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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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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. 3. Introduction Linear systems Basic results Linear systems with constant coefficients Jordan decomposition Miscellaneous applications and exercises Further remarks and references Chapter 3. Introduction 2. Definitions . 2. . 9.CONTENTS Preface Acknowledgements Chapter 1. 6. 7. 4.3. 6. Basic properties of differential equations 1. 7. 4. 5. 8. Stability methods: an introduction 1. 2. 5. Linear differential equations 1.

9. 5. 7. 2. 5. 7. 2. 6. 6. 4. 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. 6. 10. 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. 5. 8. 4. 4. 3. 3. 5. Stability of optimal control 1. Microeconomic dynamics 1. 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. 8. 3. Advanced stability methods 1. 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 .viii Contents 3. 2. 4.

3. 6. Macroeconomic policies 1. 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. Further remarks and references 187 196 Chapter 7. 7. 10. 11. Convergence of bounded trajectories A more general result Miscellaneous applications and exercises Further remarks and references 271 271 211 281 287 292 294 . 4. 6. 2. 2. 5. Introduction A first result on G. 2. 4. 8. 3.A. 9. 8. Stability in investment theory 1. 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.Contents ix 6. 6. Stability in capital theory 1. 5. Miscellaneous applications and exercises 7. 5. 4.S. 3.

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 . Introduction to chaos and other aspects of nonlinearity 1. 5. 4. 6.X Contents Chapter 10. 2. 3.

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

such as Hartman and Olech (1962). Although conditions of the . Chapter 3 gives numerous definitions and examples of stability notions. chapter 5 surveys the stability contributions of mathematical economists. 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. 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. and discusses the stability properties of linear dynamic systems. the emphasis of chapter 1 is on properties while chapter 2 balances abstraction with concreteness and illustrates some problem solving techniques. all of which took place since the mid 1970s. the linearization of nonlinear systems. Samuelson and others. the recent results of several mathematicians. Furthermore. 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. It also gives a comprehensive presentation of two dimensional systems and their phase diagrams. 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. The notion of stability in economics. The last thirty years have seen numerous papers on stability analysis applied to economic models. However. introduced by Walras and Cournot and later studied by Marshall. The above is not all we have to say on stability methods. This chapter unites the economic analyst and the mathematician at the forefront of stability research and is used as a foundation for later chapters. While chapters 3 and 4 are a collection of stability results contributed by mathematicians that were essentially completed prior to 1965. chapter 3 illustrates the significance of linear systems. Hicks. Chapter 4 continues on the topic of stability at a more advanced level. Liapunov theory for local stability and global asymptotic stability receive the bulk of our attention.xii Preface modern approach endeavors to obtain information about the whole class of solutions and their properties. This chapter surveys several important methods of stability analysis of optimal control problems. Thus. was not completely formulated until the late 1950s in the papers of Arrow and his collaborators. the counting and examination of roots of characteristic equations while chapter 4 is more topological in nature. An additional important contribution is chapter 5. In other words.

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

stability analysis and chaotic dynamics. second the relationships describing the private sector are derived from explicit optimizing procedures by households and firms. Chapter 8 extends some of the recent macrodynamic models in two ways. nor are there any books with such a comprehensive coverage of applications. Chapter 9 applies the results of chapters 1 through 5 to capital theory. All chapters conclude with two sections on miscellaneous applications and exercises and further remarks and references. Many parts of this book can be understood by someone with a good background in analysis. 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. The equilibrium structure and dynamics of this model are studied in detail and the stability of a simplified case is analyzed. Furthermore. 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. A capital theory generates a capital-price differential equation by using the Pontryagin maximum principle to write the necessary conditions for an optimal solution. 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. it specifies a more complete corporate sector that such models usually contain and. There are currently no books available covering all the methods presented here. Finally. . This chapter analyzes the stability properties of such modified Hamiltonian dynamical systems. This process generates a system of differential equations that is called a modified Hamiltonian dynamical system.xiv Preface modification is proposed and utilized to obtain stability results in investment models. The Appendix cites numerous definitions and theorems to help readers with insufficient mathematical background and gives references for further study. An attempt has been made to keep the mathematical background to a minimum. In total the reader will find a valuable guide to over 500 selected references that use differential equations. First.

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

Indiana University and Loyola University of Chicago and we are grateful to all students who have read and commented on the manuscript. Brock. Brock dedicates his portion of this book to his wife Joan "who makes his work possible and his life fun" and A. G. Finally. patience and joy". Stanford University. A. W. A. .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. Malliaris dedicates his portion to his wife Mary Elaine and their children Maryanthe and Steven for "their love. Parts of the book have been used by numerous students at the University of Wisconsin.

On the one hand. First. with its emphasis on properties of solutions rather than on methods yielding explicit solutions. In this sense. Alternatively. Introduction The study of ordinary differential equations may be pursued from at least two broadly distinct approaches. Hirsch and Smale (1974. There are at least three reasons justifying our approach in this chapter. putting aside all endeavors to master skillfully a myriad of methods yielding closed form solutions. one may endeavor to learn a large number of methods and techniques by which certain elementary equations can be solved explicitly. ix) 1. differentiability of solutions and stability. More specifically. the important property of stability is introduced in this chapter and then left to be treated in some detail in the following chapters. dependence of solutions on initial data and parameters. the notion of stability and its applications both seek to obtain information about a property of the whole class of solutions. we discuss in some detail the following topics: existence and uniqueness of solutions. p. one may concentrate on obtaining information about the whole class of solutions and their properties. 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. the present chapter's emphasis on properties will prepare the . Actually. unify and give force to those areas.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.

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

x0). x0) is called the initial condition. In other words. 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. 0(0) for each ?e /. Example 2.6) we obtain a solution of the form .2) or (2.1) consists of finding an interval / containing t0 and a solution 0(0 of (2. To illustrate the concepts of a solution to a differential equation and the initial value problem. The point (t0. (2.4) can be pictured as curves in the x-space with t as a curve parameter. (2. Consider the differential equation where a is a real number.1) prescribes a slope f ( t . Let (t0.Basic properties of differential equations 3 and also then we say that (f>(t) is a solution of the differential equation (2. a solution 0(0 is a curve whose direction at any point t e / coincides with the direction of the vector field. Integrating (2. Such a curve is called a path. The space of the variables x which contains the paths is called the phase space of (2. In R2. x ) e D and a solution (f>(t). is a function whose graph has the slope f(t. we consider two examples. tel. By graph we mean the set of all points (t. Geometrically.5) means that we are searching for a solution passing through the point (t0. Here/(t. the solutions 0(0 of (2. This problem is denoted by We say that t0 is the initial point or initial time and x0 the initial value. In other words. Geometrically. x ( t ) ) at each point (t. geometrically.1) such that 0(t 0 ) = x0. x) = ax so that the vector field depends only on the variable x. x 0 )e D.1) on 7. the paths are the projections of the graphs on any hyperplane with t being a constant.4).1. 0(0) for t e /. x) e Rn+l to the vector x e R". The function / in (2. An initial value problem for (2.1) is called a vector field on D because it takes the vector (t. See also section 6 of chapter 3.

As an illustration. (2. In the special case when t > 0 and a > 0. its solution in (2. Assume that c > 0.10) for t G(-C. for c an arbitrary nonzero real constant and 0(0) = -1/c. oo). Note that (2. assume that t0.10) for t G (-c.9) denotes the initial amount invested.11) is a solution of (2.2.8) specifies both the instantaneous interest earned by x dollars and the initial amount of capital.6). Assume that x 9=0 and integrate (2. In this special case.0 and x(t0) = x(0) = 1.4 Differential equations. in addition to (2.9) is a specific solution passing through the point (0. stability and chaos in dynamic economics where c is an arbitrary real number.9) yields at time t the total value of $1 earning instantaneously compounded interest for t periods. so that the differential equation is autonomous.6) because For the initial value problem. We write the initial value problem as and its solution is stated as The solution in (2. Thus the 1 in (2.7) is continuously differentiable for t e R and satisfies (2. Then is a solution of (2. 1). Example 2.7) denotes the current value of a sum of capital c with instantaneously compounded interest.6) can be used to denote instantaneous interest earned by an x amount of dollars. we need to specify a certain point t0 and the corresponding value x(t0). We find that -x l = t + c. Its solution in (2. Consider the differential equation Here f(t. the initial value problem (2. oo) because it is continuously differentiable in this interval . Observe that (2.10) in the following manner. x) = x2.

