dynamic economics so that m* denotes the corresponding satiation level of real money balances. the holding costs outweigh the benefits and the net marginal utility of money becomes negative. they suffer instantaneous capital gains or losses on their holdings of financial wealth denominated in nominal terms (money and bonds). in order to prevent the present value of debt from becoming unbounded as f^oo. to add to their real holdings of money. the corporate sector is driven by households in the sense that the optimizing decisions of the households determine the appropriate cost of capital facing the firms. which we have expressed in real flow terms. Finally. enabling us to separate out the real part of the system from the monetary part.230 Differential equations. Thus. corporate bonds. While most of our discussion will focus on the general utility function U. such as in Friedman (1969). Corporate sector As noted in the introduction. We have recorded this fact explicitly by the inclusion of the superscripts d ( s ) . but is one of the decision variables of the corporate sector. The household sector's budget constraint is given by (2. This income can be used in a variety of ways. and equities (the relative price of which is q). for real stocks of money in excess of m*.2. For the real stock of money less than this level. lim denotes limit inferior. 2. . and to pay taxes to the government. At each point of time the households are assumed to acquire income from a variety of sources.Id) must be added if borrowing is allowed. which in turn governs their real and financial decisions. they earn interest income on their holdings of real private and government bonds. They may use it to purchase real consumption goods. At this stage we shall simply record the financial and production constraints facing the firm and note the general form of the objective function which we shall derive. It is important to note that the decisions derived from this optimization procedure are planned demands (or supply in the case of labor). it is expositionally convenient at appropriate places below to assume that it is additively separable in m. They supply labor to firms.1b). before the firm's optimization problem can be explicitly formulated and solved.

and all other symbols are as defined earlier. After paying corporate income taxes. specified more fully below. by issuing additional equities. Equation (2. to pay dividends to stockholders. Equation (2. and the nominal stock of corporate bonds.2e) are initial conditions on the real stock of capital. equations (2.2d) expresses the firm's financial constraint. or retained within the firm. RE = retained earnings. Es = quantity of equities.2b) is the conventional definition of gross profits in real terms as being revenue less payments to labor. We define the market value of the firm's securities outstanding at time t by . Tf = corporate profit taxes in real terms. which is assumed to have the usual neoclassical properties of positive but diminishing marginal productivities and constant returns to scale. ys = real output. The final term p*bp is essentially the revenue on private bonds accruing to the firm by virtue of the fact that these bonds are presumed to be denominated in nominal terms. this may be used to pay interest to bond holders.Macroeconomic policies 231 The constraints facing the firm are summarized as follows where /d = real demand for labor by firms. 77 = real gross profit. kd = real demand for physical capital by firms. It is precisely analogous to the inflation tax generated on financial wealth issued by the government and which also appears in the household sector's budget constraint. issued by firms. Equation (2. bsp = supply of corporate bonds by firms. in real terms. Finally. or by issuing additional bonds.2a) describes the production function. Any additions to capital stock must be financed out of retained earnings.2c) describes the allocation of gross profits. Equation (2. in real terms. the number of equities outstanding.

2e) and the optimality conditions for households. In the Auerbach model. at the margin all equity based investment is financed through retained earnings. the two sets of decisions can be obtained in a convenient. k. In general. dividend policy is assumed to follow a fixed . One is to impose exogenous bounds on the rate of change of debt or equity. the appropriateness or otherwise of the value maximization criterion depends upon the dividend policy adopted by the firm. and financial decisions bsp. the interests of bondholders may conflict with those of stockholders. More will be said about this problem as we proceed. Es. The precise forms of the functions y (t). i to maximize an objective function of the form where y(0 = real net cash flow. There are two natural ways around this. In fact. Hence maximizing the market value of all claims against the firm is not the same as maximizing the market value of equity. By contrast. l. There is a technical point here which should be noted. the financial decision variables are all embodied in the cost of capital 0*(r). we shall show in section 5 below that this objective function leads to the following optimization problem for firms. depending upon the tax treatment.232 Differential equations. V(0) = bp(Q) + q(0)E0.2a)-(2. sequential manner. As a result. kd. 6*(t) = instantaneous cost of capital at time t. Auerbach (1979) has developed a model in which this objective is inappropriate from the viewpoint of maximizing the welfare of existing stockholders. This introduces a lot of messy mathematical detail. The choice of the maximization of the market value of the firm as the objective function requires further comment. in the present model. stability and chaos in dynamic economics (where we suppress superscripts) and shall assume that the firm's objective is to maximize the initial real market value of its securities. Their problem is to choose production decisions kcd. Then the equilibrium would involve eliminating the non-optimal security at the most rapid rate. Given the constraints in (2. At this point we wish to emphasize that y ( t ) is a function of real production decision variables. will be developed in section 5 below. The second is to allow jumps in the appropriate variables directly. 6 * ( t ) . Later we shall see that the value maximizing firm will specialize in either all debt or all equity financing. E0 in any equilibrium. Therefore it may not be possible to satisfy the initial conditions on b p (0). It will want to jump to the optimal level of debt or equity immediately at date zero.

one may view (2. so that at the margin. In order to restore neutrality.3) and asserts that this is financed either by increasing the real money supply or by increasing the real stock of government bonds. Finally. all equities come through new issues. interest. gross profit is assumed to be taxed at the proportional rate TP. and indeed in many economies rc = 0. 2. According to (2. ordinary personal income . As we shall demonstrate below.6a) as representing taxes on unrealized capital gains. The choice between these two alternatives. Turning to corporate income taxes. This equation defines the real deficit net of the inflation tax by the right hand side of (2.3. Its budget constraint is described in real terms by where the superscript s denotes the planned supply by the government. this generally implies non-neutrality of the various tax rates. which it finances out of real tax receipts or by issuing some form of government debt.Macroeconomic policies 233 payout rule. represents a policy decision which needs to be specified in order to close the model. and dividends . Under the present assumption.6a) implies that capital gains are realized at each point in time. Notice that (2. Alternatively. equal rv. that is. or any other monetary policy for that matter. 7). or may not. We have specified these tax functions as reasonable approximations to real world tax structures. it would be necessary to introduce appropriate tax deductions for the capital . with the interest payments to bondholders being fully deductible.6a).income from wages. the portfolio is continuously rolled over. These are hypothesized as follows where for simplicity all tax structures are assumed to be linear. In all cases full loss offset provisions are assumed. Nominal capital gains on equities are assumed to be taxed at the rate TO which may. we specify the tax functions Th. it can be shown that value maximization is indeed appropriate from the viewpoint of maximizing the welfare of existing stockholders.are taxed at the flat rate rv. The government The government is assumed to provide real goods and services g.

bg. with Th defined by (2. and the various securities in the economy all equal their corresponding real supplies. and in addition all anticipated variables are correctly forecast. In this case md = ras. stability and chaos in dynamic economics losses arising from inflation on the holdings of money and bonds as well as appropriate offset provisions for firms. and where no confusion can arise we shall simply drop the superscript. subject to the budget constraint (2. rh. equilibrium may not exist under all tax structures especially when borrowing. 6a). Substituting for Th enables us to define the Hamiltonian .1b) subject to (2.1c) with Th defined by (2. the household sector's optimization problem is to choose c. the government policy decisions constrained by (2.5) generate supplies of money and government bonds and a demand for goods. which are also functions of w. say. Thus. Since such taxes do not generally characterize real world tax structures. lending. labor. although it would be straightforward to do so. we shall focus our attention on these equilibrium quantities.1b). The perfect foresight equilibrium is defined as a situation in which the planned demands for output. etc. 3. etc. Thirdly. Carrying out this maximization yields a set of demand functions for consumption and various securities together with a labor supply function.6a). (2. etc.la). la). Likewise. with 7} defined by (2. will denote the real money supply in a perfect foresight equilibrium. rg.2e) and (2. and other parameters which consumers take as given. the corporate sector's optimization problem defined by (2. in terms of p*. Determination of optimality conditions for households As indicated above. bp.6b) yields a set of demand functions for capital and labor.2a)(2. and a set of supply functions for various securities together with output. E to maximize its utility function (2.1c). m. Nothing will be done regarding the question of existence of equilibrium. 4. In fact. Perfect foresight equilibrium The perfect foresight equilibrium (PFE) we shall consider is defined as follows. Henceforth.4). we do not incorporate them. which firms also treat as parametrically given. the quantity m.234 Differential equations. rh. and subject to the initial conditions (2. and new security creation is allowed. w. First consider the household sector's maximization problem defined by (2.

m d ( t ) . To allow for the possibility that some securities may be zero in equilibrium. We shall assume that [c(f). Ed(t)]>0 for all t. it is necessary to solve the optimization problem by using Euler inequalities rather than in terms of the more familiar Euler equations. These are simply the analogues to the Kuhn-Tucker conditions in conventional non-linear programming. some of these securities may or may not appear in strictly positive quantities in the equilibrium demands of the household sector. The assumption that financial stock variables are non-negative rules out short selling. bg. all superscripts have been dropped. In view of this. Performing the optimization yields the following conditions where v> 0 is the Lagrange multiplier associated with the household sector budget constraint. E. bdp(t). The Hamiltonian H is observed to be linear in the financial decision variables bp. Also. .Macroeconomic policies 235 function Since we are dealing with a perfect foresight equilibrium we have set p* = p. b * ( t ) . for notational convenience. the actual rate of inflation. depending upon the precise tax structure assumed.

4). if any of the decision variables are strictly positive in equilibrium. Throughout the analysis.6). (4. the optimality conditions (4.4).12). the corresponding constraint is satisfied with equality.2c).9).3). (4. bp and bg (which are identical) and E respectively. (4. so that represents the rate of return on consumption. Conversely.12) can be simplified and interpreted more readily.11) are the Euler inequalities with respect to c.5).2). The strict positivity of these quantities seems reasonable on economic grounds and can be ensured by imposing appropriate Inada conditions on the utility function of consumers. These dualistic type relationships are reflected in the equations (4.236 Differential equations. we begin by eliminating RE from the firm's financial constraints (2. The Lagrange multiplier is simply the discounted marginal utility of consumption. so that (4. (4. stability and chaos in dynamic economics Inequalities (4. (2. Determination of optimality conditions for firms To derive the objective function for firms.10).2d) to yield . and (4. (4. Introducing the above equality conditions. (4. we shall assume in equilibrium c > 0. / > 0. (4. m.7). then the corresponding decision variable is set equal to zero.8).7) all hold with equality. I.1)-(4. (4. (4.2). The optimality conditions for consumers thus may be written These optimality conditions will now be used to explicitly derive the objective function for the firms. (4. 5. m>0. If any of these inequalities are met strictly.

6) can now be readily integrated to yield a general solution where A is an arbitrary constant. y(0 equals the gross profit after tax. letting (5.S0 0* df = 00. Adding qE to both sides of this equation and noting the definition of V given in (2. Now using the definition of 7} together with (5.. and recalling the definitional relation D/qE = i. less the cost of the additional capital purchased. in order for V(s) to remain .5) can be written more conveniently as where 6* is in general a function of t.1) becomes We now define the firm's debt-to-equity ratio enabling us to write (5.2). Equation (5.3) (and hence V). the superscripts have been dropped. because we are dealing with PFE. but is independent of V. we obtain We now define the firm's real net cash flow y ( t ) to be That is.Macroeconomic policies 237 where. equation (5. Suppose for the moment that 0*>0 (an assumption which will be justified below and certainly holds in steady state) and assume that lim. Then.3) in the form Next.

is therefore where we have substituted for y ( t ) . r p . it then chooses the optimal production decisions. Thus. First it chooses its financial decisions to minimize 6*. The fact that y ( t ) depends only upon the real production variables (/c.8) is inappropriate from the viewpoint of determining the firm's financial decisions. which we assume the firm seeks to maximize. . while the discount rate depends upon the financial variables (A. However. The critical factor in the firm's objective function is 6*. i. and hence will surely be positive. we have derived the objective function (2. 0* is simply a weighted average of the real costs of debt capital and equity capital to the firm.4) and shown that V(0) is an appropriately discounted integral of the future net real cash flows. The reason is that these decisions are themselves constrained by the preferences of households. Using the definitions of A and V it may be written as In other words. /). the expression for 6* given in (5. less the rate of inflation. q / q ) means that the firm's optimization can be conducted sequentially. having determined the optimal 6*.238 Differential equations. stability and chaos in dynamic economics finite as s -> oo. The real cost of debt capital is the after-corporate income tax nominal interest rate. we require and hence the value of the firm at any arbitrary time s is The initial value of the firm. Hence (5. the real cost of equity capital to firms is the dividend payout ratio plus the real rate of capital gains on equity.8) is an expression which turns out to be familiar from basic corporate finance theory.

6* is independent of i. Dividend policy is therefore irrelevant.8).17).19) for consumers to eliminate rp and qE Substituting these expressions into (5. confirming the well known Miller and Modigliani (1961) proposition for this case.17) and (4. (4. To obtain an appropriate expression for 0*.11) may also be written in the form The expression (5. being expressed in terms of the firm's financial decision variables.12). But (5.19). together with other variables parametric to the firm is now suitable for determining the firm's optimal financial policies.11). we invoke the optimality conditions (4.Macroeconomic policies 239 These preferences. we may express 6* as It becomes evident from this expression how the cost of capital 6* provides the means whereby consumers drive the firms. impose constraints on the components of the financial rates of return. Given that the capital gains in the model really reflect accruals. Note that in the absence of taxes. embodied in the optimality conditions (4. adjusted by the various corporate and personal income tax rates. whereas tax rates in reality . the relevant cost of capital is equal to the consumer's rate of return on consumption 6.11) or (5. the adjustments themselves being weighted by the share of bonds and equities in the firm's financial structure. As written in (5. This is done by calculating the partial derivatives with respect to A. i The optimal dividend policy and the optimal capital structure will therefore involve corner solutions.

we shall simply argue that the firm minimizes its dividend payments by setting i = i. No such simple condition for (5. it seems reasonable to assume TC < ry. see Auerbach (1979). as long as D were positive. In effect. Defining the average tax rate on income from stock rs. See Miller (1977) and also Miller and Scholes (1978) for the multi-agent case.17) to hold. where i is the legal minimum payout rate. the criterion for determining the optimal financial mix can be rewritten as follows Thus. not uncharacteristic of some real world tax structures. by section 302 of the Internal Revenue Code. (5. no investor will wish to hold equities and the firm must engage in all bond financing. The opposite applies if the inequality is reversed as in (5. to be a weighted average of the tax rates on income from dividends and income from capital gains. Thus if the firm is to minimize its cost of capital. first as corporate profits. the optimal financial mix (A) is determined as follows that is all bond financing (E = 0) that is all equity financing (bp = 0).18) to hold exists.18). A simple sufficient condition for (5.17) asserts that if the net after tax income on bonds exceeds the net after tax income from equity. Loosely speaking it . at least in the U. and using the optimality condition (4.S. is that the corporate profit tax rate TP exceed the personal income tax rate Ty. where the latter are taxed twice. In the absence of any constraints this would involve the repurchase of shares. we see that our criterion is identical to that of Miller (1977). In fact such behavior is discouraged.19). written in this way. To model the legal constraints included in this code fully would be rather complicated and we do not attempt to do so here. Rather. it should minimize the dividend payout ratio i. which we take to be exogenous. secondly as personal income to stockholders.240 Differential equations. This is true for the case of a single agent. Thus setting i= i. stability and chaos in dynamic economics apply to realized capital gains.

18). when the conditions (5.Macroeconomic policies 241 requires ry to exceed TP by an amount which suffices to take account of the double taxation of income from stock. One special case of this arises when all tax rates are zero. Thus using (5. Thus while our conclusions for the firm's financial policy turn out 10 be familiar.15)-(5. then the optimal debt to equity ratio is indeterminate.17) and (5. use has been made of (5. has merit in making explicit the role played by consumers in determining the optimality conditions for value maximizing firms.10). although there is one difference.21). we feel that the derivation we have given for the cost of capital.16) simply reduce to a statement of the familiar Modigliani and Miller (1958) no-tax case. These expressions are generally similar to those given by Auerbach (1979).9) and (5. the cost of capital (expressed in our notation and invoking his assumption of zero inflation) is This is seen to be independent of the payout rate i and the rate at which dividends are taxed. the firm's minimum cost of capital may be expressed as with all bond financing this reduces to while with all equity financing it becomes In deriving the second equalities in these two equations. and furthermore is less than (5. He shows that the value of any firm in equilibrium will be independent of the amount of debt in its capital structure. he finds that with all equity financing. again in the case of a single agent. provided that the marginal rate of tax payable by stockholders on income from shares is sufficiently far below the marginal rate of tax on personal income.21). The reason for the . If (1 -T V . in terms of the underlying optimality conditions for consumers. This result follows immediately from the equality (1 — r y ) = (l —T P )(!-T S ).) = (1 -T p )(l -r s ). Instead of (5. Our results are also consistent with Miller's (1977) extension of this proposition.

Having chosen i. to maximize subject to the initial condition fc(0) = k0. thereby making it cheaper. to minimize the cost of capital and determined 0* in . stability and chaos in dynamic economics difference in this respect again stems from the difference in assumptions made with respect to dividend policy. substituting (5.24) and (5. A.7).242 Differential equations. this expression may be simplified to yield . all equity comes from retentions means that it comes from before tax funds. Moreover.24). (5.25). The optimality conditions to this problem are simply That is. The fact that in the Auerbach analysis. it must next choose k. For notational ease denote #min by 6*.25) back into (5. I.7) we may write Using the linear homogeneity of the production function and the optimality conditions (5. which in effect rules out the possibility of the values of the claims becoming divorced from the underlying sources of earnings. we are able to use the transversality condition at infinity for the above optimization problem to establish the familiar balance sheet constraint This condition requires that the capitalized value of the state variables be zero in the limit. The proof of the assertion just made is as follows. We are finally in a position to state and solve the real part of the firm's optimization problem. From (5. the after tax marginal physical product of capital should be equated to the minimized cost of capital while the marginal physical product of labor should be equated to the real wage.

18) applies qE = k. see Weitzman (1973) for the discrete time case and Benveniste and Scheinkman (1982) for the continuous time version. This completes the formal optimization of the firm.2) equates the marginal rate of substitution .19). together with the government budget constraint can now be combined to describe the perfect foresight equilibrium in the economy and to determine its dynamic evolution. bp and qE are indeterminate.18) holds with equality.1) simply defines a short hand notation for the marginal utility of consumption. Equation (6.24) and (5. Combining the optimality conditions in (4. by the necessity of the transversality condition at infinity for infinite horizon concave programming problems of this type. (5.14)-(4. 6.25) we may write Equation (6.17)-(5.Macroeconomic policies 243 Now integrating by parts and cancelling. if (5. Thus we may conclude by noting that if (5. Hence we deduce V(f) = k ( t ) .17) holds bp = k. while in the knife edge case where (5. Equilibrium structure and dynamics of system The optimality conditions for the households and firms. we obtain But the limit of the second term is zero.

c. 0* in. E(0). The size of this initial jump. and therefore the initial values m(0).6a).8). The derivation of this form of the equation involves several steps. They included pegging the real money supply. Rather than pursue it further with the model specified at the present level of generality. one obtains (6. in terms of the new notation.7) describes the rate of capital accumulation required to maintain product market equilibrium. and the minimum cost of capital respectively. Equations (6. fc(0). There are various policies which are traditionally chosen in dynamic macro models of this kind. we shall analyze a simplified version of the dynamics.13). with the initial real stocks being endogenously determined by an initial jump in the price level. Then in section 9 below. then using the optimality conditions for consumers and the optimality conditions for firms.8) is the government budget constraint. This simplification suffices to give a good indication of the nature of the transitional dynamics for the general case.3) requires that the marginal utility derived from holding a dollar in cash balances must equal the marginal utility that would be derived from spending the dollar on consumption. p. bp(0).244 Differential equations. To complete the description of the system we must consider the initial conditions. Once such a policy is chosen. stability and chaos in dynamic economics between consumption and leisure to the after-tax real wage. together with the linear homogeneity of the production function and the balance sheet constraint (5.26). pegging the rate of nominal monetary growth.5). while (6. The first two of these are exogenously determined. The dynamics governing these latter variables are expressed in equations (6. (2. while (6. in terms of the dynamically evolving variables a. the dynamics is fully determined. pegging the real stock of government bonds. etc. given the dimensionality of the system. which arises when labor is supplied exogenously. being given by /c(0) = /c0. a full dynamic analysis of the system turns out to be rather complex and not very enlightening. As part of the specification of the dynamics of the system. These five equations may be used to solve for the short-run solutions for the five variables /. k. bg(Q) are obtained from the transversality conditions at infinity for households and firms. Essentially it is obtained by first substituting the tax functions (2.8). The first of these is a restatement of (4. 6.6b) into (2. 6 g (0). m(0). bg.6)-(6. The final equation (6. we shall proceed directly to a discussion of the steady state. E(Q) = E0. Unfortunately. m.5) restate the marginal productivity condition for capital. to simplify the resulting expression for the real deficit. 6 P (0). In the case of money and bonds.4) and (6. something must be said about government financial policy. the initial nominal stocks are assumed to be given. .

with their after tax real rate of return now equaling that on equities.18) and integrating. but now exceeding that on private bonds. In the case where firms find it optimal to engage in all bond financing. Similarly. Again an initial jump may be required in q.13) to yield Next.16). which is now qE = k. The argument may be sketched as follows. With both the value of equities and their price determined. 7. the price of equities can be obtained by substituting known values into (4. The nominal rate of interest can then be determined by inserting the known values into the consumers' optimality condition (4. However. a jump may occur at time zero. Steady state The steady state of the system is attained when The fact that steady state requires k = m = d=0 is readily apparent.8).26).26) implies bp = k.8). the balance sheet constraint (5. rp = rg. since bg is determined residually by (6. in order to satisfy the balance sheet constraint (5. that is.-> U c ( t ) b g ( t ) exp(—Bt) = 0. integrate the government budget constraint (6. First integrate (4. through the price level. In this case the rate of interest on government bonds will again be given by (4. so that /c0 = bp (0) = B PO /P(0). with all equity financing. lim.16). Obviously this implies that the rates of interest on private and public bonds must be equal. to obtain . which holds as an equality. we should also explain how the equilibrium stocks of bonds and equities and their respective rates of return are determined. Note that with the nominal stocks of bonds given. the quantity of shares outstanding can be immediately inferred. The requirement that bK = 0 is less immediate.Macroeconomic policies 245 But before concluding the present discussion. the need for bond accumulation to cease in steady state can be established by integrating the government budget constraint and imposing the transversality condition at infinity for consumers.

/. then these three equations. Thus.T y ) f k ] k . p. Inserting these stationary values into the steady-state government budget constraint determines the required . bg(t) into the transversality condition and taking the limit we require (with l/c(0) finite) so that the implied time path for real government bonds is which converges to (7. andf(k.1) obtain that 6 = @. together with the policy specification. The implied endogenous initial value b g (0) is not necessarily equal to B go /P(0). if for given exogenous values of g and the tax rates. m. in order to ensure an equilibrium we require the monetary authorities to undertake an initial open market exchange of money for bonds in order to ensure that the solution for bg (t) is consistent with the consumers' optimality conditions. From (7.m and is independent of bg.( l . stability and chaos in dynamic economics where x(s) = g.mp + [ 0 . the long-run equilibrium of the system can be reduced to the following four equations The first three equations involve the four variables k. will determine the four variables k. m. even after allowing for the initial jump in the price level.246 Differential equations.Tyf . Accordingly. and p.5) in steady state. one specifies an independent government financial policy in terms of the real stock of money or the inflation. while B is an arbitrary constant. Inserting these solutions for Uc(t). /) = c + g. /. Thus.

it is necessary to introduce some government financial policy. in general. m. the system dichotomizes into two recursive subsystems. the system summarized by (7. It is of interest to note that.17) and (4. .1). the equilibrium rates of return on the financial securities can be obtained by substituting the solutions from (7. real production decisions and financial decisions are jointly determined. This is determined by the inequality conditions (5.5) is interdependent. if the policy is specified in terms of the real stock of government bonds. Finally. however. namely The real money supply m = M/ P therefore evolves in accordance with so that in steady state we have It is evident from previous sections that the steady state will be dependent on the capital structure employed by the firms. This is in part a consequence of the fact that only the nominal component of the real interest rate is taxed and the tax deductibility provisions assumed. It is also in part a consequence of the interdependence between real money balances m on the one hand. the following steady states may be characterized. I.5) into the appropriate arbitrage condition for consumers (4. Characterizations of alternative steady states In order to discuss the steady state of the system in further detail. then for given g and rates.2)-(7. 8. On the other hand. Under certain conditions. in the consumers' utility function. We shall restrict most of our attention to the case in which the monetary authorities maintain a constant rate of the nominal money supply. The first determines the real decisions k and / while the second determines the financial variables m and p.Macroeconomic policies 247 real stock of government bonds to maintain the budget in balance. Thus.19). the four equations determine the equilibrium values of k.15)-(5. for the government monetary policy specified by (8. and capital and labor on the other.2)-(7. p. conditional on these initially chosen real variables.16) and the corresponding minimized cost of capital.

so that c and g enter as separate arguments in the utility function.2). TV. On the other hand. to the extent that public and private goods are viewed as imperfect substitutes by households. For example. given the parameters B. as well as upon both the corporate and personal income tax rates. First.3). The government budget then determines the real stock of government bonds necessary to balance the budget.2)-(8. are in general dependent upon the rate of growth of the nominal money supply. the two marginal rate of substitution conditions (8. Being a perfect foresight equilibrium. the real stock of capital k is known. (8. if public and private goods are perfect substitutes. With k/l and now / fixed. This confirms the argument advanced by Fair (1978) that in a fully rational expectations model generated from underlying optimizing behavior. Having determined k/l.4) yields the marginal physical product of capital. which in turn determines the real wage/J(/c. With the linear homogeneity of the production function.248 Differential equations. and the real stock of money balances ra. the range of effective government policies may be restricted. (8. equations (8.15) holds and the steady state reduces to the following Thus the steady state in the case where firms engage in all bond financing can be obtained in the following recursive manner. an expansion in real government expenditure will have real effects on output and employment. anticipated government policies are indeed able to have real effects. /). this establishes the capital-labor ratio. k. All bond financing by firms In this case inequality (5. Also. so that c . stability and chaos in dynamic economics 8. u TJL. /.1. TP. It is seen from these equations that the real productive decisions.5) have important implications for the debate concerning the effectiveness of fully anticipated government policies under rational expectations. while the level of output y immediately follows from the production function. together determine the employment of labor /.

g disappears from the expressions Uc. They operate through the cost of capital. From equation (8.Macroeconomic policies 249 and g enter additively in U. Also. This form of neutrality in a full employment model such as this is often referred to as super-neutrality. In order for all bond financing . These effects have been discussed extensively in the literature over the years and are among the more interesting. Also. they serve to highlight very clearly how comparative static effects depend upon the equilibrium financial structure employed by firms and emphasize again the need to derive equilibria from underlying optimizing procedures. although his analysis was not conducted within an optimizing framework. which with all bond financing is their effective cost of capital.4) we may derive To understand these results it is useful to recall the expression for the nominal rate of interest (5. resulting in complete crowding out. which therefore provides the critical channel through which alternative tax structures impinge on the system.9). and (ii) the utility function is separable in real money balances.ry}.5) to the effects of tax rates and the monetary growth rate on the capital-labor ratio. is thus equal to [(1 .2)-(8. It can then be easily seen that an increase in government expenditure will cease to have any effect on the real part of the system. real activity will be neutral with respect to the monetary growth rate fji if: (i) the corporate and personal income tax rates are equal. etc. so that the marginal rate of substitution U. To preserve simplicity./ Uc is independent of m. when the results are compared to those we shall derive in section 8. so that the effect on the capital-labor ratio depends upon (TP — r v ). This result is in agreement with the analogous property obtained by Buiter (1977). It will simply displace an equal volume of private activity. we shall restrict our analysis of the comparative static properties of (8. which in steady state is rp = (ft + /i)/(l .r p )/(l -r v ) — 1].r v ). which does so by affecting the consumption-leisure choice.2 below. In this case the only government policy parameter able to influence real activity is the personal income tax rate. An increase in the rate of nominal monetary growth raises the nominal before tax interest rate by 1/(1 . The effect on the after-tax real rate of interest to firms.

In this case neutrality with respect to the monetary rate will pertain if and only if rc = 0 and the utility function is separable in m. m and hence k. if the rate of taxation on capital gains and the required minimum rate of dividend payments are both zero. all have real effects.8). (8.15) imposes a lower bound on this quantity.2)-(8.2. though the relevant cost of capital determining the capital-labor ratio is now given by (8. then TP > ry and k/l will rise.10) determine /.9). All equity financing by firms With all equity financing. Finally.5). An increase in the personal income tax rate raises the nominal interest rate 5 and hence the after-tax interest rate to firms. again confirming the proposition of Fair. Ty.16) now applies and the steady state becomes The steady state is obtained in much the same way as with bond financing described in section 8. the marginal rate of substitution conditions (8. Thus for example. On the other hand.1. 8. It therefore leads to a reduction in the after-tax real interest rate for firms. an increase in the corporate tax rate TP has no effect on the nominal interest rate. The effects of changes in the rate of monetary growth and the various tax'rates on the capital-labor ratio are obtained from (8. (5. Given the effects summarized in (8. But the reverse cannot be ruled out. thereby inducing them to lower their capital-labor ratio. The exogenous government policy parameters u. the implications for the other endogenous variables can be easily obtained by taking appropriate differentials of (8. With k/l so given. TP.6)-(8. stability and chaos in dynamic economics to be optimal.11) and have the .11). with the government budget constraint determining bg. TC. (5. the previous comments made with respect to the crowding out effects of increases in government expenditure continue to hold.250 Differential equations. inducing them to increase their capital-labor ratio.