Assume that f ( t . x) = x2 is a continuous function on the whole real line.11) is a solution of (2. consider From the preceding analysis. In general. Note that if c = 0. 4>(t) . Actually at t = 0.12) to then the solution becomes for te(—oo. we conclude this section with a useful lemma.Basic properties of differential equations 5 and also If we assume that c<0. the continuity of f(t.11) is a solution for f > 0 . the method usually followed consists of replacing the differential equation by an integral equation. (2. we conclude that is a solution for t e (-1.11) is not a solution for the differential equation for t G R because <fr(t} = —\/1 is not continuously differentiate on the real line. x) in (2. in order to establish the existence of solutions. if c = 0. 1) since now c = — 1. -c). This observation suggests that existence of a solution is a local property. then (2.6) and (2.10) allows us to integrate in order to find a solution to the differential equation. For an example of an initial value problem. then (2. This illustrates that a change in initial values may affect the interval of the existence of a solution.10) for t£ (-00. Therefore. x) is defined and continuous on some domain D for t G / and that . In the two examples above. However. although/(f.-1/t is discontinuous and does not qualify as a solution. This example illustrates that. If we change the initial value problem in (2. its solution is restricted to a subset of the real line which depends on the value of the constant c. oo) since c = 1.

15). Furthermore. we know that by differentiating (2. No loss of generality is suffered by treating this simple case. then the initial value problem x-f(t. by putting t . Existence Consider the first order differential equation where / is a real-valued continuous function on a domain D c R2. that is. We summarize this analysis in Lemma 2.1. for any continuously differentiable function x ( t ) of the form (2.15) yields the initial value problem.15). we obtain Volterra's integral equation Note that x ( t ) in (2. The analysis in this section proceeds in terms of the first order differential equation. x) results and thus (2. x(t0)-x0. t E I is equivalent to Volterra's integral equation 3.6 Differential equations. all theorems and proofs can be generalized by essentially replacing absolute values by vector norms. Xo) ED. stability and chaos in dynamic economics (t0. . By integrating (2. x). Conversely.5) since x ( t ) is continuously differentiable and satisfies (2.15) is a solution of the initial value problem in (2. x) is continuous. From the continuity of f we know that its integral exists.5) on some open interval I including the point t0.t0 we immediately obtain x(t0) = x0. x=f(t.2) between the limits t0 and t. If the function f ( t .

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

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

t0+a]. 2 . Let {en}.8) yields which means that the sequence {<£„} is uniformly bounded. Thus {</>„} is a sequence of en-approximate solutions that is both equicontinuous and uniformly bounded on a bounded interval [t0-a. From the initial point and the initial value (to. :c)|<M. Repeating the same process a finite number of times. k = 1. the resultant path <f>(t] will meet the line t .1 guarantees the existence of an e n -approximate solution. t 0 + a ] t o a. The path will lie between the lines in (3. Furthermore.3). .t0 + a. x0). denoted as <£„. x 1 ). Of course.3) on | f . lemma 3. Let us move on to the second step towards establishing an existence theorem. 2 . We wish to conclude that the sequence {</>„} is equicontinuous. Our goal now is to construct a sequence of e-approximate solutions and show that these solutions converge to a solution of (3. .Basic properties of differential equations 9 [t0 — a. Note that (3. we plan to use lemma 3. with slope f ( t 1 . X1) up to its intersection with t — t2. be a monotonically decreasing sequence of positive real numbers such that e n .7) for s = t0 we get since \t-t0\<b/M. construct a straight line with slope f(t0. this construction specifies the interval of existence which is \t .6) by definition of a and the fact that |/(f. or Cauchy polygon. tQ+a]. converging uniformly on [t0 —a. The e. This follows immediately from the construction of (j)n because for t and se[t 0 . Furthermore. of {</>„}. . where the first line ends. t0].1 and we do so immediately.0 as n-»oo. for the initial value problem in (3. Then construct another straight line starting at (t 1 .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 .f 0 | < o such that tf>n(t0) = x0. . t0+a]. applying (3. By the Ascoli lemma in the appendix. This concludes the proof of the lemma. limit function . Such a finite number of straight lines is called a polygonal path or an Euler polygon. For each en. deduce that there is a subsequence {<pnk}. . x0) until this intersects the line t = t1. One can verify that 4>(t] is the required e-approximate solution.t0\ < a. . . n — 1.

Since / is uniformly continuous on R and <p n k -»0 as fc-»oo uniformly on [t0-a. Furthermore. t0+a] we have Therefore. in the limit (3. Also.9). t0+a]. it follows that f(t. To show that </> is a solution to (3.10 Differential equations.4>(t}} uniformly as k->oo on the same interval.9) becomes which verifies that 4>(t] is a solution.1. (Cauchy-Peano existence theorem.3) we let and we write the e^-approximate solution as an integral equation of the form Choose a subsequence {</>nJ of (3.4>nk(t}}^f(t. by definition of An(t] for t E [ t 0 — a. stability and chaos in dynamic economics denoted by <£. note that cf> is continuous because each </>„ is continuous. Theorem 3. x) is a con- .) tinuous function on the rectangle R. We have proved an existence theorem. where If f ( t .

For an illustration. see exercise (4) in section 8.3) on an interval /. Continuation of solutions Theorem 3. Let </>(0. then the sequence of sn-approximate solutions can be used to construct this solution. Second. Below we give a precise meaning to the concepts of a continuation of solutions and extended interval. and if ifj(t) = <f>(t) for re /. We will see. and we explore the conditions under which such a continuation is possible. 1). It is mathematically interesting and in some applications it becomes important to know if solutions can be continued on an extended interval. If ijs(t) is also a solution of (3. however. then 4>(t}.1. then we say that ijs(t) is a continuation of (f>(t) and J is called an extension of /.1 cannot in general give all such solutions of the initial value problem. .1 assures us that a solution exists for the initial value problem on some interval /. First. If there is no such ifr(t). with the maximal interval of existence being (—00. 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. Its solution <f>(t) = l / ( l — t) is maximally continued. Example 4. 4. it is impossible to extend it to (-00. the choice of a converging subsequence is necessary to establish existence of a solution. Note that at t = l. there may exist polygonal paths {(/>„} which diverge everywhere. only under the stated assumptions a solution exists.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.14) where x = x2 and x(0) = 1. To illustrate these concepts consider the initial value problem in (2. therefore.(f>(t) becomes unbounded and. 1].1 is not helpful in showing how to construct a solution. Put differently. be a solution of the initial value problem in (3. te I. in section 6 that if we know the solution is unique. the method of construction in the proof of theorem 3. theorem 3. the existence theorem claims that. where / contains properly /. Finally. tzl is called a maximally continued solution and / is a maximal interval of existence. therefore. if more than one solution exists.3).

12 Differential equations. t e (a. 6). x) be continuous in a domain D<^R2 and suppose that f(t. that is. &)• Actually. b]> is a continuation of 0(0. Define <f/(t) as follows Then «A(0. x(t0) = x0 on an interval (a. Furthermore. 6). t e ( fl . the continuation can be extended by using (6.0 ) ) e D. (Continuation theorem. Similarly we write t -» b — 0 to mean that t approaches b from the left. 6) of the real line. To show that 0(6 — 0) exists. we write t -> a + 0 to denote that t approaches a from the right. From (4. 0 ( 6 . then Here M is the bound of f on D. then the limits 0(a + 0) and 0 ( 6 — 0 ) exist. 0(6-0))£ D. Theorem 4. x). Next. b). |f| < M <oo.1) as w and u approach b from the left. stability and chaos in dynamic economics Consider the finite interval (a.) Let f(t. if (b. we use Volterra's equation for t0 and t e (a. then 0 ( w ) — 0(u)-»0 which implies by the Cauchy convergence criterion that A similar argument establishes the existence of 0(a+0). and similarly if (a. If 0(0 is a solution of the initial value problem x = f(t. b). we define We are now prepared to state the next theorem. ' e ( a .1. suppose that (b. Note that if a<u<v< b. . then 0 can be continued to the right of b. then 0 can be continued to the left of a. 0(a + 0)) e D.0(6 — 0)) as an initial condition. For t e (a. Proof. x) is bounded on D. For a function </>(0.

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

Our purpose is to use the added restriction about df/dx to show that 4>(t) = ij/(t) for te[t0. For f(t. To show uniqueness we assume that (f>(t) and^(f) are two solutions.1. we conclude that at least one such solution exists. Theorem 5. It is therefore both necessary for applications and interesting mathematically to uncover restrictions that will guarantee uniqueness of solution. x)| and a -min(a.1). Proof. stability and chaos in dynamic economics The above example illustrates how a fairly simple initial value problem has infinitely many solutions.1 can help us discover what is wrong with the initial value problem in (5. From the continuity of f ( t . Then the initial value problem has a unique solution for te[t0. be continuous on the rec- with a and b positive and let M = max|f(t. t0+a]. We obtain. 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. using the mean . Example 5. x) = 3x2/3 we compute which becomes unbounded as x -> 0.1. b/M). 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.14 Differential equations. To remove this difficulty and obtain the uniqueness property. Upon reflection we conclude that the partial derivative df/dx does not exist at x = 0. (Uniqueness. we state and prove the next result. x) and theorem 3.) Let/ and df/dx tangle R.t0+a].

x) and (t.4) to get In (5. y) in D . U(t0) — Q.5). Integrate (5.Basic properties of differential equations 15 value theorem. x) be defined on a domain D of the (t. uniqueness of solutions can be established under a condition that is less restrictive than the existence and continuity of the partial derivative df/dx. which in turn implies that 10(0-^(01 = 0 because This completes the proof. set and rewrite (5. This implies that U(t) = 0. Let/(f.To verify this claim. We claim that this inequality implies that 0(0 = <MO.2) as with l/(f 0 ) = 0. Such a condition is called a Lipschitz condition and is defined as follows. Actually. x} plane and suppose that there exists a positive constant k such that for every (t.

10) for the initial value problem in (5. Example 5. if df/dx exists and is continuous on the rectangle R in (5. then/(f. Consider the initial value problem and let the rectangle R be We wish to show that/( t. x) is continuous on the rectangle R. y) in the rectangle R of (5.11). x) in the rectangle R in (5.6) is called the Lipschitz constant. Therefore. we conclude that the hypotheses of theorem 5. furthermore. by (5. we have which implies by placing absolute values in (5. given by with a and b positive and. From the continuity of Bf/dx on the rectangle R. x) = tx2 satisfies a Lipschitz condition. We immediately observe that if f ( t . This holds because the continuity of Bf/Bx on the closed and bounded rectangle R implies that Bf/8x is bounded. x) satisfies a Lipschitz condition. x) satisfies a Lipschitz condition in the specified rectangle R with 2 as a Lipschitz constant. This follows immediately because Therefore. stability and chaos in dynamic economics we then say that / satisfies a Lipschitz condition with respect to x.2. x) and (t. f(t.7).8) that for all (t.7). .1 are sufficient to imply that/( J.7). x) satisfies a Lipschitz condition. and k in (5. We write for some positive k and (t.16 Differential equations.9) and using (5.

Now we note that a Lipschitz condition can be deduced under slightly weaker hypotheses. a rather simple example illustrates that even when a function f(t.6) is not satisfied. Specifically.1) does not satisfy a Lipschitz condition on the rectangle R where This is so because. Some additional remarks about the concept of the Lipschitz condition seem desirable. k a positive constant. x): t\ < 1 and |x < 1}. we have already shown that if f(t. then becomes unbounded as x->O and (5. x) satisfies a Lipschitz condition. x) satisfies a Lipschitz condition.12) and using the assumption of the boundedness of df/dx. for each fixed t£ [t0 — a. x) satisfies a Lipschitz condition with 1 as a Lipschitz constant because However.Q)/dx does not exist for t^O. and if df/dx exists and is continuous on the same rectangle R. we must require that D be convex in order to be able to use the mean value theorem. Consider the function on R = {(t. The function f ( t . Taking absolute values in (5. we conclude that f(t. then a direct application of the mean value theorem of differential calculus shows that f(t. it does not necessarily follow that df/dx exists. then f(t. It is worth pointing out that if the rectangle R is replaced by a closed domain D. if x > 0. the mean value theorem implies that for some u e (x. . x) satisfies a Lipschitz condition. >>). By inspection we see that/(/. x) satisfies a Lipschitz condition.12) lies in D. t0+a].7) and that df/dx exists and is bounded on the same rectangle R with |d//dx|< k. with k as the Lipschitz constant. Second. x) is continuous on the rectangle R in (5. df(t.Basic properties of differential equations 17 Example 5. Such convexity guarantees that the point u in (5. First.3.7). x) is continuous on the rectangle R in (5. x) = 3x 2/3 of the initial value problem in (5. Assuming that f(t.

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

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

t0+a].6) to get This analysis verifies (6. x) satisfies a Lipschitz condition with a constant k and the induction assumption in (6.5) follows immediately from (6.4). (6.8) is uniformly convergent on [t.3) for n>\. Assume that for n > 1. Use both the hypothesis that f(t. that is.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 '°. and thus (6.20 Differential equations. stability and chaos in dynamic economics For n — 0. assume For the last step in the induction note that which is obtained from (6. the series . (6. Therefore.5) holds.

Example 6. A term by term integration in (6.5) shows that for te[t0. To show how the process of successive approximations works to produce a solution of the initial value problem. x) on the rectangle R implies that/(f. (f>n(t)) converges uniformly to/(r. <f>(t) = $(t). to prove uniqueness. This proves the theorem. where converges uniformly to a continuous function 4>(t) on [t0. It is easy to verify that the limit function </> (t) is a solution since the uniform continuity of f(t.Basic properties of differential equations 21 is absolutely and uniformly convergent on [t0.1) on [r 0 . As HH>OO we know that 4>n(f)-»0(0 uniformly and (6. t0+a~\ and n = 0. t0+a] and the partial sum <f>n(t). that is. 1. t0+a] and write An induction similar to (6. 0(0) as n-»oo.if/(t)\ < 0. Consider the initial value problem This initial value problem is equivalent to Volterra's equation .3) yields Finally. let ij/(t) be another solution of (6. we provide two examples.11) yields \(f>(t) .1. t0+ a].2.

Example 6. 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.2. stability and chaos in dynamic economics and yields <f>0(t) -1. ^ n (r)^e'.22 Differential equations. But as n-»oo. which is the required solution for all real t. Next. . we compute <£i(f) to get For </> 2 (0 we have In general.

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

pp. we can conclude that d(f>/dx0 exists and is a continuous function. x0 and a. x0 and p. p) is continuous in all three arguments on a closed and bounded domain D and second. Let the general solution of (7. We consider here only one parameter for simplicity.5) depends not only on t but also on f0. it satisfies a Lipschitz condition with respect to x on D. Suppose that the dynamic behavior of an economic variable is described by the solution <f>(t). Actually. 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. p) of the initial value problem is a continuous function of t.24 Differential equations. x.) Assume first that the function f(t. the next theorem establishes that <£ in (7. Under rather mild assumptions. This result is presented in the next theorem.2. t0.6) be written as to explicitly show its dependence on t. 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/?. but due to errors in statistical measurement we are not certain about the values of the initial data t0 and x0. x) is continuous in both t and x on a closed and bounded domain D . x0 and p.6) can be generalized to denote a parameter vector. Then the solution </>(f. (Continuity of the solution on initial data and a parameter. t0. if we make an additional assumption. x0 and p. The question then arises: how is the solution (f>(t) affected when tQ. This result is particularly useful in economic applications. therefore. t0. it is clear that <HO in (7. Theorem 7. Theorem 7. The above theorem establishes the continuity of 4> with respect to its arguments. but (7. For a proof see Coddington and Levinson (1955. <f>(t) can be used as a close approximation of the true behavior.) Assume that the function f(t. (Differentiability of the solution. 23-24).7) is a continuous function of t. x0. The next theorem assures us that small statistical measurement errors do not significantly alter the results of the model and. stability and chaos in dynamic economics and. that.1. t0.

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. This application illustrates the nonuniqueness property of this differential equation. 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. For a proof see Coddington and Levinson (1955. x0) of the initial value problem is also differentiate with respect to x0. Then the solution 4>(t. Consider the nonautonomous differential equation . that is. pp.Basic properties of differential equations 25 and that df/dx exists and is continuous on D. Next.1) and notice that </>(?) = x = 0 is also a solution. 25-28). Conclude that the continuity of f(t. x) = x1/2 is not sufficient for a unique solution. d<f>/dx0 exists and is continuous. t0.

1) and (l. x) = 2/(t2.26 Differential equations. 1]. To find a solution to this equation.4) corresponding to the three intervals. x) may be written as which simplifies the integration. the only polygonal path starting at (0.-1). (4) Consider the initial value problem Show that there are an infinite number of solutions on [0. and in each interval take the indefinite integral of f(t.1) has discontinuities at the points t — 1 and t = —l. the function 4>c is a solution on [0.1 does not give all the solutions of this initial value problem. Note that f(t. x). 1]. 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]. that is. Verify that (3) defines three solutions of equation (8. 0) is c^. note that if the construction of section 3 is applied in this example. . divide the real line into three intervals.1 ] by verifying that. (-00. where Furthermore. Conclude that the method of theorem 3. stability and chaos in dynamic economics Note that f(t. oo). (-1. for any constant real number c such that c e [0.