Finally. it corresponds to our short-run value of 6. . the authors (FGS) show that if one abstracts from induced changes in the debt-equity ratio and assumes that the rate of depreciation is zero (the assumption made here).Macroeconomic policies 251 following general characteristics It will be observed that the effects of a change in TP and also probably that of an increase in /u. In fact. so that as rp increases. then the effect of an increase in the inflation rate upon the steady state net yield on bonds equals (rp . The after-tax marginal physical product of capital must remain fixed.16). these two rates of return equal (3 in steady state and therefore are independent of the inflation rate. it follows from (6. which from (5. we find that under both modes of corporate financing. an increase in the corporate profit tax rate TP leaves equity costs unchanged. depending upon the expression in (8. The effects of an increase in the rate of inflation (steady-state monetary growth) on the real after-tax yield on bonds and equities has recently been studied by Feldstein (1976) and Feldstein et al. In our analysis. k/l must fall. inducing firms to reduce their capital-labor ratio. In the latter. On the other hand. are opposite to those obtained under bond financing. while with equity financing dd/dp = — rc. The reason for these results can be understood by considering the expressions for the equilibrium rate of capital gains.5) that under bond financing d6/dp = (TP — r v )/(l — r p ). With the capital-labor ratio and therefore 0*min fixed in the short run. The difference in the result stems from the fact that the FGS result abstracts from changes in the capital-labor ratio and therefore is associated with a much shorter time horizon. on the other hand. exactly as in the FGS analysis.ry)/(l Tp) while that on equities is — rc. more general analysis.10) is Thus an increase in either the rate of monetary growth or the rate of personal income tax rv will raise the equilibrium rate of capital gain on equities and hence the equilibrium rate of equity costs (i + q/q). the effect of an increase in the capital gains tax on the rate of capital gains is ambiguous. (1978).

k.4)-(9. With labor supplied exogenously. as specified by (8. the final equation determines the endogenous lump sum tax JJL required to meet the government deficit. in which case firms find it optimal to engage in all bond financing.1). it can henceforth be ignored. Given the tax rates. and g. This will arise only in the knife edge case where (5.6). the marginal rate of substitution condition determining the labor supply is no longer applicable.252 Differential equations. . stability and chaos in dynamic economics 8. p.3. monetary growth rate.16) is satisfied with equality. we assume that the government maintains the real stock of government bonds fixed. corresponding to the present set of assumptions becomes The first three equations determine c. we turn to a brief analysis of the dynamics of the system where labor is assumed to remain fixed at an exogenously set level T say. financing its deficit with an endogenous lump sum tax. in order to simplify the dynamics as much as possible.8).15)-(5. Also. To keep things simple we shall assume that rv = TP( = T). The monetary authorities maintain a fixed rate of growth of the nominal money supply. Since this equation is a residual. Dynamics in a simplified case Finally.1)-(6. Thus omitting I from the relevant functions. the dynamics of the system (6. 9. m the dynamics of which are then determined by equations (9. in which case A will be indeterminate. in terms of a. Both bonds and equities in firms' financial structure The third possible steady state equilibrium is one in which both bonds and equities appear in the firms' capital structure. 6.

. the dynamics of the system becomes Linearizing the system about its steady state equilibrium. that is. possibly complex. Now substituting (9. (9. introducing the mild restriction that consumption and money balances are complementary in utility. From (9.8). and using properties of cubic equations. we also have c°m = -Ucm/Ucc>0.7). we find that its local stability depends upon the eigenvalues of the matrix where all derivatives are evaluated at steady state .3). the sign restrictions we have imposed suffice to ensure that Thus we may deduce that there are two unstable roots. By invoking the transversality conditions. and just one stable root. p may be written in the form while 6 is given explicitly by (9.4)-(9.13) by A. Thus for . Ucm > 0.9).Macroeconomic policies 253 The solutions for c.3) into (9. we may argue that in response to any disturbance. the system will jump so as to be always on the stable locus associated with the stable eigenvalue. In addition. (9.and Denoting the roots of (9.8) we have c° =1/L/ C C <0.

It is apparent that A. The same kind of analysis can be carried out for the case of equity financing. and (iii) the savings behavior is specified arbitrarily. See. suffers from several limitations pointed out by McLure (1975). namely to invoke the transversality conditions to eliminate unstable adjustment paths.13) and is rather tedious. likewise for the other variables in the system. (ii) depend critically upon the financial structure adopted by firms. One can also use the above method to consider the case where labor supply is endogenous. and the firm's production decisions are derived from static optimization. despite its importance. several authors have considered the question of tax incidence using a dynamic growth model. Turnovsky (1982) uses the intertemporal optimizing framework presented in this chapter to show that the effects of tax changes: (i) vary between the short run and the long run. However. the capital stock will evolve in accordance with the stable first order adjustment process where k denotes the steady state value and A^ is a function of the single stable root A j < 0. One would expect that this will lead to stable first order adjustment paths similar to (9.254 Differential equations.14). the rate of monetary growth n will affect the speed of adjustment of the capital stock. To calculate the response of the adjustment speed A! explicitly involves solving the cubic characteristic equation to (9. 10. Recently. Miscellaneous applications and exercises (1) The incidence of taxes has been a central issue in public finance for a long time. the existing dynamic models suffer from at least three limitations: (i) they are variants of the traditional neoclassical one-sector growth model. although the extent to which this is in fact the case remains an open question. will be a function of the various government policy parameters. as well as its steady state level. The standard framework for conducting incidence analysis has been the two-sector general equilibrium model of Harberger (1962) which. (ii) they abstract from issues related to the corporate sector and corporate finance. and (iii) . stability and chaos in dynamic economics example. In particular. One of the general conclusions to emerge from these authors is that the incidence of a particular tax in the long run may be very different from what it is in the short run. In all cases the strategy is the same. for example Homma (1981) and his references.

is the essence of Phelp's important contributions. see. The most important proposition to emerge from this last group of studies is the Friedman full liquidity rule. other authors have focused on the consumption maximizing rate of monetary growth and have shown that this involves choosing the rate so that the economy is driven to its golden rule capital-labor ratio. And while inflation is recognized as being one way a government may finance its expenditure. Friedman (1971). there is a body of literature focusing on the optimal differential tax rates on different commodities. It is often argued that the long-run . 1975).Macroeconomic policies 255 may also depend upon government financial policy. with the general conclusion that the optimal monetary growth rate is critically dependent upon the interest elasticity of the demand for money. for example. Friedman (1969). extensive literature has determined the optimal rate of monetary growth in terms of a more general utility maximizing framework. has been devoted to investigating the optimal rate of monetary growth. at least recently. it has been analyzed from the viewpoint of government revenue maximization. Secondly. (2) The question of optimal aggregate monetary and fiscal policy making is a very broad one and many strands of literature can be identified. the optimal rate of monetary growth is equivalent to determining the optimal rate of inflation tax. which concludes that the optimal rate of monetary growth is to contract the money supply at a rate equal to the rate of consumer time preference. This question has been considered from a number of perspectives. Thirdly. investigating the possible trade-offs between these two forms of taxation. this aspect is generally regarded as a weakness of these models. and Brock (1974. recent contributions by Phelps (1972) analyze the problem within a macroeconomic context. There is also a third extensive literature dealing with optimal monetary and fiscal policy from the standpoint of a stabilization objective. While the traditional public finance approach examines the trade-offs between such taxes within a general equilibrium microeconomic context. are also available. See Turnovsky (1982) for details and also Becker (1985) and Pohjola (1985). once one realizes that the steady-state rate of inflation associated with the steadystate rate of monetary growth acts as a tax on real money balances. To undertake this. First. Specifically. it is natural to analyze the question of optimal monetary growth in conjunction with the optimal choice of income tax. Secondly. most notably the conventional income tax. Thus. Perhaps most attention. see Turnovsky (1978). While most of this literature is concerned with determining the optimal adjustment of the system about a given long-run equilibrium. other sources of revenue. see M.

optimal policies in an economy characterized by perfect foresight may be time inconsistent. which are in turn affected by the selected policy. although his analysis is purely static. In the cases discussed by Calvo. this is achieved by having the system jump instantaneously to steady state. The question of the time inconsistency of optimal policies as discussed by Calvo can be viewed as an example of the time inconsistency of optimal policies arising out of the more general dynamic framework considered by Kydland and Prescott (1977). in which all plans and expections are realized and all markets are cleared. Thus their paper can be viewed as an attempt to present an integrated. The Turnovsky and Brock (1980) model relies on the critical concept of perfect foresight equilibrium. This consideration turns out to be central to the Turnovsky and Brock (1980) analysis who discuss at some length the problem of time inconsistency of alternative policies. 1978b) has shown. though in general it will be nonoptimal. Thus a time consistent optimal policy will in general hold only if the underlying dynamics is somehow eliminated in the course of the optimization. Accordingly. but which may be used to drive the money supply . theory of optimal policy decisions within a conventional macroeconomic context. in conjunction with the corresponding short-run adjustment paths. the optimal policy will be time inconsistent if the agents' current decisions depend upon their expectations of future events. albeit simplified. Their aim is to analyze these questions within a dynamic framework. even though ostensibly nothing has changed. The general proposition to emerge from the Turnovsky and Brock (1980) analysis is that time consistency will prevail with respect to the optimization of any single policy instrument which does not appear explicitly in the indirect utility function. the issue of the time consistency or otherwise of optimal policies reduces to the question of whether or not such policies may drive the system instantaneously to a consistent steadystate equilibrium. policies which are optimal from the viewpoint of time t say. As Calvo (1978a. On the other hand. As these authors have shown in the framework of a rational expectations equilibrium.256 Differential equations. Turnovsky and Brock (1980) develop a framework which is capable of analyzing the kinds of issues we have noted above in an integrated manner. where the objective is the maximization of some intertemporal utility function. To some extent this is undertaken by Phelps. stability and chaos in dynamic economics targets should be chosen optimally. That is. so that the government and private sector are continuously solving the same intertemporal optimization. are no longer optimal at some other point t + h say. an appropriate stationary policy may be time consistent.

Aghevli and Khan study the stability properties of their model and show that depending upon the numerical values of certain parameters such . which only in special circumstances will be consistent with the structure of the system. Lucas and Stokey (1983). Uzawa shows that. The main point is that time consistency in effect imposes an additional constraint on costate variables. increase even faster than tax revenues. A similar topic is studied by Uzawa (1974) who investigates the stability properties of the Keynesian versus the neoclassical dynamic macroeconomic models. unless certain stabilizing monetary and fiscal policies are adopted in the latter case. (4) Development economists Aghevli and Khan (1977). Irving Fisher. to gain the required revenue. government expenditures. or administer them effectively. The proposition would also seem to generalize to the case where many assets subject to initial jumps appear in the utility function. Finally. (1987). and another in the style of the monetary classicist. In effect this is the Tinbergen static controllability condition. and actually. at times. such as capital. forcing the government authorities to increase money supply even further. the phenomenon of time inconsistency can in general be expected to exist in the presence of sluggishly evolving variables. Such a monetary policy of deficit financing has been attractive to numerous countries which are unable to enact adequate tax programs. both Keynesian and classical are very similar to the Cagan model. Siegel divides his models into two classes: one describing the adjustment process in the spirit of Keynes. but appearing in the dynamic relationships is at least as great as the number of such assets. the economic growth path is dynamically stable in the neoclassical model and dynamically unstable in the Keynesian model. (3) The stability of Keynesian and classical macroeconomic systems is studied by Siegel (1976) who synthesizes the work of Metzler and Cagan to produce more general models which include asset and commodity markets out of equilibrium as well as inflationary expectations. provided the number of linearly independent instruments not appearing in the utility function. Such a form of deficit financing causes inflationary pressures by increasing the money supply and as inflation rates increase. It is shown that the dynamics of these extended models. M. The nature of these circumstances in an economy with capital goods deserves further investigation. present a dynamic macroeconomic model to study the policy consequences of financing government expenditures by the creation of money. Cagan's derived stability condition holds for all models. See also Hillier and Malcomson (1984). Persson et al. and Calvo and Obstfeld (1988). under certain assumptions.Macroeconomic policies 257 instantaneously to its constant steady-state level.

Blanchard (1983) develops a dynamic macroeconomic model to emphasize the role of firms in the transmission mechanism of a shift towards savings. the adjustment mechanisms of the economy may be too weak to eliminate persistent unemployment. (6) An important macroeconomic question is this: suppose that fiscal policies are implemented which increase the savings rate. among others. Tobin (1986) shows that in some cases an unstable vicious circle can lead fairly quickly to a dramatic crisis. Obviously. the adjustment coefficients for inflation. the self-perpetuating process of inflation converges to a steady state equilibrium or it becomes explosive. Also even with stable monetary and fiscal policy combined with price and wage flexibility. the first answer is addressed to the short run and the second to the long run dynamic effects. both algebraically and by numerical simulations. (5) Tobin (1975) studies the local stability of two dynamic macroeconomic models: the Walras-Keynes-Phillips model and the Marshall model. (1986) apply the same model and suggest that inflation is not self-perpetuating in the case of the Greek economy. The second claims that larger savings imply a higher sustainable capital stock. the stability properties of the steady state and concludes that even with rational forward looking firms. are conducive to stability. The Marshallian model is separable into output and price equations. a shift towards savings may lead a temporary decrease in investment and savings before leading to more capital accumulation. For the Walras-Keynes-Phillips model it is found that (i) a strong negative price level effect on aggregate demand. (ii) a weak price expectation effect and (iii) a slow response of price expectations to experience. real government expenditures and taxes. Batavia et al. Some of Tobin's conclusions include: the Walras-Keynes-Phillips adjustment model allows the distinct possibility that lapses from full employment will not be automatically remedied by market forces. Blanchard considers the dynamics of the adjustment process. . long run crowding out generated by an easy fiscal and tight monetary policy mix. stability and chaos in dynamic economics as. See also Tobin (1986) who develops a dynamic macroeconomic model to analyze.258 Differential equations. To study this problem. The first emphasizes aggregate demand effects and claims the possible paradox of savings. Their model applied to Indonesia explains well the self-perpetuating process of inflation which occurred in that country. The output equation is stable and the stability of the price equation is similar to the stability of the Walras-Keynes-Phillips model. what will the dynamic effects on output and capital accumulation be? There are two well known but partly conflicting answers.

1971b. Benhabib (1980). Nagatani (1970). Benhabib and Miyao (1981). in a model that considers only money and capital. saving is merely a decision to invest directly in real capital or money balances. Shane's (1974) model consists of three differential equations in capital intensity. such an increase in the money supply produces a once and for all increase in the price level that is just sufficient to keep the system at its steady state and therefore to keep the system stable. the wealth ratio and price expectations. Black (1974). Calvo (1977) shows that uniqueness can be recovered in some cases if a continuity condition on the price level path is added to the Sargent and Wallace (1973) assumptions. Calvo (1977) comments that the conditions proposed by Sargent and Wallace (1973) to remove the dynamic instability of monetary perfect foresight models are not sufficient to ensure uniqueness in any of the possible configurations of the money supply path allowed in their paper. in terms of developing a policy tool. it is often claimed that versions of the Tobin (1965) model which assume perfect foresight are dynamically unstable. (8) Shane (1974) extends Tobin's (1965) model by introducing an equity security into money and growth analysis. 1979). and its global asymptotic stability is found to depend on whether the direct interest rate effect was greater than the offsetting wealth effect and whether the rate of forced saving was greater than the adjustment . that is. instead of the more traditional treatment in terms of money and capital. the price of money falls instantaneously when at an initial price level the supply of real balances exceeds the demand. whereas the introduction of a financial market allows one to analyze directly the mechanism by which saving and investment are separated. it is claimed that a once and for all increase in the money supply will set off a process of ever accelerating deflation. Several economists. See also Stein and Nagatani (1969). 1979) and Hadjimichalakis and Okuguchi (1979) have studied the saddle point stability of the Tobin model. Sargent and Wallace (1973) proposed an alternative view. First. If the system is initially in a steady state with zero inflation. Fischer (1972. Hadjimichalakis (1971a. Malliaris (1982) and Hartman (1987). In general.Macroeconomic policies 259 (7) Tobin (1965) introduced money in a deterministic. neoclassical economic growth model. thereby eliminating the excess supply of real balances without affecting the expected rate of inflation. continuous-time. according to which. What makes the equilibrium stable in the Sargent and Wallace (1973) model is that the price level rises. 1973. Such an approach has two distinct advantages. The model is developed explicitly in terms of securities and capital. Second. this approach also provides a basis for directly relating policy actions which are financial in nature to the effects on real variables such as income and capital intensity. such as Sidrauski (1967).

and supply of labor. studies uniqueness. Benhabib and Bull show that. although the difficulty of multiple equilibrium paths complicates welfare comparisons. a strengthened version of M. A. supply of capital.1978) and Smith (1978). is due to external effects translated through real balances as an argument in the utility function. The consumers who obtain utility from consumption. one preferred by everyone to the other. by explicitly specified maximizing behavior of agents. Consumers forecast the price level. Calvo (1979) shows that there are perfectly plausible cases where nonuniqueness is the rule as well as others where uniqueness can always hold. Uniqueness prevails in some cases where capital enters in production. and since welfare increases as real balances increase along the set of equilibria. and security markets in particular. For various specifications of the utility function Brock (1974) establishes existence of equilibrium. Firms maximize one period profits which determine demand functions for capital and labor services as functions of the real rental and real wage. J. is to take the short run impact of economic disturbances and allow the rate of inflation to adjust slowly to changes in the economic environment. Calvo (1979) uses Brock's (1974. equilibrium may be inefficient. and income from Milton Friedman's (1969) famous helicopter. 1975) model to check local uniqueness for cases not studied by Brock. stability and chaos in dynamic economics in the rate of inflation. real rental. including the price level. Gray (1984) motivated by Brock's (1974) paper . (9) Brock (1974) examines a perfect foresight monetary growth model that consists of the following. and money and consumption are Edgeworthcomplementary while nonuniqueness arises where money is a factor of production. Calvo also notes that nonuniqueness and instability can in principle be corrected by government policy. The model illustrates that the crucial role of financial markets in general. real wage. Friedman's optimum quantity of money theorem can be proved. See also Purvis (1973. and examines the impact of changes in the rate of growth of the money supply. real balances and leisure then solve their infinite horizon optimization problems to produce demand for goods. Benhabib and Bull (1983) and Brock (1974) attempt to formalize Milton Friedman's (1969) optimum quantity of money and to study the properties of dynamic equilibrium paths in monetary growth models. Thus all variables. Equilibrium obtains when all markets clear. income from profits. This possibility of two equilibria. are determined.260 Differential equations. demand for money. Multiple equilibria may exist if the marginal utility of consumption falls with an increase in real balances. See also Hadjimichalakis (1981). as a function of the quantity of money.

See also Obstfeld and Rogoff (1983). The difference is even more clear-cut with respect to an increase in the corporate profit tax rate. First. and (ii) the assumption of saddle-path stability which requires that there must also be market forces that present the emergence of self-fulfilling speculative bubbles. the choice of which depends upon relevant tax rates. These differences are highlighted most clearly when one considers the effects of an increase in the monetary growth rate on the capital-labor ratio. For details see Obstfeld and Stockman (1984). If all bond financing is optimal for firms. the capital-labor ratio will most probably (but not necessarily) rise. . second. Gray and Turnovsky (1979).Macroeconomic policies 261 explores the conditions under which the procedure of specifying a dynamically unstable macroeconomic model and then arbitrarily selecting the stable path of that model may be justified. Helpman and Razin (1982). if all equity financing is optimal. that is. Further remarks and references This chapter is taken from Brock and Turnovsky (1981) and its purpose is to extend some of the recent macrodynamic models in two directions. 11. Mussa (1982). individuals know the structure of the economy and use all available information to make optimal forecasts of future variables. we have discussed its steady-state structure in detail for one particular form of monetary policy. Probably the most important general conclusion to emerge from this analysis is the need to ground such models in an optimizing framework. Finally. A balance of payments analysis is found in Michener (1984). While much of our attention has been on the development of the model. it will definitely fall. (10) Obstfeld and Stockman (1984) review an extensive literature of dynamic exchange rate models. These models attempt to explain certain facts about floating exchange rates using several common features such as (i) the assumption of rational expectations. it has specified a more complete corporate sector than such models usually contain. Dornbusch (1976) and Mundell (1968). the relationships describing the private sector are derived from explicit optimizing procedures by households and firms. Additional references are Lucas (1982). It is shown how this will lead to three possible equilibrium capital structures. so that the exchange rate is tied to its economic fundamentals. and that these equilibria have very different implications for the effectiveness of various monetary and fiscal instruments. Obstfeld (1984) demonstrates the possibility of multiple convergent equilibrium paths in a modified version of Brock's (1974) model.

Look at how the disinflation and the tax cuts of the 1980s have cut the value of 6*. Equation (5. This issue turns out to be extremely complicated to analyze. Perhaps more interestingly. (ii) complaints that the quality of corporate debt is deteriorating. this raises the question of the optimal mix between these two forms of taxation.anticipated government policies are able to generate real output effects. one can look at questions concerning tradeoffs among alternative tax rates. note how the gains to issuing corporate debt have increased. view the debt to equity ratio A and the dividend payoff ratio i in (5.12) reveals a plausible partial explanation for such disparate phenomena.6) reproduced here for convenience Equation (5.S. This is another reason why a richer model such as the one in this chapter is essential for understanding the full implications of policies of this type. The predictions of such policies are indeterminate in the model until fiscal policy is specified. To take one example. This helps explain (i). These results confirm Fair's (1978) view that in a complete rational expectations model . the choice of monetary expansion can be viewed as representing the choice of an inflation tax rate. more attention could be devoted to considering the comparative static properties of alternative monetary and fiscal policies under alternative •tax structures. Also. For instance. stability and chaos in dynamic economics The equilibrium capital-labor ratio will rise with all bond financing and fall with all equity financing. If one can also choose the various income tax rates.one in which the underlying behavioral relations are obtained from optimizing behavior and fiscal policy is precisely specified . which abstracts from the corporate sector and the issues being stressed here.12) as fixed. in the short run.6) may be used to discuss real world phenomena of the 1980s like: (i) the extraordinary bull market in stocks. one has a framework capable of evaluating the welfare effects of alternative government policies. It is considered in Turnovsky and Brock (1980) using a much simpler version of the present model. The model we have developed is capable of providing a framework within which important issues can be discussed. Specifically. and (iii) the massive influx of foreign capital into the U. But the model is capable of dealing with many other kinds of issues. For example. and look at the pricing equation (5. it is apparent from our analysis that currently popular policy discussions of pegging the monetary growth rate at say 4% are seriously incomplete. In other words the cost of debt capital has dropped relative to the cost of equity capital. Furthermore.262 Differential equations.A. To put it another way .

If foreign countries. have not experienced as sharp a drop in 6* as has the U. 1978). Stability notions in rational expectations analysis Early examples of a type of stability analysis in the rational expectations literature that we shall exposit here are in Brock (1974). Although the Sargent and Wallace (1973) analysis was not in the context of a fully specified rational expectations equilibrium model it illustrates the role of the price of a stock variable like capital stock as a fast moving market equilibrator. Turnovsky and Burmeister (1977) and others. Problems of corporate financing really become interesting only in a world of uncertainty. Recent developments in stochastic calculus indicate that it might be possible to extend our framework to include various forms of stochastic disturbances. the quality of corporate debt will tend to fall. This behavior of asset prices leads to notions of stability and to solution theory that is different than much of that in the natural sciences. We are not saying that taxes explain everything.S. such as Japan. the price will jump very fast in response to a change in the expected capitalized payoffs from a unit of capital. then this helps explain (iii). The model can be extended in different directions.12) reveals that a drop in the personal tax rate relative to the corporate tax rate cuts the cost of debt capital relative to the cost of equity capital. Sargent and Wallace (1973). 11. This is so because the same capital stock is backing a larger stock of corporate debt. For a comprehensive text on dynamic equilibrium macroeconomics that stresses uncertainty see Sargent (1987). But undoubtedly the most important extension relates to uncertainty.Macroeconomic policies 263 formula (5.1. (which casually seems to be the case). Burmeister and Turnovsky (1977. We are only saying that models and techniques like those exposited in this chapter help the economist explain the real world. Alternative assets such as rented capital. That is. Having made the above remarks about this chapter's model we next offer general comments on stability notions in rational expectations analysis and related topics. This helps explain (ii). Asset markets are asymptotically stable if in response to a parameter change the prices jump in such a way that the system hops to a new solution manifold such that along that manifold the system converges to a new . Since firms would want to lever more. can be introduced. This increases the gains to leverage.

The literature on this kind of rational expectations model has grown rapidly in the last few years. Tillman (1985) and their references. Furthermore. For example. where 0* is the cost of capital. i. In this case the dynamical system that describes equilibrium is given by: where T denotes the corporate tax rate. f ( x ) is the production function. For example if one component of x is fiat money stock then the matching jump variable is the real price of money. C(p) is the inverse function of u'(c). It is a function of parameters such as the rate of monetary growth (the rate of inflation). stability and chaos in dynamic economics steady state.1) can be reduced to one differential equation in real balances. and (3 is the subjective rate of time discount on future utility. To keep things simple suppose that the firm is all equity financed and there are no taxes but corporate taxes. or capital stock variable and the corresponding component of p as a jump or price variable that can equilibrate rapidly in the very short run in order to equilibrate supply and demand for the stock. Judd (1985). all taxes are redistributed lump sum back to households. G are smooth (at least twice continuously differentiable) and x. Consider an equilibrium dynamical system which is defined by the following pair of differential equations: where F. Let the pair (x.1) is the Brock-Turnovsky model (1981) treated in this chapter. This reduction simplifies the analysis in such cases. The variable x will be called the state or stock variable and p will be called the jump or price variable. We shall briefly describe some of the main principles that have emerged from this literature in this section of the book. It is also a function of the . see Buiter (1984). 1/P where P is the nominal price level (Brock (1974)).e. and the debt/equity ratio. p lie in n-dimensional Euclidean space. p) denote the steady state and note that it is a function of the shift parameters a. the capital gains tax rate.. p = u ' ( c ) . In models where fiat money is perfectly inelastically supplied by government the equilibrium dynamics can be rewritten in terms of real balances and the pair (11. In the general case of the Brock-Turnovsky model treated in this chapter the equation (11. You should think of each component of x as a stock. An example of (11. the personal tax rate. asset.2)(b) will be replaced by.264 Differential equations.

2)(a) remains the same. cases where n of the eigenvalues of J have negative real parts. That is to say. If the proceeds of taxes are redistributed lump sum back to households then (11. near the steady state (x. solutions that are optimal. all the eigenvalues are distinct. equilibria lie on the n-manifold generated by the eigenspaces of the n smallest real part eigenvalues of the Jacobian matrix evaluated at the steady state.e. i. i. We will call EM the equilibrium manifold. p) such that if you solve (11. Recall that the stable manifold generated by a steady state of (11. x) as do .2)(a) will have parameters in it.1) starting at (x. More specifically. Call this the local solution manifold (Brock and Scheinkman (1976) and chapter 9). Examples where the equilibrium manifold is not the stable manifold Most of the examples in the published literature are examples where the equilibrium manifold is the stable manifold. The local solution manifold LEM is tangent to the EM at the steady state.1) where the dynamics were derived from the primitives of economic analysis such as tastes and technology.1) were derived from equilibrium problems that could be reduced to solutions of optimal control problems. c + dx/dt = f ( x ) by c = G(dx/dt. there will be a manifold EM = { ( x . and the projection of the local solution manifold on n-space is all of n-space we know that there is a function p ( x ) such that p = p ( x ) along this manifold. It is easy to modify the Brock and Turnovsky (1981) setup to exhibit unstable steady states and the equilibrium manifold not being the stable manifold. 11. In this case because taxes collected in equilibrium are a function of A: and tax parameters. In regular stable cases. In this special case we know that.p). Then either put capital into the utility function as does Kurz (1968b) or replace the material balance equation. In chapter 7 of this book we presented a modified form of Samuelson's Correspondence Principle that included systems (11...e. the RHS of (11. If taxes go to finance government goods g.Macroeconomic policies 265 rate of return on consumption 6 = ft -(dp/p d t ) . p ( x ) ) } of points such that if you solve (11. p ( x ) ) you will generate an equilibrium.1) is the set of all pairs (x.1) you converge to the steady state as time goes to infinity. We stick to the simple case (11. the RHS (11.2)(a).2. To do this let all taxes be zero so that the solution of the equilibrium problem is the same as the solution to the optimal growth problem. except for hairline cases. then g must be subtracted off the RHS (11.2) because it will be clear how to generalize the principles that we will set forth here. the dynamics (11.1) was the state-costate equation in current value units of an optimal control system. In general.

For specificity take the Liviatan and Samuelson model. If you follow the revised correspondence principle in chapter 7. unlike that of Samuelson. The global solution manifold is tangential to this eigenspace at the unstable steady state.A. perhaps. however . x) = 6V. To get the local solution manifold take the eigenspace generated by the smallest root. Now turn one of these examples into an equilibrium rational expectations model as do Brock and Turnovsky. The second type of analysis is: what happens if at date zero it is announced that at date T>0 the parameter a will change to a. This ad hocery introduces free parameters which robs the analysis of empirical content in that the analysis does not lead to the formulation of econometric models with strong restrictions.? This is called anticipated event analysis.we gave up as a profession on the task of modelling out of equilibrium behavior. For this reason. More generally one can study questions such as: What happens if a is changed to a\ on . The firm's balance sheet equation is given by d V / d t + G(dx/dt. forever? This is called unanticipated event analysis. Kurz and Liviatan and Samuelson show that examples of growth problems with multiple steady states can be constructed. In any event let us explain the analysis. one can argue that the unstable steady state will never be observed. we may expect to obtain a more powerful analysis given a smaller number of free parameters. In chapter 7 and in Brock (1986b) it was pointed out that when dx/dt = F(x. the rational expectations approach of Lucas replaced the earlier Samuelson-Hicks approach to economic dynamics. Follow the same procedure as for the case G(dx/dt. p. p(x). Good examples of this technique are Wilson (1979) and Judd (1985) among others. x) space. stability and chaos in dynamic economics Liviatan and Samuelson (1969).266 Differential equations.) at steady state x(a). The first question is: what happens if at date zero the parameter a changes to a{ and remains at a. then standard Samuelsonian comparative statics and dynamics could be done. for the same reason as in the Samuelson Correspondence Principle. the dynamics are derived from primitives like tastes and technology. The linearization of the system about an unstable steady state has two roots both real and positive. This came at a price. Recall that in Samuelson's formulation of his correspondence principle and his dynamics were ad hoc in the sense that they were not derived from maximizing behavior of economic agents. 464) for the phase portrait in (c. x) =f(x)-dx/dt to study equilibria and focus on an unstable steady state.S. Hence. the unstable steady state can be ignored for the purposes of comparative statics. There are two main forms of analysis of rational expectations models that we want to stress here. See Liviatan and Samuelson (1969.a) was globally asymptotically stable (G. This is so because. But in our case. a} = h(x.