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

28 Differential equations. Differential equations with economic applications are treated among other topics in Intriligator (1971). either at the elementary or the more advanced level. Gandolfo (1980) and Murata (1977). The books indicated above. and Sanchez and Allen (1983). Miller (1987). among others. and not partial. Simmons (1972). Chiang (1984) and Takayama (1985). Among these books Coddington (1961). Pontryagin (1962). At an introductory level. Hirsch and Smale (1974) present the dynamical aspects of ordinary differential equations and the relationship between dynamical systems and certain applied areas. Braun (1978. Hartman (1964) and W. Reid (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. The word ordinary refers to the fact that only ordinary. Pontryagin (1962). derivatives enter into the equation. The analysis in section 2 is carried out in terms of a differential equation of the form (2. the independent variable in this book is real and is denoted by t to symbolize time. The literature in the field of ordinary differential equations is quite extensive. Birkhoff and Rota (1978). Hirsch and Smale (1974). the reader may consult Coddington (1961). do not treat any economic applications. Martin (1983). Braun (1978) follows the modern approach with a rather unique blend between theory and realistic applications to real world problems. The order of an ordinary differential equation is the maximal order of differentiation which appears in that equation. For example. Some books written primarily for economists interested in the use of differential equations in economic analysis are Benavie (1972). Furthermore. T. McCann (1982). 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. 1983). 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. Lefschetz (1962) and Arnold (1983) emphasize the geometric theory. Boyce and Di Prima (1986). stability and chaos in dynamic economics In this book we are interested in ordinary differential equations. Roxin (1972). The advanced theory of ordinary differential equations is skillfully presented in the classic books of Coddington and Levinson (1955).2). consider a system of n ordinary . Arnold (1973).

To see the appropriateness of (9. Hale (1969) and several other standard advanced differential equations books. Also.. x2. xn) and the n functions f{ as the coordinates of a single vector function / = (/i.Basic properties of differential equations 29 differential equations written as where n is a positive integer and f1.. The original ideas on uniqueness may be found in Lipschitz (1876)..1) in this case. • • • . 23) and his detailed bibliographical references. consider the substitution which transforms (9.fn are n real continuous functions defined on some domain DC: Rn+}. In conclusion.1) can be used to represent (9. our claim is verified. then (9.1).. x) using measure theoretic techniques that originate in Caratheodory (1927). Given what was said about (9.3).2) provided that vector norms replace absolute values whenever the order of the equation is higher than one.5) is equivalent to the nth-order equation in (9. . If we regard the n dependent variables xt as the coordinates of a single vector variable written as x ../2.(x t . Finally... p. existence theorems have been established under assumptions weaker than the continuity of f ( t . there is no loss of generality in using (2. can also be expressed by (9. see also Simmons (1972). 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. f n ) . Detailed historical remarks on various existence theorems are found in Hartman (1964.2). f2. note that existence can also be established using modern functional analysis techniques as is done in Coppel (1965). 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.2).

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

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

2 . This result is the consequence of the continuation theorem 4. oo). a solution can be extended to [a.1 of chapter 1. . In applications [a. Namely. Note that h(t) is called the forcing function or the input function. a. Linear systems Consider the linear system of n first order differential equations where for t&[a. a solution exists for all t e [a.1) can be written as where A(t) is an n x n matrix whose elements are the fly(f) functions for i. elements and h ( t ) is a column vector with elements Ji. By theorem 3. stability and chaos in dynamic economics 2. . where implies that a solution exists on some interval containing t0. In matrix notation (2.1. b~\. x is a column vector with x. if ft(f) = 0. there exists a continuously differentiable unique solution <j>(t) on the entire interval [a. 2 . . the continuity of A(t) and h ( t ) on the rectangle R.y(0 and h t ( t ) are continuous real valued functions with i. Then. oo) or (-00. Furthermore. for linear systems. . j = 1.2) is called a linear homogeneous system. The system (2. .-(0» i = 1.1 of chapter 1 because a linear system is bounded in the rectangle R. . .3). n. because linear systems satisfy the Lipschitz condition. . . j = 1.32 Differential equations. . b]. Consider the initial value problem for the linear nonhomogeneous system and suppose that A(t) and h(t) are continuous for t e [a. more can be said than existence on some interval containing t0. b]. Let be an initial value problem for the nonhomogeneous linear system. n. if a solution exists it is also unique. b] that solves (2. b]. Actually. . and thus.2) is called a linear nonhomogeneous system. « . then (2. . 2 . Therefore we can state Theorem 2. . b] is usually taken to be [0.

.5) indicates that the 0-solution satisfies (2.Linear differential equations 33 Example 2. ^(0 = [</>. 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 (3.5). .1). it is called a fundamental matrix solution.4) can be written in matrix form as Inspection of (2. If a matrix solution <P(t) is also nonsingular. j = 1. Matrix solutions satisfy certain properties.5) are continuous for re (-00.4) of chapter 1. The second order homogeneous initial value problem can be written in matrix form by making the substitutions (9.1.1).1) at initial time t0 is a fundamental matrix solution such that 4>(f 0 ) = /.1 that the 0-solution is the only solution for this initial value problem. A(t) = [aij(t}~\ denotes the n x n matrix in (3.1) is an n x n matrix with each column satisfying (3. <P(t) = [4>tj(t)] and X(0 = [x«/(0] denote the derivatives of <P(t) and X(t). These properties are presented after the notation used is introduced. it follows from theorem 2. . . a fundamental matrix solution of (3. 2 .1) and such that det <P(t) T* 0. n. . These substitutions yield: Thus (2. oo). X(t) = [xij(t)'\ denotes an n x n matrix. with / being the identity n x n matrix. Since the functions of the matrix in (2.1) if each column of <P(t) satisfies (3..1). In all above cases i. In other words. 3. A principal matrix solution of (3./(01 denotes the matrix solution or the fundamental matrix solution of (3.

b]. .1). (Abel's formula. Consider the matrix differential equation If 0 is a fundamental matrix solution of (3. stability and chaos in dynamic economics Theorem 3.34 Differential equations. Theorem 3. We prove the theorem for the special case n = 2.2. then <£ satisfies (3. Then for every te [a.. Proof. . < / > „ . Note that .1). The generalization is straightforward. b]. Denote the columns of <P by $.2) for *€[«. Proof.&]. Then for te[a. Since ^ is a fundamental solution of (3.1) each of its columns satisfies (3.) Suppose that <P is a matrix solution of and let t0E [a. .1. . b].

This is an immediate consequence of (3. Proof.5. There then exists a constant n x n nonsingular matrix C such that . b] is arbitrary.1) and let C be a nonsingular n x n constant matrix. Theorem 3.3) since t0e[a. which establishes the result. Suppose that <P(t] and W(t) are two different fundamental matrix solutions for t e [a. Then. 6] of the linear homogeneous system in (3. This operation results in Therefore. this calculation shows that and upon integration (3. Let 0 be a fundamental matrix of the linear homogeneous system in (3. Theorem 3. This completes the proof. b].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.4. in the second determinant we subtract a2\ times the first row from the second row. Proof. 6] or d e t # ( f ) = 0 for all f e [ a .3) follows.3. Then <PC is also a fundamental matrix of (3. Calculate Thus <PC is a matrix solution. furthermore.1).1). either det 0(t)=0 for all re [a. Theorem 3. Suppose that <P is a matrix solution.

Consider the linear system which is written in matrix notation as Note that ^ = [S ] and </> 2 -[o ] solve (3. Therefore. stability and chaos in dynamic economics Proof. Example 3. b] and 00 ~J = /.7) conclude that 0 ] V = C or that V = 0C. b]. where C is an n x n constant nonsingular matrix. Specifically. 0 is a fundamental matrix solution which implies that det 0(0 ^ 0 for all t e [a.6) is needed to show that (d/df)(0 ' #") = ().36 Differential equations.1.9) is not a fundamental matrix solution since det 0 = 0 for all t e (-00. if we let <f>i = [Q] and $2= [e~'L then the matrix is a fundamental matrix solution because each of its columns solves (3.8) and det 0 = e' e~' = 1 ^ 0 for all t G (-00. Taking the time derivative on both sides of 00 ' = / gives from which we conclude that The result in (3. oo). . note that From (3. oo).8) and therefore is a matrix solution. By hypothesis. However (3. On the other hand. 0"1 exists for all t G [a.

11).11). The next theorem establishes that if <P is a fundamental matrix solution of (3. By theorem 3. the adjoint equation is defined to be where y and y are row vectors of the same dimension n. If 0 is a fundamental matrix solution of x = A(t)x. Let <£ be a fundamental matrix solution of the homogeneous linear system. It gives the solution of the nonhomogeneous system and it will be used several times throughout the book.) 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. Given (3. (Variation of constants.Linear differential equations 37 This section concludes with a definition and two additional theorems.1) where x and x are column vectors of dimension n.7. The next result is very important. oo).4 the general solution of the homogeneous system can be written as .6. Proof. Theorem 3. which shows that 3> } is a solution of (3. then the matrix 0"1 is a fundamental matrix solution of the adjoint equation Proof. Differentiate both sides of 3><P l = I to obtain Therefore. Theorem 3.1) then <P~l is a fundamental matrix solution of (3.

Although we do not wish to deviate from our methodology which emphasizes basic properties of differential equations.1). a matrix with n2 numbers and h ( t ) is a continuous n vector function. as and differentiate. We wish to satisfy the nonhomogeneous equation by the same expression as (3. Even when n — 2. the initial condition is <f>(t0) = x0. Rewrite (3.13) In (3. If.14) and (2.14) to satisfy the nonhomogeneous equation.2). stability and chaos in dynamic economics where c is an arbitrary constant vector. Thus c= <3>~lh or equivalently. This follows from inspection of (3. if we integrate from t0 to t.1) is not trivial to solve. that is. instead. Linear systems with constant coefficients In this section we discuss the system where A is an n x n constant matrix.12) with c now being a variable. 4. this explains the name of the theorem as variation of constants. (4. We first consider the homogeneous case when h ( t ) = 0 in (4. it must be the case that <Pc = h. to get In order for (3. using (3. . it is instructive to analyze linear systems with constant coefficients because of their importance in economic applications and in stability analysis.38 Differential equations.12) but allow c to be a function of t. then the solution (f>(t) will satisfy the initial condition O(t 0 ) = 0. then the solution of the nonhomogeneous equation becomes which establishes the theorem.15).

we must define eA' to avoid ambiguity. Let A be an n x n constant matrix.1 in chapter 1. P.1). that is. recall example 2. First note that t.2) is given by and the solution of the initial value problem is given by Remark 4. 94).2).1) with h ( t ) = Q and n = 1.6) converges for every A and t. For an n x n constant matrix A. Theorem 4. To show that 3>(t) = eA' is a solution we must show that it satisfies (4. t0 and x0 are finite. pp. Second. See Arnold (1973. so that eA( is well defined for all square matrices. oo). 97-107) or Hale (1969.1. .1. with c an arbitrary constant n vector. and consider the corresponding homogeneous system A fundamental matrix <P for (4. This example is the simplest case of (4.7) of chapter 1 as 0(0 = c e°". The next theorem establishes that this guess is correct. Proof of theorem 4. te R = (-00.Linear differential equations 39 To motivate the solution of the homogeneous case in (4. otherwise <P and </> are not well defined. Its solution is given in (2.1. the definition exp(A/) is: The infinite series (4. and so a good guess for the solution of x = Ax would be 4>(t) = QA'C.

. .2 on Abel's formula obtain that Thus <P(t) is fundamental and (4.1 gives (4. One method for computing eAt involves the following steps.5) is immediate.40 Differential equations.2.. Remark 4. stability and chaos in dynamic economics To establish (4. First. Note that they do commute if A is constant or if A(t) is diagonal.6) Furthermore..7) use the definition of a derivative and (4. p. The definition of eAf in (4. that is.6) is not generally useful in computation.5) as the solution of the differential system x = Ax for A being an n x n constant matrix. Let h > 0 and compute In the last step the limit is A because by (4. an_i are functions of t which are determined in the next step. See Coddington and Levinson (1955. if the elements or entries of A(t) are functions of time. for A a constant n x n matrix express where a0. Theorem 4. 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. This concludes the proof. using theorem 3.6). alt. 76). If A(t) is an n x n nonconstant matrix.

is an eigenvalue of At of multiplicity 1 then use to solve for a0. . k> 1. . Example 4. . The eigenvalues of At = [20' 2°. «„_. is an eigenvalue of At of multiplicity k. The two equations are and solving them for a0 and a1 yields Now that a0 and a1.12) being evaluated at A.10) obtain and use (4. define If A. then use with all derivatives in (4. to solve for the appropriate a 0 .2. an_l.1.9) can be applied to give the final result Example 4.. (4. . From (4.Linear differential equations 41 Second. Compute eA' for A = [l 4l- . a 1 } . have been found.] are given by which means that A = 2f is an eigenvalue of multiplicity 2.12) to get two equations that will determine a0 and a1.11) and (4. If A. as functions of t. . Compute eAr for A = [20 °2]. . al .

9) to get the final result In examples 4. The eigenvalues of At = [_° o] are computed from and they are A t = if and A 2 = —if.1 and 4.11) to obtain Solving these last two equations obtain Using Euler's relations . with A being diagonal.3.6) because A" is also diagonal.11). one may also use directly the definition in (4. Compute eA( for A = [0 1 £].2. stability and chaos in dynamic economics The eigenvalues of At are \l-2t (4. Substitute these two eigenvalues into (4. Example 4.42 Differential equations. The two equations are and A2 = —3t and to find a0 and a} use Solving these equations yields Put a0 and a{ in (4.

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

equations

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:

Linear differential equations 51 (3) (4) Equation (4. Compute eA' for the following matrices: (5) Solve the initial value homogeneous linear system. The next chapter on stability methods illustrates the usefulness of linear equations in approximating nonlinear ones.6) defines eA' as an infinite series. (6) Solve the initial value homogeneous linear system. 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. . 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. the infinite series must converge to a limit. (7) Solve the initial value nonhomogeneous linear system (8) Put in matrix form and solve the second order differential equation 7. Establish that convergence of the series holds.

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

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

0. Finally continuous dependence with respect to initial data x(0) = c > 0 holds since </>('. 0) = 0. T] with T a positive real number and let e > 0 be given. We ask the question: can a restriction be placed on the initial value x(0) = c> 0 so that Equation (1. Actually.4) describes how close <f>(t. Moreover.1).t0. Consider the interval [0. 0) = 0 is its solution. 1/c) is the maximal interval and the solution cannot be continued to the right because <fr(\f c) does not exist. the interval (—00.x2. c). passing through the point (0. Inspection of the initial value problem x . x(0) = 0.4) suggests that some form of a boundedness property holds for the solution in its domain [0. 0. indicates that (f>(t) = </>(*. Using the 0-solution as a reference. is unique.2) for x ( t ) and using the initial data in (1. T].54 Differential equations. the question can be reformulated: can a restriction be placed on the initial value so that .1). Actually (1. x) = x2 guarantees the existence of a solution on some appropriate interval. 0>c) m (1-3) is unique and continuous in all arguments in its domain of definition. this solution. conclude that is a solution on (—00. 1/c). x0) is to the 0-solution denoted by cf>(t. Let us go a little further. Therefore it is justified to search for a solution by integrating (1. 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 . to arrive immediately at Solving (1.

T]. x(0) = c>0 shows how the properties of existence. 5 can be chosen such that This estimate of 8 follows from (1. Actually.c) is not uniform with respect to t in the interval [0. such that if c < 8 then (1.6) we conclude that as the length of the interval [0. uniqueness and continuity with respect to initial data hold on a finite interval [0. oo) let alone a stable solution.3) with c replaced by 8 and t replaced by T. 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 purpose of the analysis is to determine the consequences that a disturbance in the initial value may have in reference to the equilibrium solution. T] increases with T^oo. In many applications the independent variable t denotes time.x2. 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. both given.0.6) it follows that if \c\ < 8 then From (1.4) holds. depending on both T and e. Definitions Consider the differential equation . T) > 0. there is a 8 = 8(e.Stability methods: An introduction 55 Equation (1. T] which is a subset of (-00. 0. 1/c).1).Q. This implies that the continuity of the solution (f>(t. Actually for this initial value problem. but that stability fails to hold on [0. oo). 2. 8 must approach zero. the answer to the question asked is: for T> 0 and e > 0. Furthermore. oo). where the latter is being used as a reference point.0) to (f>(t. and the appropriate domain for this variable is [0. oo). For the initial value problem in (1. The above analysis of the initial problem x . The source of change from (f>(t. c) is due to a change in the initial value at t = 0 from 0 to c.5) is motivated by the researcher's interest in knowing the deviation of a solution from its 0-solution. no solution exists on [0. oo). This computation illustrates the importance of the continuous dependence of solutions on initial data on a finite interval [0. for 8 as in (1.