We refer the reader to Judd (1985) for the details. Apply this type of analysis to the tax model (11.Macroeconomic policies 267 (0. but prices. If the initial value of x is at the old steady state value then p will plummet but eventually rise to a higher level. price will drop from its old value in order to discourage the speed of accumulation but it doesn't drop below its new long run value.oo). There is now a new stable manifold lying below the old one. But the only variable that can adjust in the short run is price. of the firm.3. i. on (0. jump variables can. Then the analyst pieces together the comparative dynamics by working backwards. a) changes abruptly to p(x. p(x.. 11.1) with a set equal to a. p(x0. V. This is so because capital stock will still be increasing but not as urgently as before. a. This is called overshooting.e. Tj]. What is going on here is that prices must give the signal to decrease capital stock to a lower level in the long run. Draw the stable manifold. Now let the corporate tax rate increase from T. . Unanticipated event analysis To get into the spirit of unanticipated event analysis consider the following parable. oo). The equilibrium solution solves (11.2).. Hence the price of x. i. i. But if initial capital stock is so small that it is still smaller than the new steady state value overshooting will not occur. p). It is announced that parameter a has now changed from its old value a to a new value a^ that will reign forever. in the beginning of the adjustment period price sinks below its ultimate value. The economy is at (x0. to T2 at date zero. Therefore.2) above. oo).e. T2]. The state variable x cannot change much in a short unit of time. The same thing will happen to the stock market value. Basically you jump from LEM(a] to LEM((Xi) to get the dynamics for dx and dp in response to a change da that holds forever.2) you will converge to the unique steady state (x.. p) such that starting at (x. the set of (x. What happens? The economy was on the old equilibrium manifold EM ( a ) .)) is in E M ( a 1 ) . Therefore.) so that (x0..e. a. Therefore. on (0. The initial value of p must drop instantly to get on the new stable manifold since the stock variable x cannot change in the very short run. The new equilibrium manifold is now EM(a\}. p0) at date zero. in order to make this latter kind of problem analytically tractable assume that a has the value an on (T n . Judd (1985) uses this kind of technique to analyze changes in tax policy and shows how to extend linearization analysis for small changes in parameters... the burden of the entire adjustment must fall on price at first. a 2 on (Tj. Draw the phase diagram for (11. p) and following the dynamics (11.

(1985) provide an introduction to the theory and evidence of rational expectations in macroeconomics. that is to take place T periods from now and to be permanent over [T. Marcet and Sargent (1988) draw heavily upon recent work in optimal control theory in their paper on learning. Learning and disequilibrium is an important research area in economics despite the fact that this book focuses almost entirely upon rational expectations models. Judd's article also shows the limitations of graphical analysis for many policy questions and develops a Laplace transform technique to get around these limitations.4. Attfield et al. the papers of Bray (1982). For details see Judd (1985). (1982) and Lucas (1986) contain references on learning where stability analysis is stressed. For example. see also McCallum (1977. while McCallum (1983) argues that the nonuniqueness of many macroeconomic models involving rational expectations is not properly attributable to the rationality hypothesis but. a0) to a new value p so that starting from (x0. 1988c) for learning illustrations related to the quantity theory of money. stability and chaos in dynamic economics This is all easy to see by drawing the phase diagram. An earlier standard reference is Shiller (1978).268 Differential equations. It must start at x0 at date zero and follow the dynamics (11. the stability techniques exposited here will help researchers in this area. Also. Although it is beyond our scope to study learning and disequilibrium. T). instead. T) we arrive at EM(a. is a general feature of dynamic models involving expectations. oo). See Judd (1985) and his references. Working backwards as in dynamic programming we know that to be in equilibrium the system must be on £M(a 1 ) on [T. Hence p must change from the old value. 1978. Conditions for unique solutions in stochastic macroeconomic models with rational expectations are given in Taylor (1977). 1980).1) at value « 0 over [0.) at exactly date T. See also Malliaris (1988b. We close with a comment about disequilibrium behavior and learning. 11. Blume et al. p(x0. Again Judd (1985) shows how to apply this methodology to economic problems such as change in tax policy and shows how to extend it to the analysis of small changes da. . oo). We conclude this section with some additional references.1) where the RHS is evaluated at «0 over [0. Taylor (1986) reviews rational expectations models in macroeconomics. p) and following the dynamics (11. Anticipated event analysis Consider a change in the parameter a from a0 to a.

and hence the adjustment rate to equilibrium.Macroeconomic policies 269 There is a basic economic reason why the techniques of this book will be valuable in the area of learning and disequilibrium dynamics. i. See DeCanio (1979) and his references for details. . After all. learning imposes costs that must be borne today in return for gains tomorrow.. must depend on the discount rate of the future in any sensible economic model of learning. The optimal rate of learning. because there is one parameter that plays a central role in the stability analysis of optimal dynamics. This is so.e. This is the rate of discount. One can argue that this same parameter should play a central role in any sensible economic model of learning and disequilibrium. the rate of interest that agents place upon the future.

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A general formulation of capital theory or optimal growth problem is subject to k(0) = ko. if one wants to introduce tax distortions. the methods of the current chapter will have to be modified. In this chapter we analyze the much harder case of many sectors. . . . R+ = {x<= R": x. >0. Does the economy converge to balanced growth? Stiglitz and Uzawa (1969. there is the problem of stability. we will only treat the case of the optimal growth model. n}. In order to make progress. Here u : B<= Rn X R" -> R is usually assumed to be twice continuously differentiable and concave. 406) 1. The optimal growth model may be turned into a market model by following the methods of the previous chapter. This is not restrictive. tax and other distortions will not be treated. . p. Furthermore.CHAPTER 9 STABILITY IN CAPITAL THEORY Finally. / = 1 . . and B is convex with nonempty interior. u is called the value of the initial stock k0. Introduction The previous chapter analyzed the dynamics of a one sector economy that was distorted by taxes. Of course.

The function H is called a Hamiltonian. kj is stock of capital good j and qj is the price of capital good j. This process generates a type of differential equation system that Brock and Scheinkman (1976) call a modified Hamiltonian dynamical system.272 Differential equations. k) as t -» oo. in general.1) such that (/>. what follows only depends on H being defined on an open convex subset of R 2n . k(t)] of (1. stability and chaos in dynamic economics A capital theory model generates a capital-price differential equation by using the maximum principle reported in Hestenes (1966) and Pontryagin et al. H turns out to be the current value of national income evaluated at prices q. and it is well defined on R + x Rn+ for many economic problems.1) optimal if k ( t ) is the optimal solution of the optimal growth problem when k(0) = k0. peculiar to economics. kQ). call it an MHDS for short. A definition is needed. no general results on the convergence of optimal solutions . Concerning the second branch. Problem 1. H» (q. The literature on problem 1 has two main branches: (i) analysis of the local behavior of (1. Also find sufficient conditions such that the steady state (q. The first branch of the literature is fairly complete and a brief survey is presented at the end of this chapter. A modified Hamiltonian dynamical system. k) is independent of the initial condition (q0. is a differential equation system of the form Here H: R+ x R+ -> R. of (1. See Cass and Shell (1976a) for a complete interpretation of (1.1). be optimal. In economics. The number p is a discount factor on future welfare arising from the structure of social preferences. (1962) to write down necessary conditions for an optimal solution.1) which satisfy k(0) = k0 will. until the mid-1970s. The adjective modified appears because it is a certain type of perturbation.1). and p e R+. The problem that we address in this chapter may now be defined. Find sufficient conditions on optimal solutions O. Clearly not all solutions of (1. provided the obvious changes are made. However. This chapter reports the Brock and Scheinkman (1976) approach to capital theory. of the standard Hamiltonian system.1) in a neighborhood of a steady state. We call a solution [ q ( t ] . and (ii) analysis of global behavior of solutions of (1.

1) were available. a natural question to pose is our problem 1 for MHDS.) if there is e > 0 such that |x 0 -x|<£ implies (Ot (x 0 )-» x as t->oc. The solution x ( t ) = x of x=f(x) is locally asymptotically stable (L. However. Inada-type conditions guarantee that in fact optimal solutions will satisfy our boundedness condition. We start by discussing the three basic types of results presented and their relation to the literature. Papers of Brock (1973) and Brock and Burmeister (1976) gave a fairly general set of sufficient conditions for uniqueness of the steady state. there was nothing done in the Brock (1973) paper on convergence. Note that our definition of bounded solutions requires not only boundedness on the (q. The following problem has been analysed extensively in the differential equations literature and has been reviewed in chapter 3.3. The solution x(t) = x of x=f(x) is globally asymptotically stable (G. However. Ot(g 0 .A. Thus.A. Let x satisfy f ( x ) = 0.S. Definition 1. little was known about sufficient conditions for the uniqueness of steady states of (1. new problems arise. In this chapter we present results that build on the work of Cass and Shell (1976a).) if for all x0 the solution O1 (x 0 )-»-x as t-*oo. Definition 1. k) space. Let be a differential equation system. In fact.1. Definition 1.1) if there exists a compact set K ^ Rn X Rn+ such that <j>.S. k0)<=• K for all t. if / is a modified Hamiltonian. Magill (1977a).Stability in capital theory 273 of (1. Under what conditions is the solution x ( / ) = x globally asymptotically stable for all x0? We recall two definitions. . Rockafellar (1976).1). x ( t ) = x is usually never even locally asymptotically stable in a neighborhood of x This is so because if A is an eigenvalue of the linear approximation so also is -A + p. ko) will be called a bounded solution of (1. but also requires that there exists e >0 such that In many optimal growth problems. In this case. and Hartman and Olech (1962). For this reason we concentrate on the convergence of bounded solutions. See Kurz (1968a).(q0.2.

will always apply to bounded solutions alone in this chapter. ^o) is bounded.3.1). k ) ) . if for all (q0. that is.S. ^o) is bounded. k) of (1. In section 2 we show that if F ( z ) Q ( z ) F ( z ) > 0 for all z such that F ( z ) * 0. fc0) such that 0. . and L. For MHDS the words G.(q0. k) some rest point of (1.1) as where F.S.1) if there is e > 0 such that provided that </>. Most of the assumptions in this chapter refer to the curvature matrix where H^(z) = ( d H 1 / d z l ) ( z + (q. those who satisfy definition 1. H22(z) = (BH2/dz2)(z + ( q .(<7o.A. The steady state solution (q. The steady state solution (q. k) = (q. The result is obtained by using the Liapunov function F[(z)F 2 (z).5. stability and chaos in dynamic economics Definition 1. k) of (1. This is the Hamiltonian version of the well-known result in differential equations which states that iff:R"^R and J ( x ) = (df(x)/dx). then f T (X)/(X)/(x) < 0.4.::A<^ R2" -» Rn where A is open and convex. k) = (q. for all x with f (x) = 0.1) and rewrite (1. We will sometimes call MHDS saddle-point systems when we want to emphasize their saddle-point structure.1) is said to be locally asymptotically stable for bounded solutions of (1. by letting Here again a bounded solution means a solution which is contained in a compact set K c A.1) is said to be globally asymptotically stable for bounded solutions of (1. and /„ is the n x n identity matrix. we have Definition 1. implies that all solutions of x = f ( x ) converge to a rest point. then every bounded trajectory converges to a rest point. k ) ) .274 Differential equations. Denote by (q.A.

A. The curvature matrix Q is a natural economic and geometric quantity. — H22 are positive semidefinite matrices. which is the Cass and Shell hypothesis.2) converge to the origin. The proof is inspired by the elegant proof of a Hartman-Olech type of result obtained by Mas-Colell (1974). holds. As Cass and Shell (1976a) point out. Geometric Content of Q. It is easy to show that ( R ) . in the metric induced by the arc length measure along the orthogonal field of trajectories. The method of proof of section 3 does not. As a by-product of the proof. This is related to a result by Hartman and Olech (1962) which states that if w T J(x)w<0 for all w such that \w\ = 1 and wTf(x) = Q. Hence H11. the Hamiltonian is convex in q and concave in k for optimal control problems with a concave objective function. if the Hamiltonian is quasi-concave in the state variable. A notion of a-quasi-convexity is introduced to provide a geometric interpretation for the case where p > 0. This method is similar to the method used by Hartman and Olech of constructing an orthogonal field of trajectories to the trajectories generated by a system of differential equations z = F(z). in section 4 we outline the method of proof of a more general theorem. unfortunately. Furthermore.Stability in capital theory 275 In section 3 we show that if z^F2(z) +z^F}(z) = 0 implies z T Q ( z ) z > 0 and if Q(0) is positive definite. definite provided that For the one-dimensional case.S. the results in section 4 have a nice geometrical interpretation in terms of quasi-convexity and quasi-concavity. generalize to prove results analogous to Hartman and Olech's (1962) most general results. we show that the above conditions are sufficient for the function z|z2 to be monotonically increasing along trajectories.A. then G. although in this case optimality may not make sense. and placing conditions on the Jacobian matrix of F so that all trajectories of the original field come together monotonically as f-»oo. For this reason. Note that the assumptions of sections 2 and 3 are somewhat complementary.S. then every solution to x =f(x) converges to the origin provided that 0 is L. then all bounded trajectories of (1. which is Rockafellar's . Q is positive This suggests that if the smallest eigenvalue a of H11 and the smallest eigenvalue (3 of -H22 satisfy (R) then Q is positive definite. we show that for the case p = 0. In particular.

k) can be interpreted as shadow profit when q is the shadow price of investment. that is. p. is a negative semidefinite matrix which exists for almost every k. Thus. and Thus. Cass and Shell develop in detail the economic meaning of the Hamiltonian. They show. if dR/dk exists. does indeed imply that Q is positive definite. 405). Let us expand upon the economics here. a sufficient condition for stability is that be positive definite. and the interest rate p. the demand for k should be downward-sloping. An intuitive way of putting this is that the slopes of the supply curves for investment and the demand curves for capital services are large relative to the interest rate p. See Karlin (1959. stability and chaos in dynamic economics (1976) basic stability hypothesis. The matrix Q is just a convenient way of tabulating information on supply. R"(k). that is important for stability analysis. and that cross terms are small relative to own terms. are generalized slopes of supply and demand curves for investment and capital services. More specifically. For u(y. dH/dq = optimum investment level. Like any demand curve. Along an optimum path. dH/dq is an internal supply curve for investment. . y) concave the Hessian of R. q(t) is the current value of the demand price for capital goods. Therefore. Economic Content of Q. demand.276 Differential equations. all with utility as numeraire. q(t) is a Marshallian demand curve for capital equipment. in particular. It is well-known that the Hamiltonian H(q. and dH/8k is a Marshallian demand curve for capital services.

Therefore an increase in H12 represents a type of increase of non-normality.4) hints that an increase in H12 is destabilizing. A first result on G. the system strives to maximize long-run static profit since the future is worth as much as the present. We would expect an increase in H12 to contribute to instability because an increase in k leads to more new machines. (1959).S. and Markus and Yamabe (1960).3). and that are based on a different class of Liapunov functions than those presented here. Arrow et al. Rockafellar (1976). is likely to lead to a decrease in new machines supplied by the firm to itself when q increases. q decreases in k. It is a little more difficult to explain why an increase in — H22 is stabilizing. Hartman (1961). The quantity H12 represents a shift in the internal supply curve of investment when capital stock is increased. This is so because if p = 0. 2 . a destabilizing force for q is stabilizing for k. Arrow and Hurwicz (1958). as can be seen intuitively by examining But since along an optimum path. An increase in Hu is stabilizing because R" is negative semidefinite. since H12 is the derivative of the internal supply curve with respect to k. It is also intuitively clear that moving p closer to 0 is stabilizing. Stabilizing forces are forces that lead to increased negative feedback in (1. This source of instability is not exposed by the Q matrix. Inspection of (1. it is likely that H}2 will be negative in some sense. that is an increase in fc. Magill (1977a).Stability in capital theory 211 Look at the reduced form and its equation of first variation. if some sort of diminishing returns to capital services and substitutability between investment goods and capital goods is present. For an increase in the number of machines. which leads to yet larger k. that is.A. 2. The work in this section is closely related to work by Cass and Shell (1976a). For an increase in -H22 is clearly a destabilizing force for q. Consider the modified Hamiltonian system . See Brock and Scheinkman (1977a) for stability results that focus on the role of H.

Cass and Shell are the first to obtain G. (b) 0 < W(z). roughly speaking. that the negative definiteness of JT + J is sufficient for global stability of x =f(x). that x(t)->0 as f ^ o o along trajectories.1) and let Then (2. Rockafellar (1973) and Samuelson (1972a) have used the same function to investigate stability for the case p = 0. We will make use of the result in Hartman (1964. 539) which is also theorem 4. Arrow and Hurwicz and Markus and Yamabe prove.1) by use of the Liapunov function V = zTz2 for the discounted case. therefore. . Their methods provided inspiration for many of the Brock and Scheinkman (1976) results. Let W(z) be a real-valued function on E with the following properties: (a) W is continuously differentiate on E.1) where q0 is chosen so that Ot (qo. ko) of (2. k) be a rest point of (2. Let F(z) be continuous on an open set E c Rm. rephrased for our current need.1) becomes Markus and Yamabe (1960) and Arrow and Hurwicz (1958) present sufficient conditions for global stability of differential equations of the form x=f(x). Let J ( x ) = df/dx.278 Differential equations. where W(z) is the trajectory derivative of W(z) for any z e E. Lemma 2. stability and chaos in dynamic economics Let (q. and such that solutions of are uniquely determined by initial conditions.1.A. natural to ask what may be obtained by differentiating the closely related Liapunov function F[F2. results for a discounted linear quadratic problem. We present an analog of this type of result for Hamiltonian systems.A. It is. Optimal growth paths will have this boundedness property under reasonable conditions. Consider a trajectory z ( t ) = Ot(q0. Magill (1977a) used V to obtain G. p.S. results for (2. thereby. k0) is bounded. by differentiating (x) T x = W with respect to t and showing. Here XT denotes x transposed. Cass and Shell (1976a) prove global stability of such a trajectory by differentiating the Liapunov function V = zTz-2 with respect to t.1 of chapter 4.S.

then given any z0 such that 0.Stability in capital theory 279 Let z(t) be a solution of (*) for t >0. H22= -dF l /3z 2 . in particular. Proof. and w ( y + ) = {z E R": there exists an increasing sequence {tn}OO=0 such that limn->oo Ot n (z 0 ) = z}. We can now prove Theorem 2. and solutions are continuously dependent on initial values. Let z 0 (t) be a solution of (*) satisfying z 0 (0) = z0. and z0e E. which may depend on z0. Then the limit points of z ( t ) for t > 0. Then W[z( tn)]-»• W(z0) as n-> oo. The continuity of W guarantees that for 17 sufficiently small. and by (b) W[z(t)] < W(z0) for f >0.1. Proo/ Let y+ = {ze Rn : z = <f>t(z0) for some t > 0}. there exists by the mean value theorem e > 0 and d > 0 such that for 0< t < e and. such that lim 0. Since W is continuously differentiate and W(z0)>0. Suppose z 0 /£ 0 so that W(z 0 )>0 by (b). . If F T (z) Q (z)F(z) > 0 for all z with F(z) = 0. And in particular.(z 0 )-> z as t-»oo. and In denotes the n x n identity matrix. Inequalities (2. are contained in the set E0 = {z: W(z) — 0}.(z0) is bounded.2) are isolated. if any.3) and (2. Let tn<tn+l^><x>. there exists a rest point z. Since z(tn)->z0.4) imply that W[z(e + tn)]> W(z0). in E. Let where Hn=dF2/dzl. there exists N(rj) such that for n > N ( n ) ) . and this contradicts W[z(0]^ W^(z 0 ). given any 17 > 0. and if the rest points of (2. z(t n )->z 0 as n -> OO. This completes the proof.

stability and chaos in dynamic economics Since y+ has compact closure on the domain of F. W= ktq is bounded above on optimal paths. since it is possible to find models in which optimal paths are not bounded. k0) be the optimal solution and that is. . z is a rest point. Remark 2. k) solve the MHDS corresponding to (2. however. compact and connected. then k T q = k ^ R " ( k ) k < 0 along any optimal path provided k = 0. lim Ot (Z O )H» z as f-»oo. w(y + ) = {z}. that is.1. Thus. 145). p. Let k*(t. consider an optimal growth problem given fc(0) = fc0. One can. Since the rest points are isolated and w(y + ) is connected. F(z) = 0. Here u: R2n -»R is usually assumed concave and twice continuously differentiable. See Hartman (1964. hence. then F T (z)Q(z)F(z) = 0. Benveniste and Scheinkman (1979) provide a general set of conditions on u that imply that R' exists. If we assume that R is twice continuously differentiable.280 Differential equations. bound the Liapunov function W by assuming regularity and concavity conditions on the so-called value function. R is the value of the objective function along the optimal path (the value function). Hence.(z 0 ) is bounded with the condition 0. and. For MHDS derived from optimal growth problems. if E w(y + ). R"(k) is seminegative definite. and so. In fact. By the previous lemma. then one can show that R ' ( k ) = q where (q.5). it would be useful to replace the condition that O. q = ( d / d t ) R ' ( k ) = R"(k)k. w(y + ) is nonempty. If one assumes that in fact R"(k) is negative definite. Thus. The concavity of u implies that R is concave.(z0) is optimal.

It holds with strict inequality for strictly concave functions. Convergence of bounded trajectories In this section we shall present a general theorem closely related to Hartman and Olech's basic theorem (1962. and the matrix Q plays an important role in such sufficient conditions. that is. Consider the differential equation system Assume there is x such that f ( x ) = 0 (without loss of generality put x = 0) such that there is V: Em -» R satisfying: Then (a) [ V V ( x ) ] T f ( x ) < O f o r a l l x = o.) is concave.1.> R m be twice continuously differentiate. for all k. (B) all trajectories that remain bounded. Let f:E u Rm . are contained in a compact set k c E. Theorem 3. the general theorem is stated and proved in such a way as to highlight a general Liapunov method that is especially useful for the stability analysis of optimal paths generated by optimal control problems arising in capital theory. . for t > 0 converge to 0. Thus. The Liapunov function V= z^z2 = (q — qY(k — k) amounts to Since the value function R ( .2. 3. p. Furthermore. Theorem 3.Stability in capital theory 281 Remark 2. 157). Inequality (ii) is well-known for concave functions.1 below and many other results will follow as simple corollaries. it is natural to search for sufficient conditions on the Hamiltonian that imply V is increasing on trajectories. E open and convex.

(x 0 )-»0 as t-»oo. in turn. Also. (d) implies that [V V(Ax)] T x J(Ax) x (Ax)<0. Let x ^ 0. Furthermore. But if <£. (At this point.3).Suppose now that there is A >0 such that g ( A ) = 0. By lemma 2. it must be true that there is e 0 >0 such that g ( A ) < 0 for A e [0. so g(0) = 0. all the rest points of 0. and g(y) = 0 implies g ' ( A ) < 0 for A > 0 . g'(0) = 0. and put We shall show that g(l) <0 in order to obtain (a). e0]. This result is important for global asymptotic stability analysis of optimal paths generated by control problems arising in capital theory. show that g'(A) < 0. x = 0 is the only candidate. But this.) Calculating. Let us calculate g'(A).(x0) must have a limit point. 0. Therefore.(x0) is bounded. Note that to get global asymptotic stability results for bounded trajectories. the reader will do well to draw a graph of g(A) in order to convince himself that the above statements imply g(l) < 0. Hartman and Olech . all one needs to do is find a V that is monotone on bounded trajectories and assume that £0 = {x: [V V(x)]T/(x) = 0} = {0}. a contradiction to g'(A)>0. Finally. and so. g'(A) > 0. f(O) = 0. From (3a. Then there must be a smallest A>0 such that g(A) = 0.282 Differential equations. By continuity of g" in A. and (b). Thus g'(A)<0. Also g'(0) = 0 from/(0) = 0. Also. Hence $. Now g(A) = 0 implies [V V(Ax)] T /(Ax) = 0. and get an immediate contradiction. and (b) imply But this is negative by (a).1. This completes the proof. g"(0)<0.(x0) satisfy [VV(x)] T /(*) = 0. stability and chaos in dynamic economics Proof. implies that AxTV2 V(Ax)/(Ax) = 0 by (c). We do this by showing that g(0) = 0. we get Now A=0 implies /(Ax) = 0.

dV/dt <. Then 0 is globally asymptotically stable. Assumption (a) becomes But this follows because Assumption (b) trivially holds since W(x) = 2x. If J ( x ) + JT(x) is negative definite for each x.Stability in capital theory 283 (1962) type results emerge as simple corollaries./(0) = 0. Assumption (c) amounts to 2x/(x) = 0 implies x T (2/ n )/(x) = 0 which obviously holds. Corollary 3. Proof.1. Therefore. Remark 3. The following corollary is a stronger result than Hartman and Olech (1962) in one way and weaker in another. We demonstrate the power of the theorem by extracting few corollaries. We explain the difference in more detail below. Put V = xTx. Assumption (d) obviously holds because 2x T J(x)x < 0 for all x ^ 0. This ends the proof. The condition . It is easy to use V = XTX decreasing in t in order to show that all trajectories are bounded.1. some already mentioned in chapter 4.oo. and the rest of the proof proceeds as in corollary 3. Thus all bounded trajectories converge to 0 as t . Consider the ordinary differential equations x=/(x). then 0 is globally asymptotically stable. Let f: Rm -» Rm. Then VV(x) = 2xV2V(x) = 2Ia where /„ is the nxn identity matrix.1. Assumptions (a)-(d) of the theorem are trivially verified.

3.2 is reported in Hartman and Olech (1962) and in Hartman (1964) where 0 is assumed to be the only rest point. For example.284 Differential equations. the proof of the Mas-Colell result is much simpler than that of Hartman and Olech. that is. A result similar to corollary 3.lO) amounts to pseudoconcavity of the potential F. Corollary 3. condition (3a. MasColell puts the stronger assumption: x[/(0) +J T (0)]x<0 for x 7=0 on the rest point. . Note that Mas-Colell only assumes X T f (x) = 0 implies xT[J(x) + J t ( x ) ] x < 0. there is a potential F: R" .ll) is just Thus. It is possible to obtain general results of the Hartman and Olech type from the theorem. w T f (x) = 0 implies w T [/(x) + / T (x)]w<0 for all vectors w. assume that F is maximum at x0 = 0. but he requires the strong inequality. On the one hand. But on the other hand. but negative definiteness of J(0) + JT(0) does imply negative real parts for /(0). A function F: Rn -> R is said to be pseudoconcave at x0 if Put x0 = 0. Assume that and Then x = 0 is globally asymptotically stable for bounded trajectories. Furthermore. Hartman and Olech (1962) make the assumption: for all x=0. stability and chaos in dynamic economics has a natural geometric interpretation when x =f(x) is a gradient flow. Let G be a positive definite symmetric matrix. So he places the restriction on a much smaller set of w. It is well-known that negative real parts of the eigenvalues of J(0) do not imply negative definiteness of J(0) + JT(0). and it is assumed to be locally asymptotically stable.R such that for all x. and note that (3a. and let 0 be the unique rest point of x =/(x).

157) and to a theorem in Hartman's book (1964. Assume that the MHDS has a singularity (q. Hartman and Olech also treat the case of G depending on x.2.1 to modified Hamiltonian dynamical systems. Corollary 3. theorem 14. k).bb (c) for all w = 0 . The rest of the proof is now routine. p.3 is closely related to a theorem of Hartman and Olech (1962. We have not been able to obtain their result for nonconstant G as a special case of our theorem. Assume (a)h0 = F(0) is the unique rest point of z = F(z). This leads us to believe that the method of proof outlined above is necessary for developing Hartman and Olech type generalizations for nonconstant G for modified Hamiltonian dynamical systems. w t q(0)w >0.3.b Then all trajectories that are bounded for t > 0 converge to 0 as t . We turn now to an application of the general theorem 3. theorem 2.1. Let where I„ is the n x n identity matrix. p.oo.Stability in capital theory 285 Also. we have that (c) . 549). their different methods of proof yield theorems that the methods presented in this section are unable to obtain. Thus. proof let v = 2t az where wher in is the n xn identity matrix. and rewrite it as We now state and prove Theorem 3. Since a2v(0)= A+At = 2A and (wtA)t(J(0)w)=-wtQ(0)w. Note that zt az = .2ztz2.b (b) for all z=0.