5) is a definition and that if y = 0 then g(t. 0.1) and two initial conditions. tQ. by defining that is. In most. x0) or x(t. without loss of generality. c2) behave as /H»OO? DO 0(f. 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.Q. oo) x R" -» R" and assume that the function f ( t . we ask the question: if c. and c2 are close.2) suggests. stability and chaos in dynamic economics with f(t. c2) remain very near to one another as f-»oo.Q.0. 0) = 0. The solution of (2. Consider (2. it follows that Since $(f. namely (0. how do the solutions 4>(t. Studying the stability properties of (f>(t.2). t0. Cj) and (f>(t.56 Differential equations. oo) x R". then Combining (2. x0) or x(t\ t0.4) gives Observe that the last step in (2. A system of ordinary differential equations such as (2. x ) satisfies the conditions ensuring existence. c2) both in [0. or do they drift away from one another as f-»oo. by taking time derivatives and rearranging terms.1). in how close a solution remains to the equilibrium . x0) or by </> (/11 0 . y denotes the difference between two solutions. the researcher is not primarily interested in how close two arbitrary solutions remain as f-»oo.1) which at time t0 passes through the initial point x0 is denoted by $ (t. it is necessary to specify its initial conditions. c2) is equivalent to studying the stability of y relative to the 0-solution.3) and (2. Therefore to find a certain solution. ct) and (f)(t. To once again motivate the intuitive notion of stability. has an infinite number of solutions. which is instability? The mathematical treatment of the problem of stability becomes simpler.Q. if not all applications. as (2.1). but more importantly. x): [0. 0. Cj) relative to (f>(t. from (2. 0. Cj) and (0. This is so because. uniqueness and continuous dependence of solutions on initial conditions. ct) is a solution of (2. which is stability.

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

Consider with \eR. since the solutions are independent of time. Example 2. Example 2. analyzed in the previous section.3. oo).2. the 0-solution is unstable if A > 0. as example 2. Example 2. Example 2. The equation x = x2. has a 0-solution that is unstable because neighboring solutions are not defined for all t e [0. this is as example 2. Finally.1. Consider the system . oo) as x0 approaches zero. where x0 is an arbitrary constant.2.1 Example 2.1. uniformly stable. Consider the equation x = 0. This example generalizes the previous two examples.4. The solutions of this equation are x ( t ) = x0. The equation x = x has solutions of the form x ( t ) = x0e' when x0 is an arbitrary constant. asymptotically stable and uniformly asymptotically stable if A < 0. The 0-solution is unstable because x0 e' does not approach zero uniformly on [0.58 Differential equations. The solutions are of the form x(r) = x 0 e At . but it is not asymptotically stable. The 0-solution is stable. Furthermore. The 0-solution for t>0 is stable.5. stability and chaos in dynamic economics Figure 3. The 0-solution is stable and uniformly stable if A = 0. the 0-solution is also uniformly stable.

1) and therefore all the definitions of stability presented in the preceding section. 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. Observe that This means that. This means that the paths are rays through the origin.e. By choosing y0/ x0 small. that is. thus the 0-solution is stable. for r a positive real constant. the solution paths are circles centered at the origin. the 0-solution is shown to be uniformly asymptotically stable and therefore also uniformly stable. and x and x are n column vectors. but it is not asymptotically stable. The circles can be made arbitrarily small by choosing r to be small. apply to the homogeneous linear system. The continuity of A(t) implies the existence and uniqueness of a solution satisfying certain initial data. i.7.6. Example 2. 3. Example 2. Observe that the ratio of the solution paths is constant. y ( t ) / x ( t ) =y0/Xo = constant. . with reference to the 0-solution.. Note that 4>(t] = 0 is an equilibrium solution for (3. For the system the 0-solution is unstable since the solution paths are of the form x ( t ) = x0 e1 and y(t)=y0e'. Modify the previous example to consider with solutions x ( t ) = x0e ' and y(t)=y0e '.Stability methods: An introduction 59 and let x ( t ) and y ( t ) denote the corresponding solutions.

let df(t. x + z) in (3. x + z). using (3. x) we will need to apply Taylor's theorem. t £ [0. Thus far. x) are equivalent to the stability properties of the 0-solution of the system z=f(t. Consider x=f(t. Taking the time derivative of z ( t ) . x) and set This is a translation of coordinates using x ( t ) as a reference-point and defining z ( t ) = x(t}-x(t). where f:R"+l-*R" has at least two continuous partial derivatives with respect to its variable x.60 Differential equations.3) and that the stability properties of the solution x ( f ) of x -f(t. Let x ( t ) . x) = 0. x). and using (3.3). 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. x + z). recalling that f ( t .0. Next. (3. we wish to approximate /(t. oo) be an equilibrium solution of x =f(t. stability and chaos in dynamic economics The stability analysis of the homogeneous linear system is a natural point of departure. x) .2) it follows immediately that Observe that the solution z ( t ) = 0 is an equilibrium solution of the system z=f(t. but also because nonlinear systems can be approximated by linear ones. that is. we conclude that . x)/dx = A(t) where Thus. It is instructive at this point to introduce the concept of linearization. we have simply reviewed what was stated in the previous section. This assumption is needed because in linearizing x-f(t. not only because of the relative simplicity and usefulness of such a system. which studies the linear approximation of a nonlinear system near the equilibrium.

5) consists of a linear term and a nonlinear term with higher polynomials of z. This system (3. and h ( z ) / \ z \ is a continuous function of z which vanishes for z = 0. given a nonlinear system x=f(t. among other things. that is. the stability properties of the 0-solution of The next four theorems establish various stability properties of (3. This suggests that the study of the linear homogeneous system should receive our primary attention and will lead us to theorem 4.5) can be deduced from the stability properties of the linear system z = A(t)z. Identically the same procedure of linearization can be applied to the autonomous differential equation x =f(x). uniformly in t. the stability properties of x ( t ) can be studied by analyzing the stability properties of the 0-solution of the nonlinear system in (3. f ( x ) . Using Taylor's theorem as in (3. under certain conditions. x) with an equilibrium solution x ( t ) . \h(t.5). by using a translation of variables and Taylor's theorem. Therefore. Once again the approximate linearized system z = Az can be used to deduce. x + z) as the sum of a linear system and a residual nonlinear system.1) for A(t) being a continuous n x n matrix. In summary. 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 . Since for fixed /. we can write z — f ( t .0. A is the Jacobian of the first order partials evaluated at x.4) write In this last equation.2 in the next section. In the next section we will study. 0)/dz = 0.Stability methods: An introduction 61 with h(t. 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. z)|/|z|-»0 it may be expected that the 0-solution of (3. If the nonlinear term is small compared to |z|.2) holds. then the stability properties of the 0-solution of (3.5) shows the same stability behavior as the 0-solution of the linear variational system z = A(t)z. 0) = 0 and dh(t.

84-89). t0) > 0 such that. Let f0e R and suppose that \3>(t)\ < K for t> t0.2. This means that From this last step obtain Theorem 3. The various applications of subsequent chapters will make use repeatedly of the linearization method.5 follow Hale (1969.1) and let )8 e R. Let <£(0 be a fundamental matrix solution of (3.62 Differential equations. Let 0(0 be a fundamental matrix solution of (3. where 4>(0 is a fundamental matrix solution and c is an arbitrary constant vector. that is.1) is uniformly stable for f0> (3 if and only if there is a positive constant K = K(fi) such that .12) of chapter 2 that any solution </>(0 of the linear homogeneous initial value problem x = A(t)x. The system (3. x(t0) = x0 can be written in the form <f>(t) = <P(t)c. Theorems 3.1) is stable for any t0e R if and only if there is a positive constant K = K(t0) such that Proof.1-3. Choose c = <P~l(t0)x(t0) and write the solution as Given e > 0 choose 8 = 8(e. t0) < e/K\<P I(t0)\. Recall from (3.1) are bounded. The first theorem below establishes that the 0-solution is stable if and only if the solutions of the linear homogeneous system (3. The system (3.1). suppose that stability holds.1. if |x0| < 5 then \3>(t)<P~l(t0)x0\ < e. there is a 5(e. pp. for any e > 0 and t0. Theorem 3. stability and chaos in dynamic economics of the nonlinear system x = Ax + h ( x ) . Stability follows because if \XQ\ < 8 then Conversely.