(b) of theorem 3. VV(0) = 0. The proof of theorem 3. and that is the Cass and Shell hypothesis. Also [W(z)] T = zr(A + AT) = 2zTA. This is so because theorem 3. of local form such as the Q condition of theorem 3. It is worth pointing out here that the hypothesis has a geometric interpretation for the case p . 147). Remark 3. pseudoconcavity at (q. Therefore. V < 0 except at the rest point 0.286 Differential equations. if the minimum eigenvalue of Hn is larger than a and the maximum eigenvalue of H22 is less than —B where aB > p 2 /4. as an easy calculation will immediately show. There is a neat sufficient condition for the positive definiteness of Q. Now (c) of theorem 3. If H is convexo-concave. the matrix Q is clearly positive semidefinite for p = 0. The rest of the proof is routine by now. .1 follows. Applications and economic interpretations of local conditions for stability to the adjustment cost literature are discussed in Brock and Scheinkman (1977b). Sufficient conditions.3). Theorem 3.2 also yields the result that the Liapunov function zT1z2 = (q — q)T(k — k) is monotonically increasing along trajectories.2 gives conditions for the trajectory derivative of V = z|z2 to be positive for all z = 0. k respectively. p.2. for positive trajectory derivative are useful for computations.1 amounts to [V V(z)] T F(z) = 2z T AF(z) = 0 implies z T V 2 V(z)F(z) = 2z T AF(z) = 0.2 is a local sufficient condition for the hypothesis of the Cass and Shell stability theorem to hold. Furthermore. Furthermore. /c) in q.2. stability and chaos in dynamic economics implies (a) of theorem 3. Thus. k) of H(q.1. The hypothesis aB > p2/4 is the basic curvature assumption in Rockafellar's (1976) analysis.0. (d) amounts to " But (3b. It implies pseudoconvexity. For the special case These statements may be easily checked by referring to the definition of pseudoconcavity in Mangasarian (1969. and hence. then Q is positive definite.4) is identical to (3b. which is trivially true.

in fact.2. 4. almost contained in theorem 3. that is. . Thus. Burmeister and Turnovsky use the quantity 6 as an aggregate measure of capital deepening response. It solves Differentiate this last system with respect to p to obtain where Rewrite this as Multiply both sides of this by the row vector [k'. Let [q(p). theorem 4. the positive definiteness of Q in the directions [q'. on convergence of bounded trajectories of MHDS that is related to a theorem of Hartman and Olech (1962). A more general result In this section we present a result. Furthermore.Stability in capital theory 287 The positive definiteness of Q is also related to the Burmeister and Turnovsky (1972) regularity condition. theorem 4. q'] to get But the quantity is the Burmeister-Turnovsky (1972) regularity quantity.1.2 below. k'] as p varies is equivalent to capital deepening response in the BurmeisterTurnovsky sense for each value of p. We start by presenting a sketch of the proof of a result. k(p)] be the steady state associated with p.

z20] -»0 as t -» oo}. |0.z 20 )e A. F is continuously differentiable. that is. Assume that for each z 20 e R" there is a unique z10 such that (z 10 . z 20 ]->0 as f-»oo. So suppose that z20 is in the boundary of A 2 (0 2 ). but we shall ignore those here. Ws = {z0: <£.(z0)| ^ M}.1). let Ws be the stable manifold of (4. Let A2(02) = {z20: <£. Let 0.1) on bounded trajectories. Let us proceed in a way that uncovers a natural set of sufficient conditions for the global asymptotic stability of (4. z 20 ]-^0 as f-»op for all z20£R".(zo) be the solution of (4. 02] = 02.l).(z"o)^0 as f->oo}.[g(z20). stability and chaos in dynamic economics corollary 4. Reconsider the system (3b. Here ^2[g(02). Let u2e R" have unit norm. and assume that g is differentiable. we have global asymptotic stability. This means that there is an open neighborhood N2(02) c: R" such that z 2 0 eN 2 implies </>. We are after sufficient conditions to guarantee that </>. Consider the vector put . If A 2 (0 2 ) is the whole of R".288 Differential equations.[g(z20).3). we formulate a sufficient condition involving dF/dz alone. We could just apply the Hartman-Olech result to the reduced form but this requires knowledge of dg/dz 2 . In some problems g is badly behaved. A -{z0: there is M>0 such that for all t>0. In most problems not much is known about g other than its existence and differentiability and other general properties. Thus.[g(z20). Assume the solution z2 = 02 is locally asymptotically stable for (4.1) given z0. F ( z ) = 0 for z=0.1 below gives a nice geometric interpretation of the hypothesis in terms of quasi-convexity and quasi-concavity of the Hamiltonian function. and let A be the bounded manifold of (4.1). that is. Write for this functional relation. Put Assume F(0) = 0.

that it is natural to construct trajectories of type (4. however.6).p) by xp. Consider It is natural to look at w of (4. u2)]/dp. We shall see.8) and the method of constructing the transverse trajectories (4. We call the system of trajectories satisfying (4. The reader will recall Notice here that both the Liapunov function (4. q).p]^x(q. The method of proof is also different. Consider the following differential equation (we drop transpose notation except when needed for clarity). Let y [ T ( p .7) is identical to (4.4) are different from HartmanOlech. . Observe that The last follows from the definition of Hamiltonian orthogonal trajectories in (4. They are not the same kind of orthogonal trajectories as in the original Hartman-Olech result. A theorem may now be stated.Stability in capital theory 289 Let yp(t. Note that Also note that The latter follows from But (4. and denote (d/dp)x(q. if a solution exists.6) Hamiltonian orthogonal trajectories.4).6) for our type of problem. p) = d$ r [z 0 (/>.8) in light of the previous results and the Hartman-Olech technique.p) be a solution.

Since in theorem 4. and is. Consequently G. By (i) and (ii). (d) of theorem 4. which does not use any properties of Jg. stability and chaos in dynamic economics Theorem 4. c7F2[z(0] + clF. Assume that (a) F is continuously differentiable.1. symmetric.2) holds. for all ce/? 2 " with |c| = l.290 Differential equations. In corollary 4. thus. Hence. As in remark 2. for all vectors ce R2n such that |c| = 1. Proof. (c) z2 — 02 is a locally asymptotically stable solution of ^2= F2[g(z2).1 is stated in the form above is that one can obtain the following corollary.1. c 1 F 2 [z(f)] + c2Fl[z(t)] = 0 hold.1 holds if and only if cjFj = c]"F2 = 0. c = (c l s c2). c. Notice that although in hypothesis (d) of the theorem we used information on the Jacobian matrix of g.A. we have Since if a*id only if (/gc2)TF2 + c^JgF2 = 0. (b) F(0) = 0.1. z2].S. The reason theorem 4.1.A. = /gc2 where Jg = g'(z2).l) under hypotheses (a)-(c) of theorem 4.1 only the fact that Jg is symmetric was used.1. Jg = R". must hold. for z2 = F2[g(z2). z ( t ) is a bounded trajectory and (4. F ( z ) ^ 0 for z 7^ 0. we could have stated the stronger hypothesis that for all zetf 2 ".1. c T Q[z(0]c>0 for all c satisfying (d) of theorem 4. all bounded trajectories of z=/(z) converge to 0 as f-»oo. if a value function R exists and is twice continuously differentiable. Remark 4. and (d) for all bounded trajectories z ( f ) . we have Then z2 = 02 is G.[z(r)] = 0 implies c T Q[z(f)]c > 0.1. Given a MHDS like (3b. . suppose Jg is symmetric and that the Hamiltonian function satisfies for all z = (g(z 2 ). Corollary 4. 22].S. z2) Then global asymptotic stability of bounded trajectories holds. That is.

12). Assumption 1. Suppose that (4. of convexoconcave Hamiltonians to the quasi-convex-quasi-concave case. Then (ii) says that H is /3-quasi-concave in z2.12) obeys assumptions (a) 0 is the unique rest point of (4. Remark 4. Put a(z)=jG + (jG) . The general result is now stated. z2] at z2 = 0 has all eigenvalues with negative real parts. we have . For p = 0. Now consider the system We now state the following theorem. Then. cTD/(x) = 0 implies cTD2f(x)c> a\c\2.3. w^O for all z ^ 0. In what follows G(z) will be assumed to be continuously differentiable.S. The Hamiltonian is. Define aquasi-concavity in the obvious way. (b) 0 is L. Theorem 4. Let where /„ is the n x n identity matrix. (c) Let K be a compact subset of the bounded manifold. in fact. furthermore.1 simply says that the Hamiltonian is a-quasi-convex in zl. Therefore. and. Note that p introduces a distortion that vanishes at p = 0. in the sense that the linearization of z2 = F2[g(z2).S.2. For all WE R2n. Given a function F: R" -» R we say that F is a-quasi-convex at x if for any c ^ O . This generalizes the result of Rockafellar (1970a) on the G. fc))-p(zl + q)Tz2.2. Let H(z) = H(z + (q. the equivalent bordered matrix conditions so beloved by economists may be written down in place of (i) and (ii). the following basic property holds. the trajectory derivative of the matrix a(z). (i) and (ii) can be interpreted as quasi-concavity of the Hamiltonian function H. Let G: R2" ^ M[R2n.A. always a convex function of q. (JzeK U*>o </>. R2"] (the set of all 2n x2n real matrices) be such that G(z) is positive definite for all z.A.( z ) is bounded. Let where a'( z ) = Z r = i (d<*/dz r )F r . Inequality (i) of corollary 4.Stability in capital theory 291 Remark 4.

(z0)^0 as /-»oo}) is not all of R2n. theorem 14. the 2nx2n identity matrix. and find sufficient conditions on preferences and technology for a minimal limit set to be stable in some sense. Several topics for future research follow in the next section. put a(z) — — 2G(z). stability and chaos in dynamic economics implies Then all trajectories in the bounded manifold converge to 0 as / -> oo. The proof of this theorem is long and involved. of optimal controls generated by MHDSs. . will be treated in the next chapter.292 Differential equations. therefore. Miscellaneous applications and exercises (1) A more general notion of long-run behavior needs to be formulated. for example. For example. Hartman and Olech's basic result in Hartman (1964.S. For a proof see Brock and Scheinkman (1975). This kind of theory where sets more general than points. Its interest lies in applicability to systems where the stable manifold W (where W={z0:</>. To see this. Assumption 1 then becomes Hartman and Olech's (H-O) assumption. It is. Assumption 1 becomes Note that where We have reported in this chapter some recent progress toward providing a comprehensive analysis of G.A. let G(z) = / 2n .2 would not be interesting if all it did was restate Hartman and Olech. There is really no economic reason to rule out limit cycles. necessary to build a theory that allows more general limit sets than rest points. 5. the important special case of MHDS that we are interested in generates systems where W is n-dimensional. In particular. Theorem 4.1) is closely related to this theorem. and is done in a sequence of lemmas. cycles and tori can be attractors.

1. it will still be G.A. This suggests development of a notion of block dominant diagonal for MHDSs to parallel the development of dominant diagonal notions in the study of the Walrasian tatonnement.Stability in capital theory 293 (2) Both our results and the Cass-Shell-Rockafellar (CSR) results are small p theorems. results are not dependent on the size of p. It is worth searching for an analog of theorem 5. G ( x ] . However. independent of the size of p.A. p. Further evidence to support this proposition is the Ryder-Heal (1973) experience.) for all x ^ 0 and 0 is L.A. then 0 is G. and Bhattacharya and Majumdar (1980). holds under conditions not sensitive to the size of p. into the Hartman-Olech framework was that this is needed to obtain their result. (3) It is natural to extend our findings and the CSR results to uncertainty. Therefore. 549). IfT(x)<0 See Hartman (1964.S. Intuition suggests that if we perturb such an economy slightly. their G. the sufficient conditions for G.S.A.A. Consider the differential equations Theorem 5. The above theorem is important because F is an easy quantity to interpret.A. models do not satisfy either the CSR hypotheses or the hypotheses in this chapter.S. p : R n .A. Brock and Majumdar (1978). remains to be developed. (HartmanandOlechinHartman(1964. 549) in order to be convinced that matrices of the form G(x) = p(x)In. (5) Burmeister and Graham (1973) have exhibited a class of models where G.S. Some of their G. but much more remains to be done. Brock and Magill (1979). Some results in this area are reported in Magill (1977b).R must be introduced into the basic Hartman and Olech method in order to obtain the above theorem. a general stability hypothesis that covers the one good model. Perhaps a more fruitful approach will build on Pearce's (1974) notion of block dominance. In other words. the Burmeister-Graham models and the CSRBrock-Scheinkman models.1 for MHDS. .p(x)>0 for all x .S.p.S.A. (4) One of the original motivations for introducing positive definite matrices. See McKenzie (1960).S. are most likely to hold when p is small. the Cass-Koopmans' one good model is G.S. Furthermore.

does hold.A. is well understood.1) in a neighborhood of a rest point. but G. It studies the linear approximation of (1. They generate a . In this chapter we present a set of conditions on the Hamiltonian for such dynamical systems to converge to a steady state as time tends to infinity. Eigenvalues have a well-known symmetric structure that determines the local behavior. 6. This class is basically the class where the Liapunov function V = k^H^k together with concavity of the value function yields V < 0. Kurz (1968a). Kurz points out that a solution of the inverse optimal control problem for a given competitive path may provide valuable information regarding the stability properties of the path under consideration. The simplest case with n . for discrete time models that are independent of the discount rate. Standard references are Cass (1965). Further remarks and references The qualitative study of optimal economic growth has attracted the attention of economic theorists for a number of years.1) for n -1.S. that is. The first branch of the literature on problem 1 is fairly complete. except around the steady state. stability and chaos in dynamic economics Results reported in Brock and Scheinkman (1977a) on'adjustment cost models indicate the existence of a large class of models where the CSRBrock-Scheinkman small p conditions do not hold.S. We refer the reader to the Cass and Shell (1976a) paper for an introduction to competitive dynamical systems and a complete survey of the literature. (7) Kurz (1968a.294 Differential equations. Chang (1988) extends the inverse optimal problem to the stochastic case. See also the paper by Liviatan and Samuelson (1969) which is an important study of the limits of linear analysis and the relevance of multiple steady states stability and instability. Koopmans (1965) and Burmeister and Dobell (1970). Ryder and Heal (1973) analyze a case of (1.1. the one good optimal growth model. One major focus of this research has been to find sufficient conditions on models of economic growth for the convergence of growth paths to a steady state. Although the amount of literature on problem 1 is extensive there are no general results on global stability. 1969) studies the general instability of a class of competitive growth and the inverse optimal control problem respectively.A. (6) Araujo and Scheinkman (1977) obtain conditions for G. Cass and Shell (1976a) present the Hamiltonian formulation of competitive dynamical systems that arise in capital theory. Samuelson (1972a) and Levhari and Liviatan (1972) are some representative references.

studied first by Ramsey (1928) for the one good model. The case p = 0 is the famous Ramsey problem. (1987). k) as tH»OO independently of (q0. Burmeister (1980) gives a comprehensive exposition of dynamic capital theory. k) is strictly convex in q and strictly concave in k and p — Q. 1986b). then all solution paths of (1.1) that are optimal converge to a unique steady state (q. Some additional recent references are Becker (1980). then by Gale (1967). Feinstein and Oren (1983). Epstein (1987) and Becker et al. p. that if H(q. See Burmeister and Graham (1973. These results state. McKenzie (1968). roughly speaking. Benhabib and Nishimura (1981). . Boyd (1986a. McKenzie (1982). Burmeister and Graham (1973) present an analysis of a model where there is a set S containing the steady state capital k such that for k e 5. McFadden (1967) and Brock (1970) for the n goods model in discrete time and by Rockafellar (1970a) for continuous time. Chang (1987.1988). Scheinkman (1976) has proved a result that shows that the qualitative behavior for p = 0 is preserved for small changes in p near p = 0. the value of q along an optimal path is independent of k. DasGupta (1985).Stability in capital theory 295 variety of examples of different qualitative behavior of optimal paths. k0). 149).

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Some representative references include Benhabib and Day (1981. Eckmann and Ruelle (1985) and their references. Grandmont (1985. Ecclesiastes 9. i.CHAPTER 10 INTRODUCTION TO CHAOS AND OTHER ASPECTS OF NONLINEARITY Again I saw that under the sun the race is not to the swift nor the battle to the strong. Eckmann and Ruelle (1985) is a nice review of the ergodic theory of chaos and strange attractors. This chapter relies on Grandmont (1986). 1982). Introduction The previous chapters did not spend much time on understanding sources of instability in economics. Day (1982. the present chapter focuses on systems that generate complex time series behavior that ranges from toroidic trajectories to a form of instability known as deterministic chaos. Day and Shafer (1983). Grandmont (1986) and the survey paper by Baumol and Benhabib (1988) can be used as initial reading. Boldrin and Montrucchio (1986). Revised standard version. Deneckere and Pelikan (1986).e. nor riches to the intelligent. In contrast. Benhabib and Nishimura (1985).. 1. 1983). global asymptotic stability of the optimum or equilibrium dynamics. .11. nor bread to the wise. Baumol and Benhabib (1988). Stutzer (1980). The main focus was on sufficient conditions for convergence to stationary states. but time and chance happen to them all. 1986). nor favor to the men of skill. Recently there has been a lot of interest in nonlinear deterministic economic models that generate highly irregular trajectories.

An example is the difference equation. u. at least. The second step was to study the long run behavior of the system. The idea that a system with only a few active modes could generate such complex behavior actually observed in nature was rather controversial. . This is the period doubling route to chaos. u). the long run behavior of the system becomes more complex in many cases. in his example of a period doubling route to chaos in an economic model. the long run behavior progressively passes from a fixed point. The idea was that the long run behavior would converge to some attractor set A ( u ) and the long run behavior may change (go through phases) as you change u.. . to a four-cycle. We remark that when studying the natural science literature in this area it is important for the economic theorist brought up in the tradition of . The Ruelle and Takens (1971) proposal was radical. (1983) and Swinney (1983) has documented the existence of chaos in nature. As you increase the parameter u. stability and chaos in dynamic economics Mathematical interest in deterministic dynamical systems that generate apparently random (at least to the naked eye and to some statistical tests) trajectories has dated. to a two-cycle. The state may be a finite dimensional vector. Ruelle and Takens also proposed that a useful way of looking at transitions to turbulence was to first write down a differential equation model of the system. to a 2". As you increase the parameter. dx/dt= F(x. After all. After this experimental evidence appeared. if anything looks stochastic it is turbulence. in the case of a fluid. or. back to Poincare's work in the late 1800s. the parameter. It was the discount rate on future utility in the Boldrin and Montrucchio and Deneckere and Pelikan models published in Grandmont (1986).298 Differential equations. . to chaos.... might be the Reynolds number in a fluid flow experiment. c y c l e . a point in an infinite dimensional space. In Grandmont (1985) it was the risk aversion of the old agents in a two period overlapping generations model that played the role of u. where x is the state of the system and u denotes a vector of slow moving parameters. Interest by the natural sciences was piqued by the seminal and controversial (at the time) paper by Ruelle and Takens (1971) who argued that the traditional model of fluid flow turbulence was structurally unstable and that a dynamical system that converged to a low dimensional deterministic chaotic attractor was a better model of certain types of fluid flow turbulence than the traditional one. Experimental work discussed by Roux et al. For example. . u. interest in the study of chaos was greatly increased.

Another example of the style of rebuttal of classical theory is Shiller (1984) and Summers' (1986b) attack on the efficient markets hypothesis. McCallum's (1986) review and other papers in Barro) opened a debate by showing that a class of tightly specified. the critics have to produce models based on plausible purposive economic behavior that can better account for empirical regularities in aggregative macroeconomic time series data than the neoclassical models. Sargent. parsimoniously parameterized stochastic economic models built on rational economic behavior. They propose alternative models of stock returns that lead to the prediction of negative autocorrelations in returns over 3 to 5 year periods of time. rather than postulated reduced forms of the IS/LM type. can account for a collection of stylized facts about business cycles. reasonable theoretically but accounts for a much wider spectrum of facts by paying a low price in terms of additional parameters. The criteria of what constitutes a successful direct argument and what is a rebuttal have changed. Prescott. For example.Chaos and other aspects of nonlinearity 299 abstract general equilibrium theory to realize that many natural scientists are not impressed by mathematical arguments showing that "anything can happen" in a system loosely disciplined by general axioms. To put it another way. Just showing existence of logical possibilities is not enough for such skeptics. Recall that Lucas. to rebut the new neoclassicals such as Lucas. Such common sense claim will not be accepted today unless one can produce a data set where it is shown that this effect leaves an empirical trace in that data set. The parameters of the system needed to get the erratic behavior must conform to parameter values established by empirical studies or the behavior must actually be documented in nature. Sargent. Prescott and others (see for example Lucas (1981) on monetary misperception models. Barro. Successful attacks in this area replace the target model with another model. a style of research in macroeconomics that many natural scientists may find congenial is that exemplified in the debate on rational expectations business cycle models. A good example in finance is the excess volatility debate (Kleidon (1986b) and references). Barro. especially to Sims). and others. An example of this style of rebuttal is Summers' (1986a) attack on real business cycle models. To expand upon this point. This . consider an obvious fact such as Keynes' remark that labor will resist a real wage cut of equal size much more if it is activated by a cut in nominal wages rather than by a rise in the rate of inflation. This caused the ground rules of debate to change towards theorizing disciplined by empirical regularities that show up in data (such as the observed structure of estimated vector autoregressions in Litterman and Weiss (1985) and their references. that is a priori.

Contrast this behavior with the behavior of a deterministic chaos: (i) trajectories locally diverge away from each other. you can retrocede the history of the system and predict the future. F. the error melts away as t . Interest in the Ruelle and Takens scenario and chaos theory exploded when experimentalists documented evidence supporting the existence of low dimensional chaotic attractors in nature.S.not some loosely constrained axiom system. stability and chaos in dynamic economics prediction has been supported by evidence in papers by Poterba and Summers (1987) and Fama and French (1986). That is to say. Hence. history. The reverse is the case for a f-backcast. you backcast t periods into the past in an attempt to find out what the state of the system was t periods ago. measurement. To return to the mathematical literature. your ignorance about where the system was grows with t. If. Also the equations themselves came from tightly reasoned physics .). . and evolution upside down. We attempt to follow the same research style in this chapter. system if you make a small error in measuring today's state.S.o o . dx/dt = F ( x ( t ) ) .1. The impact of small measurement errors in today's system state on t period ahead forecasts and t period behind backcasts are exactly the opposite. F.300 Differential equations. and a slightly erroneous measure of today's state.A. Elementary notions of chaos Recall the dynamical systems studied in the earlier chapters and the emphasis on locating sufficient conditions on tastes and technology so that the optimum or equilibrium dynamics were globally asymptotically stable. In the G. the dynamics are described by a factor of differential equations. where the steady state is globally asymptotically stable (G. 1. and making a small error in measuring today's state of the system. natural scientists were skeptical. Still. the error shrinks away to zero as time moves forward. Ruelle and Takens (1971) studied carefully the theoretical properties of equations of fluid flow during transition to turbulence. Notice also that if you know the initial conditions and the law of motion. knowing the law of motion. in a f-step ahead forecast based on knowledge of the law of motion. It is as if you turned your views of science.A. F. Notice that such a system has the property that trajectories starting from two distinct initial conditions converge together as time goes to oo. and (ii) small changes in initial conditions build up exponentially fast into large changes in evolution.

1. with a smooth inverse. Blatt argues that nonlinearity is so fundamental that it cannot be handled by a mere changing of units.1) are a good example of what is called low dimensional deterministic chaos. x(t+l)=f(x(t)). the system may be approximated by a linear (possibly in logs) stochastic time series model. Here ° denotes composition. then the basic nonlinearity should show up as temporal dependence in the residuals of the best linear fit. If the shocks are small enough relative to trend levels. Preview of chaos and its empirical tests Look at the following difference equation. Writers such as Blatt (1980) attack such modelling as being unable to capture fundamental nonlinearity in economic nature. with G assumed to be smooth.2. Before going further into detail let us set out some basic ideas and concepts of chaos theory.S. a concept which is explained below. then y(t +1) = G ° F° G . system buffeted by exogenous stochastic shocks. even a nonlinear changing of units cannot change an unstable system such as a chaotic system into a G. (1987). . If the underlying system is so nonlinear that the best attempt to transform to linearity after astutely changing units. The dominant approach to macroeconomic modelling (see the earlier references as well as many Keynesian approaches) assumes a G. if x(t + l) = F ( x ( t ) ) . studied by Sakai and Tokumaru (1980). deseasonalizing. For example. Obviously. we explain why such a contrast raises important issues in macroeconomic modelling.S.Chaos and other aspects of nonlinearity 301 At the risk of repeating. if and only if x(t+ 1) = F(x(/)) is G. and deseasonalization as in conventional macroeconomics. is G.A. system.A. and detrending before fitting linear models will not give a good fit. They show that most trajectories of the tent maps generate the same autocorrelation coefficients as the first-order autoregressive (AR(l)) process where {u(/)} are independent and identically distributed (IID) random variables. one to one.S.A. and y=G(x). See for example Kydland and Prescott (1982) or King et al.A.S.l ( y ( t ) ) . detrending. The maps (1. We plan to report on some attempts to test for the existence of low dimensional chaotic attractors in economics next.

This is the meaning of (1. ..e.1). Almost all trajectories converge (in the sense of (1. In this case the autocorrelation function and the spectrum generated by most trajectories are the same as that of white noise. In the case of (1. initial conditions x0 e (0. the long run fraction of x(r) in S is u(S). In general the long run fraction of x ( t ) in some set S converges to u ( S ) . trajectories such that That is to say the map (1.3): the long run fraction of x ( t ) contained in [a. Two basic properties of deterministic chaos are well illustrated by the simple tent map recursion (1. for almost all in the sense of Lebesgue measure. For simplicity.l). Care must be taken with invariant measures in chaos theory. i. suppose one makes a small error in measuring the initial state so that it is only known that the initial state lies in the interval Now imagine that at date 1. invariant measure in the sense that we have a unique u such that for all measurable sets S. b] is just b — a.1). First. Collet and Eckmann (1980) discuss sufficient conditions on maps for the existence of a unique. the IID sequence {u(t}}.. i. one only knows that x ( t ) lies in [0. 1]. In general.. Eckmann and Ruelle (1985) discuss criteria for selecting particular ones and conditions for convergence of time averages to that particular one.e. and others that are used in macroeconomics. The loss of precision in the forecast (the length of the interval where one knows that x ( t ) lies) grows exponentially fast as / grows in the short term until one knows nothing. Kydland and Prescott (1982). ergodic. for a given map f.3)) to it. i. 1]. 1]. invariant measure. Bunow and Weiss (1979) display results of calculation of empirical spectra for several examples of low dimensional deterministic chaos including the case a=1/2 of (l. this recursion generates. 1). we will assume that we have a unique ergodic. and for almost all initial conditions x0 in [0. an invariant measure of the map / turns out to be the uniform measure on [0.e.\ is especially striking. stability and chaos in dynamic economics The case a .302 Differential equations. Second. absolutely continuous with respect to Lebesgue. 1]. there are many of them.1) has a nondegenerate invariant measure u (not the same as u in the explanation of the Ruelle and Takens scenario) just like the stochastic growth models of Brock and Mirman (1972).4). the ordinary Lebesgue measure on [0. one must forecast x ( t ) based on the knowledge (1. The measure u is an invariant measure for map f if u(/~'(S)) = u(S) for all measurable sets 5.