Assume (3. with the remark that assuming uniform stability means that for a given e > 0. choose T=-a \n(rj/K}. Let <P(t) be a fundamental matrix solution of (3. There is a 5 0 >0 such that for any 77. 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. since </>(0 = <P(t)(P~l(t0)x0 with |4>(f)|-»0 and ^"'(O^ol a constant. it follows that |<£(f)|-»0 and asymptotic stability holds. Conversely. Then (3. there exists a T= T ( T ? ) > O such that by definition of uniform asymptotic stability and all f 0 >/3. Suppose that (3. suppose that the 0-solution is uniformly asymptotically stable for t0>fi. Theorem 3. we deduce stability. Then. For (3. 0 < T 7 < 5 0 .11) and by theorem (3. Furthermore.1. Let x0\ < 1 and note that for any 77 > 0 such that 0 < 17 < K. The converse is immediate because |</>(f)| = \0(t)^~l(to)x0\^0 implies (3. 8 = <5(e). let e > 0 be given and choose 8 = 8(e) < e/K. |x 0 |^5 0 .9). The system (3. This value of T establishes (3.1). we want to show that there is a T(TJ) > 0 such that l if t0>(3 and t>t0+T(rj).1) and let B e R.11) implies uniform asymptotic stability of the 0-solution of the linear system.12) to hold. The converse follows in exactly the same way as the converse of theorem 3. that is. From (3.3. uniform stability holds.11) holds.2).1) is uniformly asymptotically stable for t0> B if and only if it is exponentially asymptotically stable. Theorem 3. The system (3. Let 0(0 be a fundamental matrix solution of (3.4. 8 is independent of tQ.13) deduce that .12) and therefore (3.1. Then for any t0 > (3 if |x0| < 8 it follows that and uniform stability holds.1) is asymptotically stable for any f0e R if and only if Proof. that is.Stability methods: An introduction 63 Proof. there are constants K = K(/3)>0 and a = a((3)>0 such that Proof.9) follows from (3. Suppose that \<P(t)\-*Q as f-»oo.10).

the stability analysis presented in the last four theorems deals with the homogeneous linear system x = A(t)x of (3. Theorem 3.64 Differential equations. From theorem 3. In particular for t > /3. Proof. Also suppose that for any s > 0.15) to compute This computation completes the proof.5. stability and chaos in dynamic economics for t0>p. t>t0+T. x). So far. there is a 8 > 0 such that Then. Finally.1) is uniformly asymptotically stable for t0>(B. we present a theorem concerning the stability of the perturbed linear system.4 there are constants K = K((3) and a = a((3) such that . the 0-solution is uniformly asymptotically stable for t0 > )3.1). Note that for any t> t0.2.f 0 < ( f c + l ) ^ . there is a positive integer k such that /cT< r .2 in section 4. which is a generalization of theorem 4. 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. both because of its intrinsic importance and its use in linear approximations of the form (3.5). use (3. Suppose that x — A(t)x in (3. x):R x R"^R" is continuous for (t. B e R and suppose that h(t. Since x = A(t)x is uniformly asymptotically stable for f0> /8 by theorem 3.Finally.

16) holds. recall that from the variation of constants theorem.19) to write Make the transformation z(0 = e a '|0(0l and use it to rewrite (3. (3.17) is uniformly asymptotically stable. Recall that (3.17). Example 3.21) in chapter 2. 71) and Hale (1969. Coppel (1965. 87) report the following example to illustrate that extreme caution must be exercised in treating perturbed linear systems such as (3.eK > 0 by choice of these constants. p.23) implies |0(0| < 8 for all t> t0 provided \4>(t0)\ < d/K.1. Thus the 0-solution of (3.21) to obtain which implies for all values of t > t0 for which |0(0| < & Since a .18) and (3. the equation . p.17) is of the form Choose e so that eK < a and let S be such that (3. any solution of the nonhomogeneous linear system (3.Stability methods: An introduction 65 Furthermore. The second-order linear equation has two solutions </>(0 = sin t and 0(0 = cos t and is uniformly stable but not asymptotically stable.20) as Apply Gronwall's inequality to (3. For t > t0 such that 0(f)| < 5 use (3.24) is a special case of (4. However.

To establish stability we need to show that the solutions of (4.1.1 of the previous section.1) is in Jordan canonical form.1). Without loss of generality. the special nature of A allows us to obtain additional results.1) and that its stability can be given in terms of the eigenvalues of A. the equation which can also be considered as a perturbation of (3. Proof.10) of chapter 2.1) are bounded and then use theorem 3. 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 (3.1) can be written as where J is as (5. (iii) The 0-solution is unstable if at least one eigenvalue of A has positive real part. assume that the matrix A of (4. stability and chaos in dynamic economics which can be considered as a perturbation of (3. Theorem 4. 4.24) has two solutions (j>(t) — sin t — t cos t and 4>(t) = cos t+t sin t and is unstable.24) has two solutions (f>(t) = t~l sin t and (f>(t) = t~l cos t and is uniformly asymptotically stable. Note that x — 0 is an equilibrium 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. Then the solution of (4. On the other hand. . Although the theorems presented in the preceding section can be used to study the stability properties of (4.1). as section 5 of chapter 2 describes it. (i) The 0-solution of (4. (ii) The 0-solution is asymptotically stable if all eigenvalues of A have negative real parts.66 Differential equations.

Furthermore. .\k be the diagonal elements of J0 . . is not only sufficient but also necessary for stability.2.1) is time independent. Let \l . . For the other blocks. if an eigenvalue of A is simple. by hypothesis.. .1) have negative real parts is not only sufficient but also necessary for asymptotic stability as well. s. all eigenvalues of A have negative real parts. Finally. However. i = l. these two eigenvalues have negative real parts. in this case.1) have nonpositive real parts and every eigenvalue of A that has a zero real part is a simple zero. one cannot deduce stability for x = A(t)x. Thus. that is. . It is important to emphasize that theorem 4. The second part of the theorem follows immediately since. i = 1. . . Remark 4. there exists a positive constant K such that e j( '~' o) < K for t > t0>0.1). Actually. Therefore |ej°'| is bounded. By construction. < 0 for i = l. Finally.1. By theorem 3. . . . f > f 0 > 0 . it is easy to prove that the condition that all eigenvalues of A in (4.1) is stable.Stability methods: An introduction 67 Consider separately the Jordan blocks J0 and Jf. . s. i = 1. stability is equivalent to boundedness and asymptotic stability is equivalent to exponential asymptotic stability. note that Re Ak+i <0. . 5. For linear autonomous homogeneous systems such as (4. and by theorem 3. if at least one eigenvalue of A has positive real part.k. stability implies uniform stability and asymptotic stability implies uniform asymptotic stability. . i = 1. By hypothesis Re A . Remark 4.2) is an increasing solution that becomes unbounded and stability does not hold.17) of chapter 2 to also conclude that |ej/'|. .1 states sufficient conditions for stability and asymptotic stability for linear systems with constant coefficients. the condition that all eigenvalues of A in (4. (f>(t) in (4.1.1. s. there are positive constants K and a such that \QA('~'O}\< K e~ a( '~' o) . . . that is. it appears in block /0. Use (5. is bounded. 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. Ji. Because (4. . . . the 0-solution of (4. . the solution . .4 the 0-solution is asymptotically stable. where The eigenvalues of A(t) are A1(t) = [-1 +iV?]/4 and A 2 ( f ) = [-1 -i>/7]/4. . If the eigenvalues of a nonconstant matrix A(t) satisfy the conditions of theorem 4. .

4.4) and call the roots of p(\) the characteristic roots or eigenvalues of (4.Ax where Observe that theorem 4. the eigenvalues of A in (4. then its eigenvalues are positive and the 0-solution of x — Ax is unstable.4) is transformed into a system x . Remark 4. is exactly the characteristic polynomial p(\) 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. Since (4.4).4). are equivalent. it can be shown by induction (see Miller and Michel (1982.6). if an equation is given in the form of (4.5). If A is positive definite. This means that. with A as in (4.3. 122)) that the characteristic polynomial of A in (4.6) which are obtained by solving the characteristic equation det(A — A / ) = 0 . that is det(A-A/). in practice. p.1 describes the stability or instability of x = Ax in terms of the eigenvalues of A. If an n x n matrix A is negative definite. Remark 4. one need not transform it into a system x = Ax and compute the eigenvalues .4) and x = Ax. Suppose that (4.4).6). stability and chaos in dynamic economics is given by which is not asymptotically stable since it grows exponentially.5) which are obtained by solving the characteristic equation of the nth order equation in (4. are the same as the roots of p(\) — 0 in (4.68 Differential equations. Therefore. then its eigenvalues are negative and the 0-solution of x = Ax is asymptotically stable.

8) in order to compute the eigenvalues of [2 }]. the 0-solution is asymptotically stable. Example 4. the 0-solution is unstable.Stability methods: An introduction 69 of A in order to determine stability or instability.7) given by A 2 .A . because Aj =2i and A 2 = —2i. then (4.5). The 0-solution of is asymptotically stable because the roots are At = -2+ i and \2Example 4. The 0-solution of -2-i. Example 4. Therefore. = -l and A2 = 2. = x and x2 = Xj. with /?(A) as in (4.7) into (4. but not asymptotically stable. Example 4. Consider the system .1.2. one can directly compute the roots of the characteristic equation p(\) = 0.9) given by A2 + 4 A + 4 = 0 are AI = A2 = -2.2 = 0. note that you need not transform (4. Consider the equation Let x. One can compute the eigenvalues directly from the characteristic equation of (4.1 to the characteristic roots. Rather. Determine the stability or instability of the 0-solution of The roots of the characteristic equation of (4.4. Therefore. In view of remark 4.4.3. is stable. and apply theorem 4.7) can be written as and the eigenvalues of the matrix are A.5. Example 4.