1). A third property of deterministic chaos (redundant given the two properties listed but repeated for emphasis) is that the time series {x(t)} appears stochastic even though it is generated by a deterministic system (1. More precisely.. x ( t + l))}. b) and Takens (1983) which is discussed in what follows. In general. Example (1. a test for deterministic chaos is simple: calculate the dimension of {x(t}} and examine if it is small.Chaos and other aspects of nonlinearity 303 This property means that we have the potential ability. in the case of (1. lies in an r dimensional space for all embedding dimensions ra.. to forecast x ( t ) perfectly. i. Simply plotting x(t + l) against x ( t ) will not do because examples like can be generated that are chaotic.1) then the sequence of ordered pairs. big enough. the same as that generated by independently and identically distributed uniform [0..1). After all if the time series {x(t)} is generated by (1. Thus. if {x(t}} is generated by deterministic chaos then the sequence of ordered m-tuples.7) for noisy chaotic systems also. A popular notion of dimension used in natural science is the notion of correlation dimension due to Grassberger and Procaccia (1983a. lies on a one dimensional set embedded in a two dimensional space.. Unfortunately. They prove (1. x(t + m — 1))}.. {(x(t). . { ( x ( t ) . 1] random variables. An efficient way to test for chaos is to consider the following quantity Brock and Dechert (1987) show that for almost all initial conditions. it is not easy to come up with a notion of dimension that is easy to calculate and gives reliable results.e. if we could measure x 0 with infinite accuracy. as a matter of pure theory. Intuitively one would think that a time series is generated by a deterministic chaotic generator rather than a random generator if the dimension of the time series is low. the empirical spectrum and autocovariance function is the same as that of white noise.1) illustrates the need for a test for stochasticity beyond spectral and autocovariance analysis.

the estimated dimension will approach unity as b . and Brock (1986a)) by plotting \n(Cm(e. The definition of correlation dimension in embedding dimension m is where the limit is taken w. interpretation of dimension estimates from data is tricky. will generate low dimension estimates. Brock and Sayers (1988). Brock (1986a) and Brock and Sayers (1988) estimate several measures of dimension for macroeconomic time series data. i. It measures the percentage change in new neighbors that a typical m-history x™ gets when e is increased to e + de. such as in Nelson and Plosser (1982).t.. and Scheinkman and LeBaron (1987) estimate various measures of dimension that were stimulated by the theoretical quantities above. The correlation dimension itself is given by. It is shown in Brock (1986a) that the near unit root processes which are ubiquitous in macroeconomics and finance.t. T first and w. indeed. SCm is an estimate of the slope of the plot of ln(C m ) against ln(e). stability and chaos in dynamic economics The correlation dimension is estimated by physicists (see the surveys of Eckmann and Ruelle (1985). Hence.r.304 Differential equations. T)) against ln(e) for large T and looking for constant slope zones of this plot that appear independent of m for large enough m. Two of them are: The quantity.r.1 . A low estimated dimension does not indicate the presence of deterministic chaos. Brock (1986a) proposes a way to avoid this problem by fitting an AR(q) by Box-Jenkins methods to the data {x(f)}. For example the AR(l). More specifically. Brock (1986a). If the data was generated by .e. e second. generate low dimension estimates by this method. However. Note that the slope at e is just the elasticity of Cm at e. dimension is a crude measure of the level of parsimony (the minimal number of parameters) needed in a dynamic model to fit the data. Here In denotes the natural logarithm.

e. For large q this puts in so many "wiggles" that the estimated dimension will approach that of an IID process. A potentially serious issue is whether actual data is generated by a stochastic model of the form. a linear approximation to G. The reason is that the estimated residuals consist of an approximately linear combination of q iterates (and lower order iterates) of a chaotic map. and Grandmont) believes that strictly deterministic models like those discussed in Grandmont (1985) and references generate observed macroeconomic time series. Before going further it is worthwhile to explain why anyone should care about testing for the presence of deterministic chaos rather than stochasticity in economic data. Theories that argue that business cycles are. for example. G is chaotic when u is fixed at its mean. Benhabib. Theories that support the existence of endogenous propagation mechanisms typically suggest strong government stabilization policies. Hence. like that used by Kydland and Prescott (1982) and formally justified by the method of Fleming (1971) as used by Magill (1977a) is completely misleading. In reality we doubt that anyone (including writers such as Day. Study. say between 3 and 6. the estimated dimension of the residuals will be so much larger than the estimated dimension of the data that you will reject deterministic chaos even if it is true. for example. the most serious issue is whether the data under scrutiny is generated (after transformation to stationarity by detrending and deseasonalization) by a process G that is so nonlinear that a linear quadratic approximation to the parent optimal control problem. We do not think anyone in macroeconomics needs to be convinced of the drastic difference in policy implications of a view that macroeconomic fluctuations are generated in the main by endogenous propagation mechanisms rather than exogenous shocks. a). Generalizing. the views of Granger (1987) who has done substantial work in nonlinear time series analysis. a. in the . It is explained in Brock (1986a) that this diagnostic may reject deterministic chaos too many times when in fact it is true.Chaos and other aspects of nonlinearity 305 deterministic chaos then the dimension of the data would be the same as the dimension of the AR(q) residuals for any q. and the randomness in u is small relative to the apparent randomness in trajectories generated by G(-. This is aptly called noisy chaos.. This problem is likely to be especially acute in actual applications in trying to detect the presence of deterministic chaos when the dimension of the underlying chaos is of intermediate size. i.

semi nonparametric models (Gallant and Tauchen (1986)). These tests for nonlinearity. Here C2 denotes the set of twice continuously differentiable functions. and x0 is the initial condition at t = Q.1. caused by exogenous shocks suggest that government stabilization policies are. (h. Exceptions are bilinear models (Granger and Andersen (1978)). and to get the property of chaos it is required that any two nearby trajectories generated by F on A locally diverge. In order to make statistical analysis valid it is required that all trajectories lie on an indecomposable attractor A.} has a C2 deterministic chaotic explanation if there exists a system.). The series {a. We shall also assume that F has a unique. = h(xt). and temporal dependence in residuals of best fit linear models (after units changes and detrending) will be applied in macroeconomics and finance later in this chapter. indecomposable chaotic attractor A for F such that the trajectory {x. stability and chaos in dynamic economics main. Think of h as being a measuring apparatus and F as an unknown. time deformations models (Stock (1985. The vast bulk of econometric methods in macroeconomics use linear models after appropriate units changes and detrendings. a. be positive (Brock (1986a)). 2. GARCH models (Bollerslev 1986)). invariant measure on A. low dimensional deterministic chaos. L.} lies in A. harmful. The local divergence property is formalized by requiring that the largest Liapunov exponent. and modelling nonlinearity with normal polynomial expansions (Geweke (1987)). Definition 2.306 Differential equations. We need to expand on the meaning of this definition. at best. ARCH models (Engle (1982)). an exercise in futility and. h. xt+l = F(x. Here the map F is deterministic and the state space is ^-dimensional. at worst. where L is given by . to the observer. The scientist is trying to learn about F by taking observations using a measuring apparatus. F. The next section of this chapter explains tests for nonlinearity that were inspired by concepts in chaos theory. The map F is chaotic in the sense that there is a unique. x0). 1987). law of motion. such that h e C 2 maps R" to R. 1986. ergodic. Statistical theory for nonlinear dynamics We begin with a definition. Fe C2 maps R" to R". See Lucas (1981) for a strong statement of the exogenous shock view.

Chaos and other aspects of nonlinearity

307

Under the regularity conditions in Eckmann and Ruelle (1985) the limit in (2.1) as / ^ o o is independent of almost all initial conditions x and almost all direction vectors v. D denotes derivative, and F'(x) is t applications of the map F to x. This is a measure of the average local rate of spread between two nearby trajectories. It is positive for chaos and is ln(2) for the tent map (1.1). The term chaos is used to express this notion of sensitive dependence on initial conditions which is captured by the requirement that the largest Liapunov exponent be positive. There are several algorithms that are used by natural scientists to estimate the spectrum of Liapunov exponents as explained in Eckmann and Ruelle (1985) and their references. The largest Liapunov exponent has been estimated for some economic data by Barnett and Chen (1987) and Brock and Sayers (1988). But no statistical theory of inference seems to exist for Liapunov estimation. Some mathematical theory for the Wolf et al. (1985) algorithm was provided by Brock and Dechert (1987). The following proposition is needed. Residual Diagnostic (Brock (1986a)): Fit any time series model of the form G E C2, G(at,..., at_ L , B) = e, to your data {a,}. Here (3 denotes the parameter vector to be estimated and {e1} is an IID stochastic process with zero mean and finite variance. Then the theoretical dimension and largest Liapunov function are (generically) independent of the functional form of G and the number of lags, L. For details of this proof see Brock (1986a) and references. Outlining the proof, let {e1} and b denote the sequence of estimated residuals and the estimated value of B3 respectively. Then

The function M is just an observer of {x,,,}. Since the largest Liapunov exponent and the correlation dimension are independent of the observer (generically), therefore the dimension and largest Liapunov exponent of {e,} is the same as for {a,}. This completes the outline. The word generic means except for hairline cases. In practice it is treacherous to give precise meaning to this concept and there is more than one way to do it. We want to exclude, for example, observers, h:R"-*R that map all points of R" to a constant, such as zero. Obviously in such a case, {a,} will be a constant sequence and will have dimension zero independent of the underlying dynamics, x(t+l}-F(x(t)}. But, intuitively, such observers are hairline cases relative to the space of all observer functions; i.e., that such observers are not generic. See Eckmann and Ruelle (1985) and Takens (1980) for concepts of genericity that are adequate to exclude these degenerate cases.

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Differential equations, stability and chaos in dynamic economics

Chaos is quantified by another measure besides positivity of the largest Liapunov exponent. This concept is called Kolmogorov entropy. The idea is simple. Imagine that you are an observer who cannot tell that two states within distance e > 0 of each other are different. For example you may be an 8-bit computer. Two states have to be d > e units apart before you can tell that they are distinct. Entropy is a measure of how fast F produces information in the sense of how many iterations of F on the two indistinguishable states are necessary before we can tell that their images under iteration by F are different. See Eckmann and Ruelle (1985) for the details. It turns out that one of the statistical concepts that we shall talk about here is closely related to Kolmogorov entropy. A useful lower bound to Kolmogorov entropy (Grassberger and Procaccia (1983b)) is defined as follows:

Here the limit is taken first w.r.t. T, second w.r.t. m, third w.r.t. e. K can be looked at from another perspective. Brock and Dechert (1987) show for T = oo that

Equation (2.4) captures a measure of how well the m-past helps to predict the future at likeness of the past e. From (2.2)-(2.3) we see directly that K(e, m, oo) is a measure of how poorly the m-past helps to predict the future at likeness of the past e. Note that if {x} is IID, K(e,m,<x>) = -ln{C,(e)}^oo, e - 0 . These considerations lead naturally to a new statistical test for temporal dependence.

2.1. Size and power characteristics of the BDS test Brock et al. (1987) create a family of statistics based upon the correlation integral Cm. This is calculated by first putting

'Second, the limit of (2.5) exists almost surely under modest stationarity and ergodicity assumptions on the stochastic process under scrutiny (Brock and Dechert (1987)). Call this limit Cm(e).

Chaos and other aspects of nonlinearity

309

Brock et al. (1987) consider tests based upon the statistic,

where bm is an estimate of the standard deviation under the IID null. Brock, Dechert and Scheinkman show, under the null of IID, that W m - N(0,1), as TH-OO. The W statistic is shown to have higher power against certain alternatives than the tests of independence based upon the bispectrum. The reason is that the bispectrum is zero for the class of processes with zero third-order cumulants. There are many dependent processes with zero third-order cumulants. Given an IID stochastic process {X,} consider the formula

Here Ie(X, Y) is just the indicator function of the event {\X - Y\ < e}. This formula for the standard deviation, bm, used in the W statistic, is adapted from Brock, Dechert and Scheinkman by Scheinkman and LeBaron (1987). Look at table 10.1, which displays results from Brock and Sayers (1988). Brock and Sayers fit best linear models, after transformation of units and detrending, in the usual manner. Recall that under the null hypothesis of correct fit the estimated residuals are asymptotically IID. If the residuals were actually IID the W statistics reported below would be asymptotically N(0, 1). Of course the estimation process induces extra variance. Based on our own computer experiments and those reported in Scheinkman and LeBaron (1987) we do not believe that the correction is very large for most

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Differential equations, stability and chaos in dynamic economics

**Table 10.1 W statistics for residuals of linear models
**

Dim 2 3 4 2 3 4 2 3 4 2 3 4 2 3 4 2 3 4 2 3 4 2 3 4 2 3 4 2 3 4 2 3 4

#prs

902 272 92 12 554 5 176 2 310 12 555 5216 2 338 1 173 423 152 1 087 391 148 970 344 121 54 848 32 072 19 519 1 617 642 239 990 404 163 1 345 506 191 841 316 128

W

-0.63 0.16 1.44 5.10 6.52 8.34 5.21 6.61 8.35 0.94 1.77 1.88 1.61 2.53 3.21 -0.50 1.40 1.79 15.97 20.09 24.10 5.19 6.90 6.47 3.24 4.94 5.32 1.21 1.57 1.60 4.21 5.94 7.64

Series

ed ed ed dsearlpd dsearlpd dsearlpd dsear4pd dsear4pd dsear4pd dsegpdil dsegpdil dsegpdil dsegpdi4 dsegpdi4 dsegpdi4 dsegpdi8 dsegpdi8 dsegpdi8 edpig edpig edpig edsun edsun edsun edunemp edunemp edunemp egpdid egpdid egpdid empar2 empar2 empar2

N

147 147 147 433 433 433 430 430 430 147 147 147 144 144 144 140 140 140 715 715 715 170 170 170 130 130 130 147 147 147 130 130 130

Code for table 10.1 of W statistics ed = residuals of AR(2) fit to detrended U.S. real gnp; dsearlpd = residuals from an AR(l) fit to the first difference of In U.S. Industrial Production. The Industrial Production series is for U.S. post war quarterly data and is taken from Litterman and Weiss (1985); dsear4pd = residuals from an AR(4) fit to the first difference of In U.S. Industrial Production; dsegpdil, dsegpdi4, dsegpdiS, are residuals from an AR(l), AR(4), AR(%) fit to the first difference of In real U.S. quarterly gross domestic investment (GPDI); edpig = residuals of an AR(2) fit to detrended U.S. pigiron production; edsun = residuals of an AR(2) fit to the Wolfer sunspot series; edunemp = residuals of an AR(2) fit to U.S. unemployment rate; egpdid = residuals of an AR(2) fit to linearly detrended In real U.S. GPDI; empar2 = residuals of an AR(2) fit to linearly detrended In U.S. employment. This table is drawn from Brock (1986a) and Brock and Sayers (1988) and we are thankful to Blake LeBaron for the computations.

Chaos and other aspects of nonlinearity

311

cases in practice. Brock (1988b) has shown that the correction does not affect the first order asymptotics. In any event the reader is advised to keep this in mind while reading table 10.1. Evidence is strong for nonlinearity in (a) industrial production, (b) civilian employment, (c) unemployment rate, (d) pigiron production, (e) Wolfer's sunspot numbers. Brock and Sayers (1988) also perform symmetry tests on many of these same series. Symmetry testing confirms the presence of nonlinearity. While the evidence from the residual diagnostic did not favor the hypothesis of deterministic chaos we hope that we have made it clear that the residual diagnostic may falsely reject the hypothesis of deterministic chaos when in fact it is true. This problem of false rejection is likely to become more serious as the number of lags increases in the autoregressive linear time series models fitted to the data. It is worthwhile to amplify the argument in Brock (1986a) to explain why the residual diagnostic rejects deterministic chaos too often in short time series. Let us use the tent map sequence, x(t +1) = F ( x ( t ) ) , as a vehicle of exposition. Recall that F(x) = 2x, x<0.5, F(x) = 2-2x,x>0.5. Two effects increase the estimated correlation dimension. First, as the embedding dimension, m, is increased, the estimated correlation dimension will increase. The reason for this is simple. Fix an m-history, x™. Look at the fraction of m-histories, /u(e, x,, m) = #{x™: \\x™ — x?\\ <e} fora fixed value of e. Relax e to e + de and ask how many new neighbors of x[" are obtained. In a series of length T we can build Tm = T-(m-l) m-histories. We know from Brock and Dechert (1987), that

where zm = x™, wm e Rm, /jLm is the measure on Rm by the invariant measure fji for F, and / e (z m , wm) is the indicator function for the event, {wm: \\wm — zm\ <e}. If we use (2.12) to approximate /x(e, x,, m), then an increase in m causes /ji(e, x,, m) to fall. So, for a fixed T, we will run out of comparable points as we increase m. But this is not the worst of it. The main problem is that x™ contains iterates Fq for q < m - 1. For a fixed value of e, as we increase e to e + de and count the extra neighbors of x™ that we get, the number of wiggles in Fq that cross the e-neighborhood of x™ increases as m increases. Hence for a large m, and a fixed value of e, this effect causes the number of new neighbors of x™ that we get to scale faster than the power 1 - the true dimension. Hence the estimated dimension is biased upward. To put

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it another way, we must decrease e as we increase m in order to keep the iterates Fq, q - m - 1, from wiggling across the e-neighborhood of x™. But then for fixed T we run out of data even faster as we increase m. This effect is amplified when the residual diagnostic is applied. The estimated residuals of an AR(p), say, fitted to data generated by the tent map contain tent map iterates, F', i < p. When these residuals are embedded in m dimensions for correlation dimension estimation and for comparison with the estimated correlation dimension of the rough tent map data then the upward bias effect is compounded. That is to say, the estimated dimension of the AR(p) residuals will tend to be larger than the theoretical value of 1. Or, to put it another way, you will need even a smaller value of e to get a range of scaling of unity for the AR(p) residuals. As you increase p the upward bias in estimated dimension will tend to increase. This can be verified by computer experiments. Ramsey and Yuan (1987) have conducted computer experiments on some deterministic chaotic maps. These experiments show that dimension estimates as well as estimated standard deviations of dimension are biased in short samples. The highest number of lags that Brock and Sayers (1988) fit to their data was 2. But computer experiments on the residual diagnostic using the tent map and the logistic, x(t + 1) = 4x(t)(l -x(f)), indicate that on sample sizes similar to those of Brock and Sayers (1988), the estimated correlation dimension of the estimated residuals of AR(2)'s fit to tent and logistic data range between 2 and 3, whereas the theoretical value is 1. Therefore, we are inclined to interpret the Brock and Sayers (1988) results as evidence against the hypothesis that low dimensional deterministic chaos is responsible for macroeconomic fluctuations about trend. This evidence is supplemented by the application of the W test to the estimated residuals of best fit linear models as in table 10.1. Turn now to theoretical arguments that shed light on the likelihood of macroeconomic chaos.

3. Roads to chaos in macroeconomics

In the last section we explained how time series data can be used to test for the presence of low dimensional deterministic chaos. The evidence adduced for deterministic chaos in the macroeconomic data analyzed above was weak. Evidence did exist for nonlinearity however. We warned that evidence of low correlation dimension does not make the case for deterministic chaos. Even evidence of a positive estimated largest Liapunov exponent does not make the case for chaos as Brock (1986a) explains.

Chaos and other aspects of nonlinearity

313

Ruelle and Takens (1971) argue that in physics there are certain instances where one could make a fairly strong theoretical argument that chaos might be likely. Can we make a plausible theoretical case for the presence of chaos in macroeconomics? In this section we briefly examine and evaluate some theoretical arguments that have been presented for the presence of chaos in macroeconomics. Recall that the Ruelle and Takens (1971) setup was a differential or a difference equation model, x(t +1) = F ( x ( t ) , /JL), where x is an n dimensional state vector and ^ is an r dimensional parameter vector. Different values of ^ can give you different long run limiting behavior of the sequence {x(t}}. We saw a famous example of a map F:[0, 1] -»[0,1], i.e., x(t+ 1) = fjix(t)(l—x(t)), where as you keep increasing ^ from smaller values to larger ones, the long run limiting behavior of {x(t)} goes from a stable rest point, to a stable two-cycle, to a stable four-cycle,..., to a stable 2" cycle, to chaos (Eckmann and Ruelle (1985)). This sequence of period doubling bifurcations is sometimes called the Feigenbaum scenario or Feigenbaum cascade. Under surprisingly modest sufficient conditions the same type of behavior occurs for general maps F when F humps up more and more as you increase the tuning parameter u. This robustness of the Feigenbaum scenario to the form of map F is what makes the scenario important. Another closely related idea is Li and Yorke's theorem that a value of u, large enough to give a nondegenerate period three steady state of F indicates that there are smaller values of u that give chaos. The Li and Yorke theorem is easy to use because all that is needed to show that chaos exists is find a H value for which a nondegenerate solution exist to: a = F(b, u), b = F(c, u), c = F(a, u). See the papers by Saari, Grandmont, and references to others such as R. Day, J. Benhabib, R. Dana, and P. Malgrange in H. Sonnenschein (1986) where use of the Li and Yorke theorem, as well as the related Sarkovskii sequence, appears in economics. The long and detailed paper of Grandmont (1985) contains a wealth of references and techniques of chaos theory. He applies these techniques to locate sufficient conditions on tastes and technology to get low dimensional deterministic chaotic rational expectations paths in an overlapping generations model. Let us briefly outline how Grandmont (1985) gets chaos and why it matters to macroeconomists. He uses chaos theory to challenge the conventional neoclassical macroeconomic models that argue that the macroeconomy is asymptotically stable about trend in the absence of exogenous stochastic shocks (see Grandmont's references to Lucas, Prescott, Sargent and others). The argument is that one does not need to introduce what Grandmont calls

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Differential equations, stability and chaos in dynamic economics

ad hoc exogenous shocks in order to get equilibrium fluctuations that look like business cycles. He uses a variation of the offer curve diagram of Gale (1973) to display the dynamics of the set of rational expectations equilibria in an overlapping generations (OG) model consisting of identical two period lived agents. We give a simplified treatment here that draws partly on the paper of Brock (1988a). 3.1. Offer curve depiction of Gale equilibria Equilibria in this model are easy to depict. Draw, at each date t the offer curve of the young born at date t. That is, consider the problem

Here p(t),p(t+l), c v ( t ) , c 0 ( f + l ) denote price of goods at date t, price of goods at date t+l, consumption while young, and consumption while old respectively. The utility function is denoted by £ / ( - , - ) • The offer curve 0 is the locus of solutions to (3.1) as p ( t ) , p ( t + 1) vary. We need to specify initial conditions to start up the model. Do this by supposing that the representative old person at date 1 faces the constraint Here M denotes the initial stock of nominal money balances which is held by the old at date 1. Now draw the Ricardian production possibility frontier

We shall, like the bulk of the literature including Gale (1973), use the concept of perfect foresight or rational expectations equilibrium. Such equilibria are described by the set,

where ( c v ( t ) , c 0 ( t + l ) ) solves (3.1) facing (p(t),p(t+l)),t=l,2,...-, c y ( t ) + c0(t] = Wy + w0, t = l,2, . . . ; a n d p ( l ) , c 0 (l) satisfy (3.2). In order to get a set of equilibria where money has value in Gale's model and to display the dynamics of monetary equilibria (in order to locate sufficient conditions for chaotic dynamics) draw an offer curve 0 through the endowment point (w v , w> 0 ) in 2-space such that 0 cuts R but with slope

such as convertibility of each unit of fiat money to e units of real goods. used also by Grandmont (1985).1 . Third. Figure 10.Chaos and other aspects of nonlinearity 315 less than one in absolute value. illustrates several features of the class of OG models most commonly exploited by macroeconomists. there are steady state competitive equilibria where money has value. Notice the sequence ( c y ( t ) . The work Figure 10. figure 3. cQ(t + l)) that converges to autarchy (wy. Second. Notice the positive steady state L in figure 10. This is a monetary equilibrium where fiat money loses its value asymptotically. This is the situation depicted in Gale (1973. (1980)). will get rid of the hyperinflationary equilibria that converge to autarchy. This leads to the general presumption that the presence of valued fiat money in an equilibrium is associated with Pareto optimality. for example the equilibrium denoted by L.2 depicts equilibria that cannot be disposed of so easily. 24) in the analysis of his "Samuelson" case. This is sometimes called indeterminacy. no matter how small e is. First. w 0 ). p. if there is a steady state equilibrium where money has value then there is a continuum of equilibria where money has value. It is obvious that arbitrarily small policy perturbations. This is a steady state equilibrium where fiat money has positive value. the presence of money moves the economy to Pareto optimality at the steady state with valued fiat money in this setup. This general presumption is not true in all OG setups (Cass et al.1. This method of analysis. and steady state equilibria (autarchy in our case) where money does not have value.

This suggests that if you can find a parameter of the model to play the role of u in the Ruelle and Takens (1971) setup then you could generate a Feigenbaum period doubling cascade as you increase u. a2. stability and chaos in dynamic economics Figure 10. p. Notice how cycles appear when the offer curve is bowed out to the left more than in figure 10. We are not concerned with sunspot equilibria here. even though the model is deterministic. 1030) displays a period doubling cascade generated by letting the relative risk aversion parameter. 3.2 of Azariadis and Guesnerie (1986) shows that there are sunspot equilibria. (Caution: Grandmont's u is our limiting value of {x(t}} and his a2 is our u. equilibria that are random. Indeed Grandmont (1985. of the representative old person play the role of Ruelle and Takens' parameter. deterministic chaos. .316 Differential equations. Difference equation depiction of Gale equilibria The Gale equilibria can be depicted alternatively by a difference equation analysis as in Brock and Scheinkman (1980) and Scheinkman (1980).2. whenever cycles like those in figure 10.2 are present.2. and.) Let us explain how Grandmont generates the Feigenbaum scenario. hence.1 so that you get the situation in figure 10. u. figure 4. that is.

This argument did not convince critics like Sims (1984) who argued that this kind of model. we must have by the first order condition for optimality of the young: Call the LHS of (3. Intuitively. then (3.y } .When U is separable in consumption today and consumption tomorrow. u) to have the same qualitative behavior as the function u y ( l . He then shows that a parameterization by u. Assume positive endowment while young which implies A(0) = 0.3) can be written as a difference equation in the form: Solutions of this difference equation that can be continued forever are equilibria. c0) — u(cy) + u(c 0 ). Following Grandmont (1985) write. v " ( y ) y / v ' ( y ) .0 ( y ( t . since A is invertible. it" < 0 implies that A ( .Chaos and other aspects of nonlinearity 317 Put x ( t ) = M ( t ) / p ( t ) where M ( t ) is nominal money supply at date t. exists such that a Feigenbaum cascade occurs.3) A ( . As in the offer curve analysis one may locate the conditions for a positive steady state to exist. and argument where the time scale is on the order of human lifetimes. Grandmont achieves this by putting the old person's utility v ( y ) = y / / ( l ~ b ) . Observe that along any candidate equilibrium path of real balances. This argument shows that it is not necessary to introduce exogenous stochastic shocks into macroeconomic models in order to get random looking behavior of equilibrium time series output. cannot explain business cycle fluctuations where the modal length is three to three and a half years. All we have to do to generate a Feigenbaum cascade is to find a parameter to play the role of u so that 0(y.) is strictly increasing. The critics were basically using results like those in chapters . This is equivalent to Gale's condition in his "Samuelson" case that the offer curve of the young cut the PPF from below.) and the RHS£(-). Here b is the relative risk aversion.1 ] . u) becomes more humpy as u increases. of the old agent. To put it another way. we want &(y. U(cy. Since A and B intersect at 0 when w0> 0. Now run time backwards: y ( t ) . that is. Note also that u' > 0. increasing b makes & humpier but there is more to it than this. u). See Grandmont (1985) for the details. the condition needed for a positive steady state to exist is that A cut B from below. Note that B = 0 at x = 0 when w0> 0. {x(t}}.

3. In order to counter the critics' argument that the parameter values and time scale used in previous examples of chaotic equilibrium paths did not agree well with the range of values established by empirical studies. He constructs examples where equilibrium trajectories are chaotic. E. skepticism still exists among writers such as Sims (1984) and Granger (1987) whether low dimensional deterministic chaos is a phenomenon that is likely to exist in actual economic time series. Woodford (1987) has built a class of models where one type of agent is liquidity constrained and the other type is not. This strategy was pursued by Bewley's paper in Sonnenschein (1986). 7. However. 7. stock market assets and productive land Introduce real assets into the model along the lines of Lucas (1978) by replacing the budget constraints of the young and old in Gale's model with . Turn now to the question whether introduction of a stock market or commodity money has any effect on the theoretical likelihood of deterministically chaotic equilibria. Commodity money. stability and chaos in dynamic economics 5. The most recent paper on global asymptotic stability of rational expectations equilibria in deterministic general equilibrium models with long lived agents is that of Epstein (1987). The message is that in order to get chaotic intertemporal equilibria there must be substantial obstructions to the basic intertemporal smoothing behavior that does so much to stabilize fluctuations that are deterministic and forecastable. Hence. no one has constructed examples of economic models that generate chaotic paths where the parameters of the tastes and technology are constrained by the range of parameter values established by empirical studies. and 9 of this book. and 9 of this book to argue that optimizing agents. One way to do this is to introduce restraints on borrowing and lending. 3.318 Differential equations. one for each agent such that the allocation for E maximizes the weighted sum of discounted utilities) low discounting by consumers or low rates of return to production by firms leads to global asymptotic stability much along the lines of chapters 5. a set of positive weights exist. Epstein's results show that when markets are complete (so that for a given competitive equilibrium. to our knowledge. facing discount rates (like those discount rates implicit in observed bond prices) on future utilities would indulge in optimal smoothing behavior to such an extent that cycles of modal length of three to four years could not exist.

The inefficient equilibria are overaccumulative in that the interest rate is negative enough of the time to fail the Cass (1972) . However. a new twist now appears. the first order necessary conditions for a perfect foresight equilibrium are: In the same manner as earlier. The reason for Scheinkman's result is intuitive. where q(t) < 0 at some finite t. This is an example of how limited liability assures Pareto Optimality. z ( t ) denotes the quantity of the asset demanded by the young at date t.e. limited liability eliminates equilibria where the value of the asset goes negative. This is so because once the asset goes negative in value the owner can harvest his y and throw the asset away. i. by hindsight. If free disposal of the asset obtains then any path. But Pareto Optimality alone is not enough to eliminate chaotic equilibria as we shall see below.Chaos and other aspects of nonlinearity 319 where q(t] denotes the price of the asset that pays constant real earnings y at date t. no matter how small y may be. For the separable case. Think of changing y from 0 to a positive value in Gale's model. 3. cannot be equilibrium.4. Then the set of hyperinflationary equilibria that converge to a real balance level of 0 moves to a set of equilibria that converge to a negative steady state qn. A payment of epsilon real earnings on fiat money is efficient Scheinkman (1977) has shown how introduction of a market for claims to an earnings stream of y > 0 each period. a chain of self-fulfilling beliefs in a world of unlimited liability can get started where the value of shares becomes negative and welfare goes down. if the asset is like a nuclear plant that yields earnings of y each period that is perfectly safe. eliminates the inefficient equilibria in the Samuelson (1958) and Gale (1973) overlapping generations models.. Let us explore the logic of this proposition. This brings us to Proposition. Free disposal of the asset. However. A perfect foresight equilibrium is defined as previously in the Gale case except that z ( t ) = l at each / (demand for the asset = supply of the asset). paths {<?(/)} are equilibria provided they can be continued indefinitely. There is one perfectly divisible share of the asset outstanding at each point of time.

5. tends to force efficiency of all equilibria in overlapping generations models provided that free disposal or limited liability obtains. c0): cy + c0=wy + w0 + y}. Figure 10.4 depicts three positive steady state equilibria and a continuum of positive Figure 10. but replace the PPF. Recall that free disposal eliminates these and that they are the analogues of Gale's hyperinflationary equilibria when y = Q. stability and chaos in dynamic economics and Benveniste and Gale (1975) efficiency criterion. with Ry = {(cv. The offer curve diagram for an asset market The offer curve apparatus can be easily amended to depict equilibria when y > 0. This finding allows us to state Proposition. Also. recall that the case y = 0 is the case of pure fiat money. Figure 10. A payment of y > 0 of earnings on fiat money. Just draw the offer curve of the young through the same endowment point (wy. But introduction of a market for claims to y > 0. and a sequence of equilibria that converge to the lower steady state L" where the value of the asset is negative. forces the interest rate to be positive enough of the time to force efficiency by the Cass-BenvenisteGale criterion. w0) as before.320 Differential equations. 3. no matter how small is y.3 depicts steady state equilibrium. under limited liability. L. R.3 .

These equilibria are robust in the sense that they cannot be perturbed away by a small perturbation of tastes and endowments. World War II..S. the Great Depression. rather than transitory. More examples are surveyed in Baumol and Benhabib (1988). It should be straightforward to conduct an exercise much like that in Grandmont (1985) to show that a parameterization of tastes may be found such that. Intuitively you would construct an offer curve that bows out to the left around Ry as Grandmont did for case y = 0. We have cited several papers that have established theoretical examples of chaotic rational expectations equilibria. How convincing are such arguments to skeptical writers such as Sims (1984) and Granger (1987)? Skepticism about deterministic chaos in macroeconomics probably comes from some evidence which we briefly review next.4 equilibria. . the two oil shocks. even though y > 0. shocks to development along trend such as World War I.Chaos and other aspects of nonlinearity 321 Figure 10. First. a period doubling cascade can be constructed. This shows that y > 0 will not get rid of the possibility of a continuum of equilibria. Even the unit root literature which argues that many shocks are permanent. seems to be moving toward a consensus that there is more evidence of a return to trend rather than divergence (cf. seem to wear off as the economy returns to trend. etc. Cochrane (1988) and references). in the U.

See P. it is an irresolvable question whether macroeconomic fluctuations are generated by high dimensional chaos or infinite dimensional. In this section we try to tie these ideas together with . Low dimensional chaos involves instability and overshooting. The behavior of nominal and real interest rates will be discussed in section 4 of this chapter. David and J. What is potentially resolvable is whether the fluctuations are generated by a low dimensional deterministic chaotic generator or a stochastic generator. While no one denies that business cycles are accompanied by periods of booms and busts the evidence is more consistent with a view that the fluctuations are generated by a deterministic cycle buffeted by noise about trend (an AR(2) process for detrended real GNP for example) or stochastic trends (a unit root process for example). savings as a fraction of GNP seems to be a rather stable fraction of GNP over time. Fama (1976) has adduced evidence that the expected real return on T-bills is constant across time. Applications to finance In the first three sections we outlined some concepts from chaos theory. i. some concepts from empirical nonlinear science. stochastic processes. p. p. Automobiles might be a good example. Lucas (1987). Fourth. 98) reveals a relatively smooth path to trend in auto sales after World War II. if chaos had a really good chance to appear it would happen in situations where there are production lags and where there are heavy durables with a natural replacement cycle. 4.S. and applications to macroeconomics. A dramatic graph that shows the historical movement of real interest rates is in Rostow (1983. Scadding (1974) and references for discussions of the strong evidence supporting Denison's Law. As we have said before. Third. and McCallum's review (1986) of evidence for and against the real business cycle paradigm. real interest rates do not move much across time except for the recent Reagan period.. known as Denison's Law. Pent up demand for automobiles after World War II in the U. stability and chaos in dynamic economics Second. 34). is a natural place to look for cycles and chaos in auto sales. In summary. A graph of auto sales in Rostow (1983. It is even harder to construct a model so that it is consistent with other stylized facts of the macroeconomy detailed in works such as Tobin (1980).322 Differential equations.e. it is difficult to formulate a chaotic model in macroeconomics that is consistent with the existing evidence already mentioned.

1. the demonstration that chaotic equilibria exist in a two period overlapping generations model was not a theoretically convincing argument to macroeconometricians. At this point in time. At the minute to minute level Wood et al. Since business cycles have a modal length of about 3 and one half years. Scheinkman and LeBaron (1987) have documented dependence in weekly aggregate stock returns that does not appear to be just autoregressive conditional heteroscedasticity. It only serves. They get an estimate of the correlation dimension of about six. The choice of time scale on which to look for complex dynamics in finance In serious confrontation of the theory of complex dynamics with data the issue of appropriate time scale comes up. An attempt is made to link evidence on dependence in returns to the business cycle but the attempt is only speculative. to recognize that some models with borrowing restraints can generate equilibrium dynamics that behave much like the dynamics generated by an overlapping generations model and are capable of generating chaotic fluctuations at business cycle frequencies (Woodford (1987)). 4. Below we review possible explanations for this finding as well as other evidence for intertemporal dependence in stock returns. as a logical possibility. Let us explain. t + h] are defined by. however. For short time intervals first differences in the logarithm of stock prices should not be very predictable in a frictionless market. this issue is not resolved. It is important. This is currently an active area of research. the issue arises whether the degree of tightness of borrowing constraints needed to generate chaos at business cycle frequencies is consistent with empirical evidence on the tightness of borrowing restraints in reality. We saw in section 3 how important the issue of time scale was in the debate on whether chaos was theoretically plausible in macroeconomics. Otherwise arbitragers could exploit the dependence and turn a profit over and above the opportunity cost of the funds tied up in the arbitrage position. (1985) have documented: (i) . But. This estimate is invariant under linear autoregressive versions of the residual diagnostic unlike the case for the macroeconomic data studied by Brock and Sayers (1988).Chaos and other aspects of nonlinearity 323 applications to finance. Returns on stock i over time period [t. The same issue arises in finance. at this stage. then.

4.3 billion shares traded during this week was more than the total number of shares traded during all of 1964. and rise in the last 20-30 min to the close. look unpredictable in the middle. /.74 at Monday's close .r. Definition. See Marsh and Rock (1986) for details. Here E.} is an increasing sequence of sub sigma fields of a master sigma field. Similar patterns emerged in most of the world's major stock exchanges during the same week. almost surely.a 508 point drop accompanied by a huge volume of trading. Details of market micro structure are very important at this frequency.2. even though the equilibrium theory to be discussed makes it look extremely unlikely that one would ever find evidence of chaos at the minute to minute frequency. an apparent disequilibrium panic like the Monday Massacre of October 19. The whole week of October 19-23 was turbulent with the Dow falling from 2178.324 Differential equations. A process {P(t}} is instantaneously unpredictable if and only if. Incidents like these are worth keeping in mind as we discuss the standard theory of unpredictability of stock prices. Measured returns may show spurious dependence due to measurement difficulties such as "bid/ask bounce". Markets seesawed while volume skyrocketed.69 at Monday's open to 1738. the information set /. "for an instantaneously unpredictable process prediction error is the dominant component . fall over the first 20-30 min. stability and chaos in dynamic economics returns tend to be higher at the opening of the exchange. The volume of 1.t. Are daily and weekly price changes unpredictable? Sims (1984) gives the standard economic reasoning that price changes must be unpredictable over small time intervals in a frictionless market. For reasons of measurement error problems as well as a theoretical presumption that chaos should not be likely at the minute to minute frequency. Actually. 1987 might generate evidence of chaotic dynamics. This is formalized by Sims' (1984). such as the stock markets. (ii) trading volume and price volatility follow the same pattern near the opening and the close.) In words. ({/. we will not spend any time analyzing stock price dynamics for chaos in this case.. is taken w.

Short periods for Sims are daily to weekly. t+1]. The discount process {G} and the net cash flow process {y} can also be random. stock returns index for the mid 60s. arbitraging on the part of traders should destroy it provided it is easy to be recognized by traders over very short time intervals. After all. Of course. This is the intuitive content of the Sims argument. They . over the period [t. the ratio in (4. In practice (4. But if you measure the state today with error. Malliaris (1981) gives a detailed mathematical description of (4. if a predictable structure is present.3) with illustrations from financial economics. and net cash flow. R2 = Q.2) doesn't rule out predictability over longer time periods.2) is exactly 1". Sims points out that. Evidence on complex dynamics in stock returns Scheinkman and LeBaron (1987) have estimated the correlation dimension for 1226 weekly observations on CRSP value weighted U.2). Recall that chaos theory teaches that trajectories generated by chaotic maps are potentially perfectly predictable provided that you can measure the state perfectly.3. Yet the financial logic leads us to believe that low dimensional chaotic deterministic generators for stock prices and returns over daily to weekly time periods should be extremely unlikely. for a martingale (4. on any variable in It have R2^> 0.S.3) can be obtained from representative agent general equilibrium asset pricing models such as Lucas (1978) and Brock (1982) by making the utility function linear. s^O. nonlinear dynamicists sometimes say that chaotic dynamics are unpredictable.3) is adjusted for discounting. for any dividends paid out. and adjusting P. They find roughly 6. 4. Hence. G(t+l). y(t+l). The martingale hypothesis is Notice that (4.3). Under (4. then forecasts of the future state become worthless at an exponential rate. Similar results for closing prices over the mid 1970s to the mid 1980s for gold and silver on the London Exchange were reported by Frank and Stengos (1986).3) below with finite second moments. the subjective discount rate equal to zero. regressions of Pt+s — P. under (4. He then argues that this is consistent with empirical evidence in finance.Chaos and other aspects of nonlinearity 325 of changes over small intervals. They calculate another estimate of dimension due to Takens (1984) which is also close to 6. He also points out that (4.

2. The Brock. We then compare this series of empirical derivatives for the shuffled counterpart. weekly. These empirical derivatives are going to look rough because we lose the inherent smoothing involved in estimating the slope of the constant slope zone of the Grassberger Procaccia diagram by regression analysis or by eyeball analysis. This is comforting. It is significant because they calculate Brock. (b) EW= Monthly returns on the Equation Weighted New York Stock Exchange index for the same period. Note however that the difference in behavior between the original series and the shuffled series is smaller for the second half than for the first half.326 Differential equations.9". Put SC is an estimate of the empirical derivative at 0. Dechert and Scheinkman (1987) statistics for the spread between the Grassberger Procaccia plot for their prewhitened January adjusted data and the Grassberger Procaccia plot for the shuffled data. It is striking that the . Gennotte and Marsh (1986) calculated Grassberger Procaccia plots for this same data set after taking out the January effect and taking out linear structure. We have succeeded in replicating the Scheinkman and LeBaron study. especially for EW. Notice that they display similar behavior to the weekly BLVW data set. We deliberately make the analysis difficult by estimating correlation dimension and by reporting step wise empirical derivatives of the Grassberger Procaccia diagram. The dimension of both halves of the data set is between 6 and 7 when taking into account the roughness of empirical derivatives relative to the estimated empirical slopes of Grassberger Procaccia plots. Recall that the Grassberger Procaccia (GP) diagram is I n ( C m ( e ) ) plotted against ln(e). By way of comparison we looked at the monthly EW and VW indices. We examine several stock returns series below: (a) VW= Monthly returns on the Value Weighted New York Stock Exchange index for the mid 20s to the late 70s. Look at table 10. Both EW and VW are CRSP indices taken from the Gennotte and Marsh (1986) study. (c) BLVW = Weekly returns on the Value Weighted CRSP index used in the Scheinkman and LeBaron (1987) study. They find significant evidence of nonlinear dependence. stability and chaos in dynamic economics get correlation dimension estimates between 6 and 7 for daily. Here shuffling refers to the process of creating an IID series with the same stationary distribution as the original series. Dechert and Scheinkman statistics were highly significant. The dimension of the shuffled series is surely bigger in both halves of the data set. and biweekly series.

9 8.Chaos and other aspects of nonlinearity Table 10.9 4. BLVW[ 1:600].2 8.4 7. VW.9" 1. BLVW[601:1226]. SC.6 7.0 7.8 7.0 9.5 8.3 BLVW[ 1:600] : N = 600.9 7.99 5.911 5.9 10.3 4.1 0. modulo estimation error. m = 10 0.2 4.7 SCsf 6.914 1.914 9.914 7.97 e 0.914 0. All data were divided by the standard deviation and multiplied by 0.4 4.9 0.8 0.0 5. Dechert and Scheinkman statistic fell to 2.3 BLVW[ 601: 1226]: N --= 626.97 e 0.99 4.98 0.5 SCsf 6.6 7.6 0.3 0.915 9.0 6.5 6.2 EW: N = 696. residuals of an AR(8) fit to first difference's of tbill returns.7 0. m = 10 0.0 0.912 2.0 0.6 1.1 SC 5.0 9.45 for EW and 1.7 7.7 DSE8TBLM: N = 628 .96 7.3 7.4 6.914 8.9° 7.3 6.96 1. But Gennotte and Marsh took out the January effect.8 5.98 0.98 0.0 5.913 8.7 644.96 0.7 0. N equals number of observations.9 6. The Brock.0 6.7 9. m = 10 0.1 0. and returns on Kodak stock.97 0.2 7.2 4.4 4.2 0.4 0.910 7.01 for VW in contrast to 7.7 0.2 SCsf 6.2.915 1.9 5. SCsf denote the empirical slope of the GP diagram for the original series and the shuffled series.98 0.912 8.6 3.6 6.912 5.913 7.7 0.6 0.0 6.5 645. Dechert .912 6. next 626 returns on SIB's value weighted index.915 7.4 0.23 for EW and 4.1 5.911 7.910 7.39 for VW for the whole sample.5 10.6 7.0 327 0.6 5. Gennotte and Marsh looked at the subsample January 1942-December 1971.9 7.910 1.1 7.3 8.3 0.4 19.97 e 0.911 4.1 8.6 7.912 7.1 0.9 0.3 0.1 7.910 5.1 0.4 SCsf 3.1 12.9 0.0 5.96 3.7 10.97 e 0.8 8.97 e 0. first 600 returns on SIB's value weighted index.7 5.0 0.911 8. m = 10 0.9 KODAK: N == 720.4 SC 1.7 0.8 10.99 0. This table is drawn from Brock (1987b).98 0. returns on value weighted CRISP index. m = 10 0.6 8.0 9.6 0.99 0.910 7.911 8.6 VW: N = 696.915 8.0 SC 2.96 0. KODAK equals returns on equal weighted CRISP index.913 9.5 0. m = 10 0.0 11.8 7.8 Code for Table: EW.3 0.97 e 0.5 3.910 4.1 0.5 10. DSE8TBLM.2 9.914 0.915 6.913 6. respectively.912 7.6 SCsf 5.913 1.915 9.9 SC 4.8 7.99 0.1 5C 3.0 0.6 0.8 1. Since Gennotte and Marsh fitted best linear models to the data as well as taking out the January seasonality therefore under the null hypothesis of linearity. significance of dependence was so high for EW because most of the January effect resides in small firms which loom relatively large in EW compared to VW.98 0.5 SC 5. m equals embedding dimension.9 6.3 0.1 8.6 SC 5.9 7.7 14. the 5% level of the Brock.2 0.96 7.8 0.

Shifts in the government posture toward controlling ease of credit and controlling interest rates impact on the short run opportunity cost of funds. We are puzzled by the T-bill results. this prewhitening does not change the dimension of the underlying dynamics if they are chaotic. stability and chaos in dynamic economics and Scheinkman statistic is around ±2. Exhibit B8). There seems to be strong evidence consistent with a chaotic explanation. Now test the null hypothesis that first differences of T-bill returns have a low dimensional deterministic chaotic explanation. It is interesting that the subsample January 1942-December 1971 appears linear. We get low dimension of the residuals even after fitting an autoregressive process of order 8 to the first differences of T-bill returns. There were periods where T-bill rates did not move at all because the government was controlling interest rates. There is one thing that the scientist must keep in mind when interpreting this evidence. 90. Furthermore. Recalling the discussion of the residual diagnostic. In other periods.328 Differential equations. The market . unlike Swinney's (1985. All we can say at this stage is that T-bill returns are worthy of further investigation. We identified best fit linear models by Box-Jenkins methods to eliminate the linear dependence in T-bill returns. Hence. The dimension appears to be around 2. These data were also used by Gennotte and Marsh (1987) to measure the risk free rate of return. In contrast with these results (especially for the value weighted indices) the behavior of the monthly returns for the individual stock. p. the government was more concerned about the growth of the monetary base and less about fluctuations in interest rates. Therefore the size of the Brock. What difference there is seems to be due to the roughness of empirical derivatives. The results for DSE8TBLM are typical. Dechert and Scheinkman statistic could be looked upon as a rough measure of nonlinearity in these data. the dimension of the shuffled counterpart is much larger although it is not equal to the theoretical value which is 10. such as KODAK appear IID. p. During the period under scrutiny the government intervened in determining interest rates. 285) case for the BelousovZhabotinski chemical reaction the dynamics have not been reconstructed. There is little difference in behavior between the original returns and the shuffled returns. We do not conclude that however because the largest Liapunov exponent has not been estimated and shown to be positive. Also. Contrast this with the behavior of Treasury Bills taken from Ibbotson and Sinquefield (1977. the dynamics is subject to regime shifts. This influences stock returns. We reduced this series to stationarity by taking first differences.

Financial economists use the term anomaly to refer to patterns in returns that appear inconsistent with absence of arbitrage profits after investors are paid the competitive price for systematic risk bearing. of systematic sources of risk. Form widely diversified portfolios to diversify away the unsystematic risks {ejt}. e are random and independent of each other at date / and have conditional mean 0 at each date t. Insert (LFM.__l[G(T}eil] = 0. It is typical in finance to search for an explanation in terms of systematic movements in risk return tradeoffs.l) allows enough diversification opportunities so that the market acts as if E. B are deterministic at date t. Arbitrage Pricing Models (APT) adjust returns for a small number. L0. Assuming that the E. Note that Ait is expected returns on asset i at date t conditional on date t — 1 information. Movements in this tradeoff have the potential for explaining the findings in table 10. As a quick idea of how the CAPM and APT models work assume returns on stock i at date f. Let us explain. 4. {Rit can be written as a linear factor model: Here the sum runs from k = 1 . . K « N. . A. What may explain the evidence for nonlinearity There are well known anomalies in finance. Let's take a brief look at this theory.2) gives. Theory predicts that diversifiable risks bear no price in financial equilibrium and that there is a tradeoff between expected return and systematic risk across portfolios.l) into the pricing equation below where the discounting process is {G} to get Assume that K « N and the structure in (LFM.1 as well as the Scheinkman and LeBaron findings. ._}[G(t)eit] terms are zero and rewriting (LFM. The Capital Asset Pricing Model (CAPM) adjusts returns for one source of risk .covariance with the market as a whole. Thus government activity in the financial markets makes it even harder to interpret the evidence. plus .4. say 3 to 5. is the sum of the risk free return. . Ait. It states that expected returns on stock /. This tradeoff depends upon the state of the economy. The meaning of the (APT/CAPM) equation is intuitive. 8.Chaos and other aspects of nonlinearity 329 watches the central bank very carefully.

for daily returns over 1962-1968. This movement of tastes for risk bearing impacts on stock prices through the above equations.} is proxied by returns minus conditional expectation of returns where the returns are on a wide index such as the New York Stock Exchange index.330 Differential equations. These differentials are not large enough to return a profit if you have to pay commissions (Haugen (1987.e. Note that G(t) = bu'(c.19% for all other months. the return from Friday's close to Monday's open) appears to be negative. The t subscripts denote that this relationship can shift over time. These models are operationalized by constructing indices to proxy for the unobservable to the scientist {5^.}. But so also does own risk. For the CAPM case {5. Wednesdays and Fridays tend to have higher returns than Tuesdays and Thursdays. With this background look at some evidence presented in Haugen's (1987) textbook and its references.. times the quantity. The CAPM can be viewed as the special case of one source of systematic risk that cannot be diversified away. January's average return was 6. i. 478)). The APT is the more general case of several sources of undiversifiable risk..)/u'(c.63%. This has been confirmed for later periods. °f type k risk borne by stock i. In January. Most of it occurs in the first five trading days of January and most of it is in the smaller firms.-l) for a representative infinitely lived consumer as in Lucas (1978). Monday's return (that is. high beta (large covariance with the aggregate market) stocks produce higher than average rates of return. In general G ( t ) is determined by tastes of the public for risk bearing. Stock returns are higher in January for nearly every other country with highly organized stock markets. So the relationship between expected returns .e. K = 1. Systematic risk (i. where excess returns adjusted for risk appear to exist. Over 1929-1940. This is a version of the consumption beta model where returns are predicted to vary with aggregate consumption. stability and chaos in dynamic economics the sum over k = 1 to K of the price of risk of type k. p. The association between size and average return is as good as the association between measured beta and average return.. Rothschild (1986) reviews some of the evidence that is pertinent here. compared with an average of 0. For the Standard and Poor's Index of 500 stocks. Lkt. Factors help explain average returns but they are hard to measure and it is difficult to get a consensus on which factors are most important and how to measure them. This will be relevant in trying to interpret some of the evidence. Bkit. beta risk) as measured by the CAPM helps explain average returns. These tastes may change through time. Evidence for and against the above theory is mixed.

T-bills.31 respectively. Scheinkman and LeBaron (1987). long term bonds. From 1947-1975 inflation and T-bills march in tandem.r. This is so because the consumption beta model is soundly rejected by data. Prescott and Mehra (1985) argue that you need ridiculously high risk aversion to reconcile this spread in returns between stocks and T-bills with a consumption beta model.5%/day and —0.t. See Person and Merrick (1987) and references especially to Hansen and Singleton. robust. Cochrane (1987) finds it easier to reconcile the equity premium with aggregate marginal rates of transformation than Prescott and Mehra do with aggregate marginal rates of substitution.57. yielding a real return on T-bills of about 0 during 1947-1975. 4.44. and Frank and Stengos (1986) that is dependent upon the consumption beta model. The January average daily excess return falls as value increases. Cumulation of an initial investment of $1 on common stocks.Chaos and other aspects of nonlinearity 331 and beta also changes in January. small firms are a factor. More puzzles and anomalies It seems risky to construct an explanation for the findings of table 10. Most of the research uses a context like APT/CAPM to search for plausible explanations.02% in comparison with 0.2. The average daily excess return for January (adjusted for beta risk) over 1963-1979 for the smallest ranking (based on value of a share) 10% of stocks is around 0.36% for the rest of the months over 1935-1980. Researchers are looking for a source of systematic risk that differentially impacts upon small firms during the December-January period. This is so because Gennotte and Marsh (1986) took out the January effect and still got similar results.S. For example. It is approximately 0%/day for all other months for all value classes. rather it is the low return of T-bills relative to stocks. that is the CAPM/APT is not wildly rejected across risky portfolios. The CAPM risk premium for January was 3.25. The puzzle is not so much that stocks behave oddly w.5. Consumption beta models are more consistent with data when nonstationarities and business cycle effects are accounted for (Person and Merrick .3.5. theory. We doubt that the January effect can explain the dimension findings of table 10. and has stimulated a lot of effort in finance to explain it. It is fair to say that the January effect is striking.1. and inflation over 1925-1975 in the U. are 90. This is dramatically vivid on page 3 of Ibbotson and Sinquefield (1977).3%/day for the largest ranking 10% of stocks.3. see also Prescott and Mehra (1985).

(ii) volatilities are persistent. Bollerslev fits the model. stylized facts dating back to Mandelbrot and others are these: (i) unconditional distributions of stock returns are fat tailed. is monthly returns on the S&P. stability and chaos in dynamic economics (1987)). Lehman's findings are a potential explanation for the Scheinkman and LeBaron (1987) results. it appears that volatilities move together across financial assets (even exchange rates) at a point in time. appear to have no systematic risk in them. Furthermore.6. dependent upon current conditional volatility.\t-i. Lehman (1987) finds sharp evidence for market inefficiency in the "form of systematic tendencies for current 'winners' and 'losers' in one week to experience sizeable return reversals over the subsequent week in a way that reflects apparent arbitrage profits". y. The idea is intuitive: Looking at the APT/CAPM formula suggests that aggregate returns should be high on average when volatility is high in order to compensate investors for bearing higher risk. The GARCH-M class of models is an attempt to parameterize this kind of data in a way to do statistical inference. This is an example of a Generalized Autoregressive Conditional Heteroscedastic (GARCH-M) model with conditional mean. Here y. (iii) large linear forecast errors tend to come together but appear unpredictable in sign. Lehman's results appear to contradict many versions of the CAPM/APT equation because his portfolios are wealth free. but yet earn significantly positive returns when closed out. Furthermore. Turn next to evidence of mean reversion in stock returns at the weekly frequency. Autoregressive conditional heteroscedasticity Even though returns may not be predictable on average it still may be true that their variances may be predictable.332 Differential equations. . There is sure to be controversy whether Lehman controlled for all sources of systematic risk. 4. Issues of measurement are paramount in testing financial theories and will probably prevent us from ever getting a decent ("decent" from the point of view of natural science) consensus.

Summers (1986b) has shown that adding a slowly mean reverting measurement error process (say zt = 0z. Thorp and Mitchell referenced in Montroll and Badger (1974) fit a log normal model to the duration of business cycles across 15 countries over 1790-1925. we have no idea how fast the distribution converges to the asymptotic distribution. While the results are not overwhelmingly strong the persistence parameter b1 for volatility is surely significant.Chaos and other aspects of nonlinearity 333 Bollerslev's results are: Asymptotic standard errors are in parenthesis.5 years. It is fat tailed to the right . {n. The fit is quite good. Of course. Montroll and Badger (1974) suggest that many fads and popularist movements seem to last for a similar length of time. Fama and French (1986) have shown that a version of the Shiller and Summers process leads to negative autocorrelations in monthly returns at the 3-5 year level and that actual stock returns data have statistically significant negative autocorrelations at the 3-5 year level. at an impressionistically suggestive level. with <P near unity) to the geometric random walk (a random walk in logarithms) leads to a stochastic process that is hard to distinguish from a geometric random walk by autocorrelation function tests. The fitted log normal peaks at a frequency between 3-3. Third. Miscellaneous applications and exercises (1) Evidence of mean reverting fads and long term dependence. A reading of Shiller's (1984) list of fads and fashions does not contradict this.} IID with mean 0 and finite variance. all this is conditional on the GARCH-M being the correct model for S&P returns. We continue with more examples in the next section. First.. This might be false. Second. Shiller's (1984) prominent work on stock prices and social dynamics argues that swings in fashion of say 3-5 years in length could lead to long swings in returns that would be hard to detect in autocorrelation tests performed on weekly or monthly returns. + «. Fourth._. 5. The weekly and monthly levels are a good place at which to search for evidence of complex dynamics in stock returns for several reasons. Also. One may also view Lehman's (1987) results of mean reversion at the weekly level as consistent with a version of the Shiller and Summers model.

including T-bills. Therefore. They investigate a version of the Shiller and Summers mean reverting fads model and reject it.[G(t)] (cf. it impacts widely across all stock groups. Therefore. He also argues that social pressures influence investors in much the same way that social pressures influence teenage kids (and the rest of us). G(t). Turn back to Shiller's (1984) suggestive article. it is suggestive that the modal length of business cycles matches Fama and French's 3-5 year interval for negative autocorrelations. stability and chaos in dynamic economics however. General random walks are vigorously rejected by weekly returns on the CRSP equally weighted index and still are rejected by weekly returns on the CRSP value weighted index over 1962-1985. Given Lo and MacKinley's claim to reject the mean reverting pricing error model. These rejections are largely due to small stocks. Fama and French (1986) present evidence that suggests. Shiller argues that interest in the stock market waxes and wanes much like interest in fashions. even though the surface behavior of T-bills may contradict the . the APT/CAPM formula) and since T-bills did not move like stock prices. that whatever it is that causes the 3-5 year mean reversion in stock returns. movements in G(t) or movements in net cash flow appear to be a good place for chaos to enter stock returns if it enters anywhere. They construct another test for random walks driven by heteroscedastic innovations (ARCH innovations are included). over time as well as with a Shiller and Summers mean reverting pricing error process. is not constant over time. Furthermore. that a chaos with 3-5 year swings could be consistent with this data. So 6-8 year cycles are not all that scarce. Lo and MacKinlay (1988) build a statistical test on the observation that variances of kth period differences of a random walk must grow linearly in k. What are we to make out of the somewhat confusing collection of evidence presented? It appears worthwhile. we must proceed cautiously if we are to interpret the evidence in terms of movements in G(t) alone. One fact that impresses itself quickly on a financial analyst is that the quantity of government paper. the Fama and French evidence is consistent with slow movements in the discounting process. the evidence suggests that it enters the system through G(t) or mean reverting pricing errors or perhaps through mean reversion in the net cash flows of firms. in the context of APT/CAPM. in view of the evidence that the correlation dimension of stock returns is somewhere between 6 and 7 together with the fairly strong evidence for predictability of stock returns over long intervals like 3-5 years._. Nevertheless. Since returns on nearly risk free assets move like l/E. (2) A wildly speculative story consistent with the evidence.334 Differential equations.

In order to relate this to mean reverting evidence on the time scale discussed by Fama and French consider investors at the trough of the cycle expecting a rise. Corporate profits covary with general activity such as real GNP but are more volatile. Since rises are highly persistent (real GNP about trend is a near unit root AR(2) process) one could expect the stock market to rise and the bull market to last towards the peak of the cycle. N ( t ) . T-bills cumulated much faster than inflation during this period. The 1947-1975 Ibbotson and Sinquefield evidence on T-bills and inflation is consistent with the close substitute view. However. N ( t ) . The marginal rate of substitution between this period's consumption and next period's consumption determines G(t + l). It seems possible to get chaos or complex dynamics for plausible specifications of N ( t ) .S. Profits power the ability to pay dividends on corporate stock. Holding the quantity supplied of stock fixed at unity for all time and imposing supply of stock = demand for stock. One would expect a bear market. (ii) the amplitude (severity) of business cycles is less in the post World War II period in the U. the details have not yet been worked out. Let each investor plan as if they live for two periods and let all active investors have identical tastes to keep the analysis simple. After all it is known that: (i) fluctuations of real GNP about trend are fit well by low order autoregressive processes such as AR(2)'s with near unit roots.Chaos and other aspects of nonlinearity 335 story that we are going to propose. Hence this cyclical change in the attitudes toward risk bearing should magnify swings in stock returns over the cycle. the contradiction may be resolved when government activity to control interest rates and when government monetary and fiscal policy is taken into account. than in the pre World War II period. . (3) Another story for the evidence: the business cycle. makes G(t+l) a function of the current number of investors this period. Swings in the public's tastes for risk bearing may be tied to the business cycle. It is also important to realize that T-bills may be a close substitute for fiat money. One would also expect people to be more tolerant of risk bearing when they expect things to get better and stay better relative to trend and vice versa for the fall. Consider a world where the current quantity of stock market investors is a function of the past history of returns on the market and past history of numbers of investors in the market. Modest conditions show that G(t+l) is increasing in the number of active investors. in equilibrium. Their evidence from 1925-1946 is not. Now contrast this with investors at the peak anticipating a fall in economic activity. We have an overlapping generations structure much like those discussed and referenced in Baumol and Benhabib (1988) and Grandmont (1985).

can be translated into other examples of public hysteria quite easily. French and Summers. It also links swings in asset prices to relative swings in generalized profitability or generalized productivity across the economy. With this perspective look at the distillation of the history of speculation by Montroll and Badger (1974). Motivated by Shiller's well known work on excess volatility of asset prices we are going to look for forces that magnify movements of stock prices from their fundamental values. The model of Scheinkman and Weiss (1986) generates equations related to CAPM/APT but contains two agent types. After all. "We close this historical review of speculational orgies with a brief summary of the mechanism behind practically all these events. stability and chaos in dynamic economics This seems roughly consistent with the evidence but pushes the ultimate roots of swings in stock returns back to swings in economic activity in general.business cycle evidence. There is evidence that stock prices are systematically related to business cycle movements. The data may not be as hostile to a model where G(/ + 1) is not forced to be the marginal rate of substitution of a single risk averse infinitely lived agent type as it is in the consumption beta models. This is an attempt to capture the mean reverting idea of Shiller. a pure fads interpretation of the Fama and French findings is not very attractive. (II) If at the same time private savings and uncommitted cash is increasing. the rise attracts new investors and enlarges the depth of involvement of those already in the market. There are eight important steps: (I) Increasing industrial production and sales (or demand for some commodity such as land) in a period in which there is general optimism causes a rise in price of stock (or of the commodity). in fact. If this is completely random then we have a reconciliation problem with the stock market . So we are going to identify "fad" with magnification effects ignited by the business cycle. . We use the words of the stock exchange. We will entertain the notion that the theory describes a central tendency for stock prices over time. We have the problem of explaining when fads start and when they die. but the basic ideas are general and. Fama. We quote them verbatim. We will look for forces that magnify upswings and downswings so that there are persistent movements from the fundamental that eventually revert back to the fundamental.336 Differential equations. The fundamentals themselves move over the business cycle. There is also the problem that this is a consumption beta type of story.

The investor is buying only to sell soon after profits are made. Apparently. the behavior of the market becomes practically uncoupled from industrial production. (IV) The small down payment (margin. As the continuous drop occurs. We hope to discuss such a scheme elsewhere . but they also become a little greedy so that they stay in as long as there is some rise. group observes that the original reason for the excitement. This. prices go down somewhat as these sales are made. more knowledgeable. The excess volatility literature flounders on the fundamental measurement difficulty: the scientist can never capture all the information . the number of new people entering the speculative orgy decreases.. swamp land. We conjecture that Montroll may have found that it is not easy to write down such a model and have its testable implications treated fondly by the data in any way that would command a consensus by fellow scientists.Chaos and other aspects of nonlinearity 337 (III) This induces larger rises in market prices and attracts less sophisticated people who pay attention only to changes in market prices. or the actual value of the use of the object being invested in. (VI) As values skyrocket. has not kept up with the inflated values of the stock. The stock held as security is sold in a market of few buyers and the panic is on. essentially ignoring the activity of the companies whose stock they purchase. Furthermore. It should not be difficult to make a mathematical formulation of this mechanism. The sensitive people react. for example. industrial production and its future prospects.. (VIII) Since new buyers are few. Montroll never discussed such a scheme elsewhere. investment trusts or. of course. (V) Success and demand for stock breed enterprises which have nothing to do with production. the installment (or margin) buyers are in trouble. We buttress this conjecture below. They know they want to get out while they are ahead. They start to sell out. (VII) A small. is a simplified model but still it contains most of the main ideas. etc. ". binders in Florida real estate. etc. in the case of real estate booms. We searched a list of his publications published in a memorial volume by Shlesinger and Weiss (1985) and found no mention of such work in his published papers.) becomes widely used so that the demand for stock increases more rapidly than the rate at which real money is put into the market. Those already committed become more sensitive. Much has been written in economics on bubbles and excessive movements in asset prices. in stocks.

Fama. They found a strong positive association between subscriptions to the magazine Coin World and movements in coin prices for 1960D small date pennies. 1955 half dollars. A review of recent empirical work on bubble testing and excess volatility especially that of Flood. The bubbles literature suffers from similar difficulty. stability and chaos in dynamic economics that the traders have. How can we try to settle this dispute? One thing that Montroll and Badger focused on in their review of the history of speculation as told by economists of a more literary bent (such as J. They argue that most of the evidence of bubbles and excess volatility is due to model misspecification and not due to actual self propelled expectation bubbles that diverge from fundamentals like that of the Montroll and Badger scenario. and Kaplan (1986). Montroll and Badger had no data on the number of people buying stocks so they examined another market. convergence in distribution is implied and the BDS test is fooled. is in Flood. French and Summers' type of processes account for the evidence of nonlinearity in stock returns in table 10. In spite of this difficulty we believe that most economists share (yet see the next paragraph) the belief that stock prices are excessively volatile relative to fundamentals. West. Fama. French and Summers slow mean reverting processes have failed to detect this kind of dependence with tests based upon methods of Brock. Fama. and 1950 pennies over the period 1960-1972. (4) An underlying chaotic process driving stock returns. Dechert and Scheinkman like those used above. the market for collectible coins. Garber. at the minimum. Hence. Hence. French and Summers. Shiller. This appears to be true because as the persistence O. Gennotte and Marsh (1986). Frank and Stengos (1986)) that the dimension of stock returns is between 6 and 7 or. . the first difference over a fixed time interval of observed log stock price goes in mean square norm to an I ID process.1 of the mean reverting "pricing error process" of Shiller.338 Differential equations. therefore there will always appear to be excess volatility relative to any fitted model attempting to match measured stock prices to measured fundamentals. Hodrick. We have presented evidence from other studies in empirical nonlinear science (Scheinkman and LeBaron (1987). we do not believe that Shiller. Our initial computer experiments with simulated Shiller. The height of the boom in prices followed by the depth of the collapse was especially severe for the 1960D small date pennies.2. Galbraith's The Great Crash) is some measure of the depth of interest in the stock market. K. stock returns are nonlinear in the sense that the residuals of best fit linear models are highly dependent.

futures or options . This new perspective has already led to a new statistical test (Brock. Shiller (1984) and Montroll and Badger (1974) deserve as much attention as investigation of dependence upon conditional variance (ARCH and its cousins). (6) Multivariate test. Nothing said here proves that there are chaotic dynamics driving stock returns at business cycle frequencies or that business cycle data are chaotic. At the very least chaos theory stimulates the researcher to look for magnification or overreactive effects in data in the search for evidence of the endogenous instability that is characteristic of chaotic dynamics. deseasonalization. But the best fit linear models (after reduction to linearity by units changes. Back's test has excellent size and power characteristics. (ii) Brock. and Scheinkman (1987)) for nonlinearity and intertemporal dependence that has good power against alternatives for which many tests have weak power. (7) It would be interesting to use the methodology of this chapter to investigate the behavior of volume of trading in equity. Dechert and Scheinkman have shown that GARCH processes generate zero bispectra and cite evidence that the bispectrum of stock returns is significantly nonzero. (i) Scheinkman and LeBaron (1987) argue that simulated ARCH-M processes calibrated to their data do not display the observed pattern of their "S" statistics.Chaos and other aspects of nonlinearity 339 We do not believe that ARCH or GARCH processes account for all of the nonlinear dependence for several reasons. and detrending) do not account for all of the temporal dependence in these data. and (iii) Brock (1987b) discusses conflicts between GARCH and ARCH models as currently applied and theory and evidence in macroeconomics and finance. (b) civilian employment. Real GNP failed to show nonlinear structure but it may have been eliminated by aggregation. transformation of variables. (d) pigiron production. Baek (1987) and has been used to test for possible nonlinear dependence missed by Stock and Watson (1987) in bivariate money and industrial production vector autoregressions. (5) Brock and Sayers (1988) have presented evidence of strong nonlinear dependence in (a) industrial production. This nonlinearity may have been channeled into stock returns through this equilibration of the market. We confidently predict that ideas from nonlinear science and chaos theory will continue to stimulate useful new methodology in economics even though the evidence for deterministic data generators in economic nature may be weak. Dechert. (c) unemployment rate. Investigation of dependence of stock returns on variables like measure of the "depth of interest" in the market. This test has been generalized to multivariate series by E.

Not to be outdone by the Europeans.. serves us by shifting the attention of scientists and intellectuals to disorder. 1986 did a full length article on this topic. Prigogine and Stengers (1984) and Prigogine (1980)). An October. computer simulations demonstrated that a vast variety of stochastic-like paths these models generated will have to confront data with the same success of the received models in order to persuade macroeconometricians. For a brief survey of existing theories of trading volume behavior and for random walk tests see Malliaris and Urrutia (1988). disequilibrium. stability and chaos in dynamic economics markets at various time dimensions. diversity.. A somewhat controversial example is the output of the Brussels school (e. August 4. (Prigogine and Sanglier (1987.) Business Week. 330). and the importance of time". attracted such notables as Jonas Salk and Alvin Toffler. instability. p. Applied scientists did not take much interest in this phenomenon until the piece by Ruelle and Takens (1971) successfully challenged the high dimensional Hopf-Landau view of the transition to turbulence and replaced it with a view that assigns a dominant role to strange attractors of low dimensional nonlinear dynamical systems. 1985 conference at the Palais des Academies in Brussels on theoretic ideas on chaos and their applications. Further remarks and references That low dimensional deterministic dynamics could generate stochastic looking trajectories has been known in mathematics at least since the days of Poincare. machine model taught by classical science". at the Brussels conference argued that Western science has been dominated for three centuries by the Newtonian paradigm which Toffler called "the bloodless. the American Santa Fe Institute hosted a conference . especially in Europe. 1985) and others made the case for the presence of strange attractors in data generated by real physical systems.g. Several speakers. One scientist was quoted in Business Week as saying that the study of chaos "is as important historically as the discovery of the wheel". Substantial frictions and market imperfections will have to be present to get around the randomness inherent in the logic of frictionless asset markets. This view received a chilly reception in the scientific community until evidence adduced by Swinney (1983. Interest in the general theory of chaos has even stirred up the world community of intellectuals and literati.. 6.340 Differential equations. cold. In the meantime. He said. "the new science of instability. non-linear relationships.

It is not an exaggeration to say that activity in this area is feverish at the present time. Kenneth Arrow (Economics) and Philip Anderson (Physics). For the reader who wishes to study further the mathematics of nonlinear dynamics and chaos we suggest Guckenheimer and Holmes (1983). The proceedings are being published in David Pines (1988). Special acknowledgement. Meanwhile the American National Academy of Sciences National Research Council issued a public research briefing on "Order. and Patterns: Aspects of nonlinearity" (NAS (1987)). Chaos. That is to fuse a synthesis between the recent methods used by natural science to test for the presence of nonlinear low dimensional dynamics in data when the noise level is small with the statistically sophisticated methods of social science that can handle a lot more noise in the data but a lot less nonlinearity. Percival (1983). Thompson and Stewart (1986). Dee Dechert and Jose Scheinkman have greatly contributed to the development of ideas in this and other chapters of the book and we are intellectually indebted to them. For a historical survey see Gleick (1987). the really exciting work for economics remains to be done. . Some early economic applications of chaos are presented in Brock (1985). This chapter gives a survey of the relevant natural science literature and offers some extensions and adaptations appropriate to economics. It also outlines some preliminary approaches to detecting the presence of noisy nonlinear dynamics in economic data. Jordan (1987) and the readings in Holden (1986). Devaney (1986). However.Chaos and other aspects of nonlinearity 341 organized by two Nobel Laureates.

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Its basic elements are logic and intuition. equicontinuity and others are used. p. xv) 1. linear algebra. Alternatively. the contemplative reason. generality and individuality. analysis and construction. and the desire for aesthetic perfection. 2. that is limx-cf(x)=/(c). uniform convergence. Results from analysis In chapter 1 and elsewhere. A function / which is defined in some neighborhood of a point c is said to be continuous at the point c provided that the function has a definite finite value f(c) at c. elementary topology and optimization theory to offer the reader a source for a quick reference of mathematical concepts used throughout the book. the concepts of continuity. let f be a function and let c be a . and also as x approaches c . f ( x ) approaches f(c). The definitions of these concepts follow. The material is covered briefly and several references are supplied for the reader interested in studying specific concepts in more detail. Introduction This appendix collects numerous definitions and results from analysis. convergence. Courant and Robbins (1941.APPENDIX MATHEMATICAL REVIEWS Mathematics as an expression of the human mind reflects the active will. uniform continuity.

For a proof see A.3. then it is said to be continuous on D. (Fundamental theorem of integral calculus. We say that {/„(*)} is a Cauchy sequence if for any £ >0 there exists a positive integer n0 such that whenever n > m > n0.2. to each e > 0 there corresponds a 5>0 such that \ f ( x ) — f ( c ) \ < e whenever \x — c\<8 and xeD. 102). and only if. stability and chaos in dynamic economies number in an open and connected set called the domain of f and denoted by D. Next we recall a few important theorems. The uniform limit of a sequence of continuous functions is a continuous function. Theorem 2. Theorem 2. then we say that/(x) is uniformly continuous on D. A sequence {/„(*)} defined on a domain DC R" is uniformly convergent to some function/(x) on D if. If a function is continuous at all points of a domain D. for any e > 0 there is a positive integer n0 such that. |/n (*) —/™ (*)| < e for all x in D. and if F ( x ) = J /(x) dx is an indefinite . for all x in D.c\ < 8 and x e D holds for all c e D. Theorem 2. If for any e > 0 there exists a number 5 > 0 such that |/(x) —/(c)| < e when |x . p.) Let /(x) be a function that is continuous and has n +1 first derivatives on an open interval containing the points a and x. Then f is continuous at c if. and only if.344 Differential equations. Let {/„(*)} be a sequence of real valued functions defined on a domain DCI R". |/ n (x) ~/(x)| < e whenever n > n0. Friedman (1971. Then the value of the function at x is given by where is called the remainder. Suppose that a function / is denned on a domain D. p. 159). For a proof see Friedman (1971.1.) If f ( x ) is continuous in the interval a < x < b. (Taylor's Theorem.

36-37). a are real valued and continuous functions for a . 253).b. p.t .) If O.) If c is a real constant.5. . (Gronwall's inequality. Theorem 2. (Generalized Gronwall inequality.4. B ( t ) > 0 is integrable on [a. b] and then For proofs of these two theorems see Hale (1969.Appendix 345 integral of f(x). f ( x ) > 0 and h ( x ) are continuous real functions for a < x < b which satisfy then Theorem 2. then the definite integral where the derivative of For details see Kamien and Schwartz (1981. pp.

The point 0 (zero) is called the origin of the real line.346 Differential equations. a = c and b = d. Moore (1964) gives an introduction to elementary general topology. or {x: a < x < b} or a < x < b. b]. or {x: a < x < b} to be the set of all points satisfying a < x < b. Two complex numbers a + bi and c + di are equal if. Similarly. with a < b. we define the closed interval [a. b). The sum of two complex numbers (a + hi) + (c + di) is the complex number (a + c) + (b + d)i. We denote this open interval by (a. These notations can be generalized in R". stability and chaos in dynamic economies We conclude this section by recalling some simple properties of complex numbers. The set G is bounded below if there is a number L such that x > L for all x E G. If G is bounded above and below. L is called the lower bound of G. Complex numbers are expressions of the form a + ib. Finally we give Euler's Relations: A standard reference for complex analysis is Churchill (1960). it is closed and bounded. Such a number K is called the upper bound of G. and only if.bd} + (ad + bc}\. there exists a positive number M such that |x| < M for all x e G. Given any points a and b. and only if. where a and b are real numbers and i is the symbol for v — 1 . then we say G is bounded. A set G is said to be unbounded if it is not bounded. and only if. we call the set of points satisfying a < x < b the open interval with endpoints a and b. This is clearly the case if. . and the product of a real number x and a complex number a + bi is the complex number ax + (bx)i. Basic topological concepts Any real number is called a point and the set of all real numbers is called the real line. The product of two complex numbers (a + bi)(c + di) is the complex number (ac. Division of two complex numbers (c + d\)/(a + bi) is a complex number x + yi where The absolute value of a complex number |a + ib| equals va2 + b2. A set G is compact if. A set of real numbers G is said to be bounded above if there is a number K such that x < K for all x e G. 3.

. then we say that I is a bounded function on I. a matrix is a rectangular array of numbers. b].y. For a proof see Coppel (1965. Let I be a continuous function on a closed and bounded interval [a. where x varies in I. . n. (Ascoli lemma. If G is a bounded set. there exists a constant N such that /(x) < N. Then every sequence {/„} of functions in F contains a subsequence which is uniformly convergent on every compact subinterval of /. m and j = 1 . A key result used in the theory of ordinary differential equations is the famous Ascoli lemma. 7). 51). This is the case if. The numbers in the array are called the entries in the matrix. then we say it is unbounded. F is called equicontinuous on / if for any e > 0 there is a 5>0 (independent of x.) Let F be a family of functions which is bounded and equicontinuous at every point of an interval /. . .Appendix 347 Let /(x) be a function denned on an interval I. F is called uniformly bounded if there is a positive constant M such that |/(x)| < M for all x e / and / in F.1. and /) such that \f(x)-f(y)\<e whenever |x —y\ < 8 for all x and y e / and for all / in F.2. If G is bounded above then we say that I is bounded above. is denned to be the n x m matrix whose first column is the first row of A. Theorem 3. . Consider the set G of its values f(x). denoted AT. . Let F be a family of real valued functions defined on an interval /. A useful result is the following: Theorem 3. An mxn matrix consists of mn elements a(j. For mxn matrix A. and only if. the transpose of A. for all x e I. This is the case if. . Results from linear algebra Put rather simply. . written in an array of m rows and n columns. and only if. . there exists a positive constant M such that f(x) < M for all x G I. p. 4. whose second column is the second row of A and so on with its final column being the last row of A. p. Then f is bounded. If/ is not bounded. with i = 1 . For a proof see Friedman (1971.

det A = 0. Matrix multiplication is possible only when the number of columns of A equals the number of rows of B. Now consider two matrices A and B with A an m x p matrix and B a p x n matrix. . Multiplication of a matrix by a scalar k. the product BA may not be capable of being formed. The product of AB is an m x n matrix defined by with It is not in general true that AB = BA. Thus. (iii) A matrix A is invertible if. one simply adds the corresponding entries. the inverse of a matrix bears the same relationship to that matrix that the reciprocal of a number bears to that number in ordinary algebra. one subtracts corresponding entries. In fact. For example. These properties are: (i) detA = detA T (ii) If A and B are square matrices of the same size then det (AB) = (det A) • (det B). stability and chaos in dynamic economies Two matrices A and B with the same number of rows and also the same number of columns may be added or subtracted. denoted by /. is performed by multiplying every element of the matrix by k. that is AA-1 = I = A. However. Division is not defined for matrix algebra. although AB can be formed. to add two matrices. and only if. to subtract two matrices. We assume that the reader is familiar with the notion of a determinant and we state some simple properties for the determinant of a matrix A denoted by det A. The identity matrix. is defined by Thus. is an n x n matrix with ones as the elements on the main diagonal and zeros elsewhere.348 Differential equations. in matrix algebra the product of a matrix A and its inverse A-1 is the identity matrix /. A matrix A that does not have an inverse is called singular.1 A.

We also offer two more definitions of linear dependence: (i) A system of equations A. we say that B is similar to A if there is an invertible matrix P such that B = P-1AP. (ii) A set of two or more vectors is linearly dependent if. Similar matrices have the same characteristic polynomials and the same characteristic values. To find the eigenvalues of A we rewrite Ax = Ax as Ax = \Ix or equivalently (A/ — A)x = Q. and only if. For A to be an eigenvalue. and only if. B is similar to A if. which has and consequently is not invertible.Appendix 349 has at least one solution. If this is the only solution. It is particularly useful if a similar matrix is triangular. we have a nonzero solution if. If A is an n x n matrix. The characteristic roots of a triangular matrix are the elements along the principal diagonal. 279-280). is linearly dependent. A is similar to B. at least one of the vectors is a linear combination of the remaining vectors. An important result is this: Theorem 4. For a proof see Paige and Swift (1961. and only if. A matrix is called triangular if it is a square matrix such that all its elements either above or below the main diagonal are zero. However. there must be a nonzero solution of this equation.1 orA = (P~l)~lBP~l. for a given . Letting Q = P~l yields A = Q~l BQ which says that A is similar to B. If there are other solutions. that is for some scalar A. namely k1 = k2 = • • • = kn = 0. Therefore. The scalar A is called a characteristic value or an eigenvalue of A and x is said to be an eigenvector corresponding to A. then A is called a linearly dependent set. This last equation is called the characteristic equation of A and the polynomial obtained by expanding det(A/-A) is called the characteristic polynomial. pp.1. then a nonzero vector x in R" space is called an eigenvector of A if Ax is a scalar multiple of x. Therefore. then A is called a linearly independent set. If A and B are square matrices. Note that the equation B~ P-1AP can be rewritten as A = PBP.

A matrix A is called symmetric if AT = A. in the sense that each entry of A is a function of t. pp. Suppose 0 is a scalar function of matrix A. Then d</>/dA is a matrix whose ( i . It is however possible to get close to a diagonal form using the Jordan canonical form as is explained in chapter 2. j ) entry is d^/da^. if it is possible to find a similar triangular matrix. denoted by tr A. For an n x n matrix A with elements aij we define the trace of A. as In stability analysis we often use the fact that the trace of a square matrix is the sum of its characteristic roots. 287-289). Then It follows that The integral of a matrix is defined as Suppose o is a scalar function of vector x. Not all matrices are diagonalizable.1 . Suppose A is a function of a scalar variable t. A key theorem is the following. A special case of a triangular matrix is the diagonal matrix. A matrix A is called orthogonal if AT = A.2. If a square matrix A has distinct characteristic roots there is a similarity transformation P-1 AP . Then d0/dx is a vector whose ith entry is dfi/dXj. If A is a real symmetric matrix it has only real characteristic values. stability and chaos in dynamic economies matrix A. the characteristic roots of A can simply be read off the diagonal of the similar triangular matrix. Let . For a proof see Paige and Swift (1961. Theorem 4.D where D is diagonal. The square matrix D with elements dij is called diagonal if dij = 0 for all i=j. If A is a real symmetric matrix it has an orthogonally similar diagonal matrix.350 Differential equations.

On quadratic forms There is a close connection between the characteristic roots of a matrix and the properties of quadratic forms. . we define the induced norm of A to be These topics are presented in detail in Bellman (1970) and Hernstein (1964). ur). . . u°). . . The matrix or briefly dFj/ditj is called the Jacobian matrix of ( F l 5 . . 5. Fr) with respect to ( M I . . *„) are: For an m x n matrix A representing a linear mapping from R" ->• Rm.Appendix 351 be functions having continuous first derivatives in an open set containing a point (x°. Recall that a quadratic equation may be written as which can be put into matrix form . . The norm of a vector x is a real valued function denoted by |x| or ||x|| that satisfies the properties The three most commonly used norms of a vector x — ( x t . . . .

1. also called the indirect utility function. starting at state y at time t0. t) gives the law of motion of the state. and x = dx/dt = f(x. stability and chaos in dynamic economies With this simple illustration we can define the quadratic form as a relation x^Ax where A is an (n x n) matrix with real entries and x is an n-vector. for all real x = 0 we define The basic result of this section is Theorem 5.2) is analogous with x replaced by ( x ( t +h) — x ( t ) ) / h and J replaced by E. (2) A quadratic form is positive semidefinite if and only if characteristic roots are all nonnegative. B:R" x R ->• R.R" x Rm x R -» R. pp.352 Differential equations.R f : R " x Rm x R.R'\ v. Here V is the state valuation function. B is a bequest or scrap value function giving the value of the state x(T) at date T.1) and (6. . Optimal control In continuous time the general optimal control problem is stated thus: where V:R" x R. 255-256). (3) A quadratic form is negative definite if and only if characteristic roots are all negative. v is the instantaneous utility or payoff when the system is in state x = x(s)e R" at time s.xTAx. (4) A quadratic form is negative semidefinite if and only if characteristic roots are all nonpositive. (5) A quadratic form is indefinite if and only if at least one characteristic root is positive and one is negative. For a quadratic form Q . (1) A quadratic form is positive definite if and only if characteristic roots are all positive. Under modest regularity conditions the solution to the discrete time problem converges to the solution to the continuous time problem as h -0. u. For a proof see Hadley (1961. The horizon T may be finite or infinite. The discrete time version of step size h of (6. 6. and control u = u ( s ) e Rm is applied at date s.

3)-(6. Equations (6.1) may be written: The first equation is obvious. the fourth follows from the integral mean value .6) are the workhorses of optimal control theory. or dual variable. and the function H* is called the Hamiltonian. These variables are introduced for the same reasons and have the same interpretation that Lagrange-Kuhn-Tucker multipliers have in nonlinear programming. furthermore the state and costate necessary conditions must be satisfied with p = Vx: The variable p is called the costate variable.Appendix 353 Under regularity assumptions by dynamic programming the value function V satisfies the Hamilton-Jacobi-Bellman (HJB) equation. We briefly explain their derivation and meaning here following Brock (1987a) and other standard references such as Athans and Falb (1966) or Miller (1979). The terminal conditions (6. Equation (6. the third follows from the definition of the state valuation function. T]. the second follows from the following principle called the principle of optimality: to maximize a total sum of payoffs from x(to) =y over [t0.6) are sometimes called transversality conditions. T] you must maximize the subtotal of the sum of payoffs from x(t0+h) over [t0+h. adjoint variable.

4) is just a definition.6) is simple.7). called the costate variable. The condition p(T)x(T) = Q means that nothing of value is left over at the terminal date T. t0) and future instantaneous value px — pf(y. u. The principle that the optimal control u0 must maximize H* is important. Benveniste and Scheinkman (1982). It is called the maximum principle. assume the state valuation function V(y.7). the fifth follows from Ax = x(t0 + h) — x(t0) = fh + o(h). To motivate this definition rewrite equation (1.9) is necessary and sufficient for optimality for a large class of problems. for a large class of problems the condition takes the form and is called the transversality condition at infinity. Here o(h) is any function of h that satisfies Subtract V(y. The relation x = H*° follows from x=f(x. stability and chaos in dynamic economies theorem and expansion of V(x(t0+ h). is the marginal value of the state variable. p = Vx.3).5) is easy to derive. Araujo and Scheinkman (1983).3) is nothing but the principle of optimality in differential form. Equation (6. The relation p = -H*° follows from substitution of the derivative of (1. It measures the incremental sum of payoffs from an extra unit of state variable.3) wrt x into the expression for d/Vdf = (d/dt)V x . t0). For any date T with terminal date in (6. If there is an inequality constraint x ( t ) > b for all t. p ( T ) = Bx(x. divide by h and take limits to get (6. thus putting p = Vx. but B = 0. Observe that the Hamiltonian function H* just collects the terms that contain the control u. Equation (6. T) takes the form p(T)x(T) = Q. When T is infinite. tQ+h)) in a Taylor series about x(t0) = y and t0. u. 0 and the envelope theorem. and Weitzman (1973) show that (6. M°.9) might be necessary for optimality. This follows directly from equation (6. It is instructive to give a rough heuristic argument to motivate why (6.1) set equal to infinity. then. T) is . Finally (6. One chooses the control to maximize the sum of current instantaneous payoff v(y. the transversality condition.354 Differential equations. So (6. The quantity p. t0) from the LHS and the extreme RHS of the above equation. The control u must be chosen to maximize H* along an optimum path.

9).Appendix 355 concave in y. and Araujo and Scheinkman (1983) for the details and references. q = e5'/>.) Use concavity and p(T)= V x ( x ( T ) . See Benveniste and Scheinkman (1982). Then it is plausible to expect that the LHS of (6. f0) = es' V(y. Examples exist where (6.3)-(6.oo. t0). T ) . the transversality condition becomes .0 . W becomes independent of T so that W. The idea is that if the distant future is significant then there is no reason to expect the value of leftovers p ( T ) x ( T ) to be forced to zero along an optimum path. T) to get the bound Now suppose that the distant future is insignificant in the sense that V ( z ( T ) . In the same manner and for the same reasons as a time series analyst transforms his time series to render it time stationary the dynamic economic modeller searches for a change of units so that (abusing notation) problem (6. If x(T) >0 and p(T)>Q (more x is better than less) then which is (6.1) here. (Note that t0 is replaced with T and T is replaced by x in (6.1) may be written in the time stationary form By the change of units W(y.9) is not necessary for optimality.6) in the form: When the horizon T = oo. H = e s 'H* and we may write the optimality conditions (6. = 0.10) will go to 0 as T. TH-x for any state path z.

Finally.15) to be optimal. Turnovsky (1974) and B. Friedman (1975) apply control theory to stabilization policies. 9 and 10 use elementary notions from measure theory which are presented in Royden (1968). For further details see Mangasarian (1966). . Barron et al.17) determines q0.356 Differential equations.17) is necessary as well as sufficient. Arrow and Kurz (1970) or Kamien and Schwartz (1981). Pindyck (1973). The condition (6. (1987) use monotone control methods to solve certain problems in economics. 7. stability and chaos in dynamic economies and (6. Brock (1987a). for a solution of (6. chapters 5.

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"Market Excess Demand Functions".M. 4. Skiba.P. 1088-1096. and K. G. Bulletin of the American Mathematical Society. C. Shane. 40. 73. K. Essays on the Theory of Optimal Economic Growth. Differential Equations. M. Sydsaeter (1987). North-Holland Publishing Company. and Stability". H.W. "On Competitive Dynamical Systems". R. Simmons. eds. (1982). (1978). American Economic Review. Springer-Verlag. S. S. Schlesinger. "Do Walras' Identity and Continuity Characterize the Class of Community Excess Demand Functions?". "Optimal Growth With a Convex-Concave Production Function". (1972). Springer-Verlag. in: H. Econometrica. 70. Seierstad. Sims. (1976). R. Department of Economics. M. New York.L. 449-476. American Economic Review. (1967). R. working paper. "Dynamic Models of Portfolio Behavior: Comment on Purvis". University of Minnesota. Brookings Papers on Economic Activity. ed. G. Quarterly Journal of Economics.. J. Global Stability of Dynamical Systems. 72. 565-583. American Economic Review. (1984). "The Firm's Optimal Financial Policies: Solution. Optimal Control Theory With Economic Applications. 75. 46. (1978). North-Holland Publishing Company. Journal of Financial and Quantitative Analysis. Journal of Political Economy. Weiss (1985). (1974). Jr. (1978). (1975). 527-540. "Rational Expectations and the Dynamic Structure of Macroeconomic Models". Springer-Verlag. American Economic Review. 543-555. (1984). Smale. The Wonderful World of Stochastics: A Tribute to Elliot W. "A Contribution to the Theory of Economic Growth". "Stock Prices and Social Dynamics". Montroll. 66. Siegel. "Stability of Keynesian and Classical Macroeconomic Systems". (1980). New York. Journal of Economic Theory. "Dynamics in General Equilibrium Theory".J. S. 2. Differential Games and Related Topics. (1986). (1956). (1972). A. American Economic Review. ed. "The Stability of Cournot Revisited". Models of Economic Dynamics. M. (1976). (1973). 1-44.F. 410-416. . A. 457-510. Shell. A. Sonnenschein. 6. 23. Kuhn and G. "Price Dynamics Based on the Adjustment of Firms". MIT Press. H. H. H. Econometrica. 288-294. 10. Shiller. and G. and Related Topics. Amsterdam. 64. 345-354. (1980). New York. Shub. New York. Shell. McGrawHill. Amsterdam. (1967). M.Selected bibliography 379 Seade. (1986). Smale. (1980). Sidrauski. 257-266. Szego. Massachusetts. K. 68..J.J. 549-563. (1967). Smale. New York. Equilibrium. Cambridge. J. "Differentiable Dynamical Systems". "Martingale-Like Behavior of Prices and Interest Rates". (1971). 65-94. North-Holland Publishing Company. With Applications and Historical Notes. Minneapolis. Sonnenschein. Shiller. 70. The Mathematics of Time: Essays on Dynamical Systems. Smith. 796-810. Minnesota. Stein. Senchack. "Capital Markets and the Dynamics of Growth". Journal of Economic Theory. Solow. "Inflation and Economic Growth". Journal of Monetary Economics. Sonnenschein. J. 1527. "The Dynamics of Spot and Forward Prices in an Efficient Foreign Exchange Market with Rational Expectations". Economic Processes.J. Sonnenschein. 747-817. Journal of Monetary Economics. 162-169.

Cambridge. (1980). (1973). North-Holland Publishing Company. Fundamental Problems in Statistical Mechanics VI. Stiglitz. (1978). Massachusetts. New York. "Observation of Complex Dynamics and Chaos". England. "Interpreting the Evidence on Money-Income Causality". Barenblatt. Joseph. J. England. 22. (1986). Massachusetts. Massachusetts. 1-34. (1984). Unemployment". Stiglitz. (1974). (1986). 36. "Measuring Business Cycle Time". Yorke (1969). D. J. Nonlinear Dynamics and Turbulence. Strauss. 851-866. GNP". "Detecting Strange Attractors in Turbulence". Taylor. working paper. Cambridge. G. Stock. 1377-1387. "Chaotic Dynamics and Bifurcation in a Macro Model".K. (1986a). Cambridge. Harvard University. Proceedings of the American Mathematical Society. 513-518. Tarr. A. Massachusetts. 45. eds. L. 41. A. Kennedy School of Government. J. (1985). Kennedy School of Government. (1985). Review of Economic Studies. ed. Swinney.G. working paper #2228. (1980). National Bureau of Economic Research. Review of Economic Studies. Young. Honkapohja. looss and D.B.D. 64. 165-183. Harvard University. Springer-Verlag. Uzawa (1969). Harvard University. Strauss. 315-333. Journal of Economic Dynamics and Control. Takens. 591-601. Takens. working paper. eds. "Liapunov Functions and Global Existence".G. Bulletin of the American Mathematical Society. Oxford: Basil Blackwell. and M. and J. Boston. Takens. 45. "Taxation. 3-15. MIT Press. (1983).S. Journal of Finance. working paper. H. J. Stutzer. Arrow and S. "Estimating Continuous Time Processes Subject to Time Deformation: An Application to Postwar U. "On the Numerical Determination of the Dimension of an Attractor".S. "Conditions for Unique Solution in Stochastic Macroeconomic Models with Rational Expectations". F. Pitman Advanced Publishing Program. Kennedy School of Government. J. Stock. in: K. "On the Irrelevance of Corporate Financial Policy".. Cambridge. and the Cost of Capital". (1965). Swinney. unpublished manuscript. . (1987). Dynamical Systems and Turbulence. American Economic Review. in: E. (1977). Takayama. "Rational Expectations Models in Macroeconomics". Cambridge University Press. 366-382. in: G. J. A. H. J. Massachusetts. Corporate Financial Policy. "Identifying Perturbations Which Preserve Asymptotic Stability". Stock. Stock. 353-376.D. Taylor. Summers. Summers. J. L. Watson (1987). Cohen. Journal of Public Economics. (1986b). "Does the Stock Market Rationally Reflect Fundamental Values?". and H.B. Stiglitz. Econometrica. "Some Skeptical Observations on Real Business Cycle Theory". 519-520. "Hysteresis and the Evolution of Postwar U. 71. Rand and L. in: D. J. 617-620. Frontiers of Economics. F. Amsterdam. Nagatani (1969). "Observations of Order and Chaos in Nonlinear Systems". eds. 898. 23-27. eds. Readings in the Modern Theory of Economic Growth.380 Selected bibliography Stein. Mathematical Economics. Lecture Notes in Mathematics. and U. and K. 10. "Stabilization Policies in a Growing Economy". Quarterly Review of the Federal Reserve Bank of Minneapolis. M. 2. Cambridge. 2. (1983).A. "Expectations and Stability With Gross Complements". Massachusetts. Physica. second edition. (1985).L. 391-425. Cambridge. ID. F. "Distinguishing Deterministic and Random Systems". J.

Asset Accumulation and Economic Activity. A. (1969). Turnovsky. translated by W. (1975). Turnovsky. Expectational Consistency. "Optimal Growth in a Two-Sector Model of Capital Accumulation". 33. J. 523-553. 13. Turnovsky. Illinois. International Economic Review. Shalit and A. Journal of Money. Journal of Public Economics. American Economic Review. (1964). Treadway. Schmitz (1980).J. (1982). and H. North-Holland Publishing Company. Econometrica.B. G.J. Vainberg. Scandinavian Journal of Economics. W. (1986)..J. Turnovsky. (1973). "On Rational Entrepreneurial Behaviour and the Demand for Investment". Reading. Variational Method and Method of Monotone Operators in the Theory of Nonlinear Equations.J. American Economic Review. John Wiley & Sons. New York. 273-309. and Macroeconomic Equilibrium". 213-218.J. Jaife. J. 15-29. and Consumer Welfare". 65. Buiter (1976). H. "Macroeconomic Dynamics and Growth in a Monetary Economy: A Synthesis". Econometrica. London. 1-26. J. Journal of Public Economics. "Perfect Foresight. G. (1974). 39. S. 48. Elements of Pure Economics. 79. Uzawa. Turnovsky. eds. 64. 183-212. (1978). (1980). R. in: G. Turnovsky. Thompson. "Time Consistency and Optimal Government Policies in Perfect Foresight Equilibrium". Tobin. Chicago. (1975). "Keynesian Models of Recession and Depression". in: J. and W. "Consumer's Surplus. 845-855. Journal of Economic Theory. John Wiley and Sons. H. 379-393. J. ed. Stewart (1986). Amsterdam. Structural Stability and Morphogenesis: An Outline of a General Theory of Models. 671-684. 260-270. and W. "The Distribution of Welfare Gains From Price Stabilization: The Case of Multiplicative Disturbances". Tobin. 161-194. (1974). Horwich and P. (1954). 31. H. Academic Press.A. Samuelson. "The Stability of a Disequilibrium IS-LM Model". Tobin. (1985). Allen and Unwin. "On the Dynamic Stability of Economic Growth: The Neoclassical Versus Keynesian Approaches". "The Monetary-Fiscal Mix: Long-Run Implications". "The Incidence of Taxes: A Dynamic Macroeconomic Analysis". Macroeconomic Analysis and Stabilization Policies. 10. 76. S. 227-239. .M. J. S. "Long-Run Effects of Fiscal and Monetary Policy on Aggregate Demand". 133-148.B. Burmeister (1977). (1965). Review of Economic Studies. J. England. Monetarism. Inc. S. L. Massachusetts. S. Stein. (1976). "The Rational Multivariate Flexible Accelerator". American Economic Review. 135-152. 36. "The Stability Properties of Optimal Economic Policies". "Existence and Stability of Rational Expectation Equilibria in a Simple Overlapping Generation Model". Econometrica. J. England.Selected bibliography 381 Thorn. S. Tillmann.R. Credit and Banking. "Money and Economic Growth". 136-148. Credit and Banking. Tobin. Cambridge University Press. S. Review of Economic Studies. (1969). 36. 333-351. Turnovsky. 1. Nonlinear Dynamics and Chaos: Geometrical Methods for Engineers and Scientists. (1971). Tobin..J. Price Instability. M. New York. Varian. Benjamin.T. (1977). University of Chicago Press. Trade. Treadway. Turnovsky. Walras.M. New York. 18. 1-24. (1977). Tobin.J. Journal of Political Economy. Uzawa. S. Stability and Macroeconomics. Brock (1980).J. H.A.. "A General Equilibrium Approach to Monetary Theory". Cambridge.A. Journal of Money. 17.B. and E. A. 195-202. 85.

(1973). Springer-Verlag. Journal of Mathematical Economics. 783-789. 40. Chicago. S. American Journal of Mathematics. "An Investigation of Transactions Data for New York Stock Exchange Stocks". "Imperfect Financial Intermediaries and Complex Dynamics". (1975). (1979). Groningen. Yoshizawa. Woodford. Wolf.A. A. M. 5. 639-647. "Recent Work on Business Cycles in Historical Perspective: Review of Theories and Evidence".V. Wintner. working paper. P. Methods of A. "On the Structure and Stability of Local Pareto Optima in a Pure Exchange Economy". 60-72. Swinney. "An Essay on Monopoly Power and Stable Price Policy". New York. (1987).I. A.M. "Does the Consumer Benefit from Price Instability". Swift. Weitzman.Y. American Economic Review. M. Holland. 58. F. Stability Theory and the Existence of Periodic Solutions and Almost Periodic Solutions. Zubov. 125132. 723-741. "Asymptotic Equilibria". "Anticipated Shocks and Exchange Rate Dynamics". J. Wu. "Determining Liapunov Exponents from a Time Series". Wilson.H. H. (1946). (1964). Waugh. Liapunov and Their Application.. Vastano (1985). Wood. (1985).J. 285-317. 602-614. Noordhoff. 68. (1944). 87. 16D. University of Chicago. 19. (1979). Quarterly Journal of Economics. R. and J. Journal of Economic Literature." Management Science. C. T. Graduate School of Business. 523-580. Journal of Political Economy.382 Selected bibliography Wan. "Duality Theory for Infinite Horizon Convex Models. Journal of Finance. 23. Zarnowitz. Illinois. (1978). 69. T. Physica. . Y. V. V.. Mclnish and J. 255-274. Ord (1985).

176. 237 Cauchy convergence criterion. 268-269 a-quasi-convex. 321 Characteristic equation. 211. 163-168 Corporate sector. 231-233 Correlation dimension. 344 Center. 226. 186 Balance sheet constraint. 68 polynomial. 337 Cambridge controversy. 301-312 Chaotic rational expectations equilibria. 263. 325 . 114 All bond financing. 303. 332-333 Averch-Johnson regulation ( A J ( v ) ) . 308-312 /3-convex. 84 Autonomous differential equation. 297-341 and anomalies. 242 BDS test. 170. 142. 248-250 All equity financing. 34 Absolutely continuous. 346 solution. 224 Complementarity. 196. 111 [see also Global asymptotic stability] local. 219 Continuation of solutions. 291 Arbitrage pricing models. 148 Adaptive expectations. 347 Asset pricing. 326 Consumer surplus. 68 roots. 190. 148 Bifurcation. 11-13 Continuity with respect to initial data and parameters. 12 Cauchy polygon. 324-325 and evidence for nonlinearity. 223 Canonical form. 222 Constant slope zone. 190. 133 [see also Time independent differential equation] Autoregressive conditional heteroscedasticity. 175 Ascoli lemma. 287 Cash flow. 120 Convergence of bounded trajectories. 332-333 and daily and weekly stock price changes. 250-252 Comparative statics (dynamics). 329 Capital deepening. 322-340 and macroeconomics. 57 [see also Local asymptotic stability] Attractive solution. 193 Adjoint equation. 170. 29 Cauchy sequence. 87. 115. 89-130 a-limit set. 37 Adjustment cost model. 212-214. 24. 232. 208. 79 Capital asset pricing. 329-331 and finance. 208. 130 Block dominant diagonal. 263. 281-287 Breakeven problem. 207-212. 200 a-convex. 9 Cauchy-Peano existence theorem. 9. 142. 329 Arrow-Debreu economy.INDEX Abel's formula. 329 Asymptotic stability global. 331-332 and autoregressive conditional heteroscedasticity. 325. 273 trajectory. 331-332 Anticipated event analysis. 68 Characterizations of steady states. 247-252 all bond financing. 248-250 all equity financing. 266. 215 Advanced stability methods. 281287 Convexo-concave technology. 250-252 Anomaly. 329. 210. 325. 83 Chaos. 261. 297-306 empirical tests of. 3. 306-312 elementary notions of. 153 Bounded function. 10. 312-322 and statistical theory for nonlinear dynamics. 214-219 theorems. 347 set. 171 Bubbles.

353-354 Cost of adjustment theory. 314-318 G. 41. 188. 260 informational. 147.384 Index of chaotic rational expectations. 190-193. 33. 57. 32 Picard-Lindelof theorem of. 317 First best regulation. 161. 132 Feigenbaum cascade. 347 continuous. 275 Curvature assumption. Polygonal path] Euler's relation. 196. 111. 190. 344 Domain of attraction. 336 Exchange rate. 237. 5 as a local property. 190 Critical behavior. 153 Differential games. 266. 275 economic meaning. 150 Gale equilibria. 202 General nonlinear nonquadratic problem. 39 examples. 10 continuity and. 227. 321 structure. 5. 316 Equilibrium manifold. 344 Fundamental matrix solution. 234. 241. 265-267 . 273 Correspondence principle. 123. 188. 174. 153 D-stability. 105. 120. 129.. 347 Equilibrium-disequilibrium adjustment process. 141. 127 Denison's Law. 249. 276 geometric meaning. 232 [see also Steady state] examples of. 322 Dependence on initial data and parameters. 261 Existence of solutions. 272 e-approximate solution. 299 Eigenvalue. 192-193. 200-201. 161-176 Focal point. 123 Dominant diagonal. 133. 343-344 uniformly bounded. 42. 51 Exponential asymptotic stability. 346 Evidence for nonlinearity. 195 manifold. 7 and initial value. 241 Equity value. 272 modified Hamiltonian. 307 Global asymptotic stability. 318 definitions. 83 Forcing function. 42. 204. 169. 300. 50 Future invariant. 313. 169 Euler polygon. 9 [see also Cauchy polygon. 262 Cournot oligopoly. 74. 306 Diffeomorphism. 105 existence of. 160. 39 definition. 79. 27. 154 Dirichlet function. 237. 286 Daily and weekly stock price changes. 98. 157 [see also Samuelson's correspondence principle] Costate variables. 139 Curvature matrix. 110 [see also Global asymptotic stability] General competitive equilibrium. 146 Decrescent. 139. 73. 326 Equicontinuous sequence. 125 Differentiability of solutions. 294. 7 Efficient markets. 157 Deterministic chaotic explanation. 243-245 sunspot. 238. 2. 63 Fads. 110-124. 249. 7 of linear systems. 219 Equilibrium solutions. 191 Duration. 23-25 Destabilization. 172 Decreasing returns. 19 Exp(AO convergence. 7 Domain. 282. 241 Decentralized regulated competitive equilibrium. 274. 267 Equity-debt ratio. 24. 68 EM. 207. 258 Current value Hamiltonian. 32 Function bounded. 336 Feedback form. 107.A. 127 Crowding out. 29 and discontinuity. 265 [see also Equilibrium manifold] Empirical derivative. 299. 265. 7 Cauchy-Peano theorem.S. 347 uniformly continuous. 139. 329-331 Excess demand function. 123. 221 Cost of capital. 139-140 Generic. 195 Dynamical systems. 203 Excess volatility. 324340 Debt-equity ratio. 232. 5-11.

146-147. 162 Hicksian stability. 119. 46-50 Kinematic interpretation. 86. 43. 60. 213. 170 left. 159. 79. 77 Klevorick problem. 32. 283. 14. 5. 297.. 146. 11 superior. 200. 331 Jordan canonical form. 214. 308 Lagrange stability. 52. 315 Industrial organization. 276 Interval extension of. 139. 60. 48. 223 Hamiltonian function. 158 Initial condition. 139-152. 206. 194 Household sector.A. 116. 300. 109. 100. 281 Liapunov method first(direct). 351 January effect. 293 Global social optimum. 128. 234. 277-281. 57 [see also Instability] Liapunov exponent. 188 Indefinite function. 353-354 Hamilton-Jacobi equation. 135-138 . 155 Hamiltonian orthogonal trajectories. 216. 188. 31-52 Jordan decomposition. 119. 190 Incidence of taxes. 232. 90 Indeterminacy. 121. 190. 118. 305 Linear quadratic approximation. 112. 186 Government sector. 274. 38-46 Linear homogeneous system. 268 Li and Yorke's theorem. 116. 324 Instrument vector. 306. 126. 7172. 94-95. 289 Heterogeneous consumers. 43. 90 examples. 146-149. 92. 93-95 for nonautonomous systems.Index Global asymptotic stability Cont. 217 Linear quadratic approximation to general problem. 3. 3 value. 272. 90 Liapunov stability theorems for autonomous systems. 114. 114. 86. 66. 57 [see also Local asymptotic stability] stability (local). 11 maximal. 307 Liapunov function. 191. 132 Internal revenue code. 51 Linearization of nonlinear system. 102-103. 118. 57 [see also Local stability] instability (local). 210-211. 278. 302 set. 115 Instability. 127. 103 Jordan blocks. 190 Hotelling rule. 108. 114 Inverse optimal control. 206. 326 Gronwall's inequality. 121. 50. 238 value problem.S. 291. 26. 144-145. 162. 153. 117. 43. 32. 95. 129 L. 129 second. 123-124 theorems. 3. 122 in the plane. 128-129. 153. 153 as distance. 294 385 Jacobian matrix. 51 Linear nonhomogeneous system. 254 Increasing returns. 49 Jordan decomposition. 57 [see also Local asymptotic stability] Learning. 150-151. 208. 90 Graph. 136. 266-267. 127. 231. 90. 144 Linear differential equations. 11 right. 228-230 Imperfect stability. 51 Inner product. 345 Gross substitutes. 111. 3 Grassberger Procaccia diagram. 134-135. 32. 137-138. 339 [see also Unstable and Local instability] Instantaneous unpredictability. 180 Kolmogorov entropy. 46-50 with constant coefficients. 322. 204 Hahn problem. 11. examples. 240 Internal supply curve for investment. 244 Gradient. 142. 215. 253. 103. 3. 190. 233-234. 313 Liapunov asymptotic stability (local). 307 time. 244. 106-110 Lienard equation. 120-121 Invariant measure. 117 Limit inferior.

134. 90 semiorbit. 347 triangular. 77-84 uniqueness of solution of. 32 variation of constants for. 181-184 Multivariate test. 239. 15-18 Local asymptotic stability (Liapunov) definitions. 118. 69. 201 nonsingular. 241 Modern approach to differential equations. 225-269. 255 perfect foresight. 68. 71-72. 37 and forcing function. 233-234 household sector. 201 limiting set. 50 homogeneous. 66. 108 Local stability vs. 257-258 theorems. 339 Market value. 38-46 Lipschitz condition. 33 stability of. 243-245 macroeconomic structure. 236-243 perfect foresight equilibrium. 127 theorems. 33 orthogonal. 36. 101. 218. 103. 159-197 Modigliani-Miller propositions. 248. 354 Mean reversion of stock prices. 299. 154-155. 228-234 corporate sector. 32. 97-98. 260 Multiple optimal paths. 190 similar. 51 initial value problem of. 32. 230-233 government sector. 50 Multiple equilibria. 263-265 steady state. 350 transpose. 215 Multiple eigenvalues. 65 principal matrix solution. 43. 46. 94. 272 Monetary growth constant rate. 63.236 optimal conditions for firms. 268-269 characterizations of steady states. 227. 133. 350 dominant diagonal. 45. 103. 114 semidefinite. 189. 69. 350 trace. 15-18. 33 quasidominant diagonal. 106-110 Local stability (Liapunov) definition. 312-322 offer curve and Gale equilibria. 58. 348 singular. 274-276 diagonal. 60. 110. 70. 59-67 two dimensional.386 Index Macroeconomic structure. 90. 228-230 Magnification effects. 351 negative definite. 325 Matrix curvature. 234-236. 50 Jacobian. 32. 93-94. 249 optimal rate. 153 exponent of. 113 Linear systems. 47 existence of solutions of. 234. 68. 97. 66. 44. 32 fundamental matrix solution. 38 with constant coefficients. 109. 57 examples. 314-318 stock market prices. 43. 106.28 Modified Hamiltonian dynamical system. 89. 256 stability of rational expectations. 339 Negative definite. 32 Lipschitz constant. 57 for autonomous systems. 247. 332-333. 293 Local instability (Liapunov). 349 Maximum principle. 43 nonhomogeneous. 33. 32-39 adjoint equation of. 190-192 Lotka-Volterra system. 32 and input function. 127. 273 examples. 2. 32 examples of. 57. 74-76. 33. 245-247 unanticipated event analysis. 336. 27. 33. 259 Mortensen's theorem. 318-322. 58. 305 anticipated event analysis. 93-106 for nonautonomous systems. 43. global stability. 62. 267-268 . 99. 39 fundamental. 247-252 equilibrium structure and system dynamics. 324-340 Macroeconomic modelling. 228-234 optimal conditions for households. 20. 200-201. 71-72. 260 Tobin's. 136. 350 principal. 301 Macroeconomic policy. 348 symmetric. 105 Macroeconomic chaos. 276 Martingale. 37. 338 Microeconomic dynamics. 41. 51 perturbed. 231 Marshallian demand curve for capital services.

219-220. 131-158 dividend policy. 154-155. 188. 163-168 multiple paths. 140. 336 Quadratic form. 126 Nondegeneracy condition. 9 Perfect foresight equilibrium. 125. 154 Noncritical behavior. 182 Phase space. 319 Path. 19 Poincare-Bendixson theory.A. 190-192 Riccati equation. 113 Orbital stability. 9 Polygonal path. 98. 87 Picard iterates. 189 Principal matrix solution. 68. 101. 234-236 control and stability.A. 149 Saddle point. 234-236. 162. 267. 27. 159. 272 steady states. 171 Pure fads. 299. 162-176 second best modes. 29. 33 Nonuniqueness. 268 nth-order homogeneous differential equation.Index Neoclassical economic growth model. 305 Noncooperative equilibria. 148 limiting set. 239 economic growth. 262. 161. 183 Regular economy. 313 Overshooting. 90.S. 121 Routh-Hurwitz criterion. 314. 215 Polygon Euler. 165 Non equilibrium. 139-140. 181-184 path. 204-206 Optimal linear regulator problem (OLRP). 107.. 256. 68. 193-194 Perturbed linear systems. 1-29 Overlapping generations. 104. 130 Ordinary differential equations autonomous. 261. 28 properties of solutions. 168. 164. 340 Noisy chaos. 186 Nonlinear nonquadratic problem. 130 Policy function. 313. 125. 248. 157 Newtonian paradigm.S. 322 Pareto optimum. 135. 130. 176-186 Rational expectations. 25. 212 Regular stability. 149 Nonsingular matrix. 31-52 modern approach to. 155 Right hand maximal solution. 3 linear. 114 semidefinite. 168 Neoclassical theory of investment. 133. 321 Real business cycle. 65 387 Phase diagram. 351-352 Radially unbounded. 256. 9 Positive definite. 33 Principle of optimality. 271 economic growth under convexo-concave technology. 18 [see also Successive approximation] Picard-Lindelof existence and uniqueness theorem. 129 Price instability and welfare. 255 solution. 8( 110. 75 Offer curve. 149 Orbit. 77 PHASER computer program. 248. 175. 3. 268. 274 0. 263. 314. 153. 137. 106. 260. 259. 162. and G. 236-243 conditions for households. 176-180 Relationship between L. 122. 113 Practical stability. 123 Ramsey regulation. 9 Cauchy. 120. 284 Public utility pricing. 319 Perfect stability of first kind. 75-77. 77. 2. 134. 71 Properties of differential equations. 84. . 87 Poisson stable. 171. 133 rate of monetary growth. 161. 28. 75 order. 226. 146. 335 Regular dynamics. 239 conditions for firms. 107 semiorbit. 1-29 [see also Solutions] Pseudoconcave. 161. 265 Regulation. 298 Permanent income hypothesis. 190 Period doubling. 353 Principle of small oscillations. 160 first best modes. 266. 314-316 Optimal capital structure. 28 nth-order. 160.

259-260. 190 in the first approximation. 147 State space. 212-214. 130. 57 . 89-130 notions in rational expectations. 273 Speculation. 336 Speculative bubbles. 157 imperfect. 24. 287 optimal steady states. 313 Saving rate. 176-180 Self-fulfilling expectations. 82-83 Stable tangent node. 80 Stability and continuous dependence of solutions on initial data. 77-84 orbital. 66-75 Stability of optimal control. 191 expectations and. 215. 131-158 of two dimensional linear systems. 53-87. 263-265 Stability of linear systems with constant coefficients. 154-155. 62. 14 maximal. 125-126 Stable node (or focus). 298 Social dynamics. 110. 271-295 in investment theory. 134. 23-25 differentiability of. 67 weak. 265. 71 Lagrange. 79. 59-66 of optimal control. 266 as a methodological principle. 147. 211 Shuffling. 87. 260. 5-11 infinitely many. 77 variable. 98. 221. 115. 214-219 capital deepening. 13-19. 57-58. 129 Stability in capital theory. 130 practical. 130 perfect. 123. 201-204 Stability in rational expectations. 70 Slow moving parameters. 7 equilibrium. 308-312 Steady state. 105. 82 Stable manifold theorem. 261. 56 and permanent income hypothesis. 202 revised. 24. 268. 199. 49 Simple zero. 89. 27 nonequilibrium. 333 Solutions attractive. 191 uniform asymptotic. 226 Separable Hamiltonian. 281-287 Stability in investment theory adjustment cost model. global. 57. 65. 110-124 D-stability. 25. 104 Simple discontinuity. 75-77 saddle-path. 43 of nonhomogeneous linear system. 190-192 methods. 204-206 Samuelson's correspondence principle. 263-265 of competitive equilibrium. 64. 3 dependence on initial data and parameters. 55. 132 Static first best regulation. 86 total. 190 Poisson. 18-23. 157. 83 Stable improper node. 153. 84 bounded. 129 Routh-Hurwitz criterion for. 27 uniqueness of. 57-58. 247-252 Samuelsorfs correspondence principle. 271-295 convergence of bounded trajectories. 186 nonuniqueness of. 84. 298. 245-247. 32. 153 structural. 161. 201-204. 273 continuation of. 268 of homogeneous linear system. 66-67 uniform. 258 Second best regulation. 224. 43 optimal. 204-206. 261 stochastic.388 Index asymptotic (global). 352 vector. 193 asymptotic (local). 232 existence of. 306-312 BDS test. 11. 149. 199-224 in oligopoly. 204 Sarkovskii sequence. 174. 155. 175 Statistical theory for nonlinear dynamics. 11-13 continuity with respect to initial data and parameters. 210. 190 in capital theory. 153 e-approximation. 120 definition. 131-158 Stationary solution. 129 local vs. 207-212. 272 stability methods of.326 Significant behavior. 7 Simple eigenvalue. 206. 53-87 successive approximations. 337 Spiral sink. 73-74. 190-193 of linear systems. 193 hypothesis.

82 saddle point. 82-83 Unstable tangent node. 153 Stock market. 37. 66. 57. 188-189 Unstable improper node. 38 Vector field. 80 stable tangent node. 299 Stochastic stability. 229 Unanticipated event analysis. 259-260. 71. 13-19. 193 Taylor's theorem. 344 Time derivative. 135 Tinbergen controllability condition. 158. 245-246. 249 Successive approximations. 340 Transversality condition. 149. 267-268 Uniform asymptotic stability. 79 cases. 243. 129 Weekly stock price changes. 80 Trajectory derivative. 57-58. 86 Stochastic economic models. 83 unstable tangent node. 74-75. 133 scale. 191 Trading volume. 78 spiral sink (or stable focus). 253. 324-340 w-limiting set. 95. 27 T-bill returns. 105. 323-324 stationary optimal linear regulator problem. 82 stable node. 226. 67. 256 independent differential equations. 18-23. 21 Weak stability. 82 Unstable node (or focus). 80 unstable focus (or source). 3. 205. 12. 58-59. 83 stable improper node. 91. 29. 216. 107. 97. 156. 232 Stock returns. 169. 170 Value of the firm. 6. 271 Variation of constants. 108. 110 Uniqueness of solution. 329. 194 Valuation formulae. 108. 66-67. 69-71. 324-340 Stock market crash. 160. 80 Urban economics. 351 state. 103. 108 examples.Index Structural stability. 91. 291 Ultrarationality. 117. 324 Stockholder welfare. 80-82 center (or focal point). 192. 242. 62. 130. 316 Super-neutrality. 110 Uniform stability. 353-355 Two dimensional linear systems. 165. 268. 155. 328 Tatonnement. 338 Sunspot equilibria. 132 norms. 32. 324. 318-322. 238 Value of the initial stock. 65. 155 canonical form. 107 inconsistency. 77 nonlinear case. 83 kinematic interpretation. 64. 66. 57-58. 114 389 . 257 Total stability. 132 Volterra's integral equation. 174. 169. 3 instrument. 273 Unstable. 77-84.