1 states conditions for the stability or instability properties of the 0-solution of x . the eigenvalue zero is not a simple zero and the 0-solution is unstable. Having analyzed in some detail the system x = Ax in (4.1).10). Thus.10). To do this we need to determine whether there are 2 linearly independent eigenvectors for the eigenvalue 0.Ax.70 Differential equations. not much could be said about the stability or instability of the 0-solution of (4. Therefore assume that h(0) = 0 and also that h(x) is very small compared to x. Therefore. . although A = 0 is of multiplicity 2. Consider h ( x ) of (4. This eigenvector is of the form for c an arbitrary constant. the next logical case to consider is the system In (4. Recall from the previous section that x = Ax is the approximate or linearized equation for (4.10) 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. stability and chaos in dynamic economics and compute the eigenvalues to find that A! = -7. Theorem 4. Unless we put some restrictions on h(x). If /i(0) = 0 then 4>(t) = 0 is an equilibrium solution of (4. Since zero is an eigenvalue of multiplicity 2. Theorem 4. Note that this latter assumption is motivated by (3. x and x are n column vectors and h(x) is an n column vector with each element being a function of x. A2 = A3 = 0. This means that. then the 0-equilibrium solution of (4.16) of theorem 3. A is an n x n constant matrix. for which we would like to know its stability properties.10) is also asymptotically stable. Then (i) if the 0-solution of the linearized system x = Ax is asymptotically stable. we must determine whether or not it is a simple zero..2. we only have one linearly independent eigenvector associated with A = 0.10).10) and suppose that h(x)/\x\ is a continuous function of x which vanishes for x — 0.10). Solve the equation for A = 0 to find that p} = 3p2/2 and p3 = -3p2.5 in the previous section. is it possible to deduce stability or instability for the 0-solution of (4.5.

Example 4. Thus. Consider the system which can be expressed as in (4.2.7. The first part of this theorem can be proved in a way similar to theorem 3. Since the eigenvalues of the linear part are -2 and -3.Stability methods: An introduction 71 (ii) if the 0-solution of x = Ax is unstable. by theorem 4. Recall that if the condition just stated holds. the 0-equilibrium solution is asymptotically stable. This cannot be claimed for the 0-solution of (4. We will present a proof after we have developed the Liapunov method in the next chapter. Theorem 4. Remark 4. the 0-solution of x = Ax is stable.1(i). the 0-solution of this system is unstable.2 is called the Stability Theorem in the First Approximation or the Principle of Small Oscillations.5 of the previous section. should all the eigenvalues of A have a nonpositive real part with at least one eigenvalue having a simple zero real part. the stability of the 0-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. Note that this theorem does not tell us what happens when all the eigenvalues of A in (4. then the 0-equilibrium solution of (4.10) 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. Example 4.10).6. therefore.2.10) is unstable.5. 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 4.10) cannot be determined from the stability of the 0-solution of the linearized system. Proof. .

8. 77).72 Differential equations. 364) and Hahn (1967. system The standard example to illustrate remark 4. the 0-solution of (4. by slightly modifying the nonlinear part. Therefore.12) is only stable. the system in (4. The linearized system of (4. This illustrates that the nonlinear part of the system can influence the stability of the entire system.13) observe that x\(t} + x\(t)->0 as f-»oo and x2l(t) + xl(t) < c.1.12) is stable. On the other hand.11) is asymptotically stable.11) given by (4. To study the behavior of the nonlinear part of (4.12). stability and chaos in dynamic economics Example 4.5 is the following presented in Braun (1978. p.14) has the same linearized system as (4. From (4. although the linearized part in (4. the system can become unstable. Therefore by part (i) of theorem 4. Consider Note that (4.11) is given by and the eigenvalues are ±i. p. but with solution .11) observe that Integrate this last equation to conclude that where c = c\+c\.

These ideas are illustrated in the next two examples. To study the stability properties of x^t) — 1 and x2(t) = 1. approaches infinity in finite time. 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 4.18) yields x = ( x 1 . 1) as a unique equilibrium solution.9. Example 4.12) is stable. presented in theorems 4. x2) = (1.14).17) as The last system can be put in matrix form as .Stability methods: An introduction 73 where c — c]+cl is as before. We close this section by connecting the stability results of x = Ax and x = Ax + h ( x ) .1 and 4. Therefore. set and using (4. to the stability analysis of an arbitrary nonlinear system x = f ( x ) . In turn. such that x^(t) + x l ( t ) ^0. From (4. with an equilibrium solution x. rewrite (4. the equilibrium properties of the 0-solution of (4.14) is unstable.2 respectively. xi(t) of (4.15) conclude that every solution *i(0.1.16) are determined by the properties of the 0-solution of z — Az as presented in theorem 4.2. Recall from section 3 that given a system x =/(x).19). Consider the two dimensional nonlinear system and note that its equilibrium solution is found by solving the system Solving (4. the 0-solution of (4. despite the fact that the linearized system in (4.

21). A2 = (-3 -iV3)/2.20) is the Jacobian of partials of (4. 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. x 2 ( t ) .20). Example 4.23) rewrite (4.2 the 0-solution of (4. observe that the Jacobian is . This example is slightly more complicated than the previous one. More specifically for (4.20) satisfies the hypotheses of theorem 4. There are four equilibrium solutions: We first study the equilibrium solution x1(f) = 0.10. Note also that the 0-solution is an equilibrium solution for (4. Set and using (4.21) as or equivalently.17) evaluated at the equilibrium solution. is also asymptotically stable. obtain that Aj = (-3 + iV5)/2. stability and chaos in dynamic economics Observe that the 2 x 2 constant matrix in (4. Note that A is the Jacobian of partials evaluated at the equilibrium point.24) is unstable and finally the solution x1(t) = 0 and x 2 ( t ) — 1 is unstable.1. Computing the eigenvalues of the linear part of (4.20) and that the nonlinear term of (4. the 0-solution is asymptotically stable and the equilibrium solution Xi(t) = 1 and x2(t) = 1.74 Differential equations. as The eigenvalues of the matrix A = [2 Q] are ±2 and therefore the 0-equilibrium solution of z = Az is unstable. Thus. Again. in matrix form.2. by theorem 4.

(5.1 to jc = Ax with A as in (5. Therefore.4) of chapter 1. and particularly remark 4. 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. the first three equilibrium solutions in (4.1) is equivalent to the system x = Ax where A is given by The foregoing analysis. can be used to determine the stability or instability of the 0-solution of the nth-order equation (5. More specifically we can state: Theorem 5.25) becomes respectively with corresponding eigenvalues A = ±2. = A2 = 2 and A. (c) and (d).22) in (4. = A2 = -2.4 in the previous section.2) or by finding the roots of the characteristic polynomial of (5. Using the substitution (9.1).1) without computing the eigenvalues of A in (5.1). (4.1. We have already completed case (a) and concluded that it is unstable.2) or the roots of the characteristic polynomial of (5.) Consider the nth-order polynomial p(\) with real coefficients given by .1) by applying theorem 4.25) we can determine the stability properties of the respective equilibria. For cases (b). (Routh-Hurwitz criterion.Stability methods: An introduction 75 Thus. putting the four equilibrium solutions of (4. 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. 5. A.

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. or Gantmacher (1959). Remark 5. The autonomous nth-order linear equation or the autonomous linear system . stability and chaos in dynamic economics Assume without loss of generality that a0>0. pp.3) have negative real parts was initially solved by Sturm in 1836.1. 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. pp. 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) . Example 5. A unified theory of this classical problem and its variants is found in Coppel (1965. 142-158). Thus the real parts of the roots of 2A2 + 3 A +2 = 0 are negative and the 0-solution of (5. It is of some historical interest to note that the problem of determining how many roots of the polynomial p ( A ) in (5. In 1877.5) is asymptotically stable.1. 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.(2 • 0) = 6>0. 16-22). Some results of the preceding analysis can be conveniently summarized as follows.

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

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

In particular. One way would be to solve explicitly this system by computing the exponential of the 2x2 matrix A. This third method is the subject of the remainder of this section. then by letting y = x — 4>(t}. for two dimensional systems. phase analysis can be used to evaluate the qualitative properties of the model. or compression toward.7). Without solving x = Ax explicitly. Having made the above three remarks. as is the case with many economic models. some line through the origin. . 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. It can be shown mathematically that the transformation P amounts to. at most. Remark 6. we assume that the system has already been transformed into canonical form.Stability methods: An introduction 79 if (f>(t) is an equilibrium solution of (6. 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. Phase analysis is an additional tool in the study of stability of differential equations that supplements the theorems already stated. phase analysis supplements the methods described previously for solving such systems explicitly. Under these assumptions. This reflection is followed by a stretching of the plane away from. or a reflection in a line through the origin. Or. 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.5).1 of this chapter. which nevertheless preserves the essential properties of the phase diagrams. the transformation P does not change the character and essential properties of these portraits. Remark 6. For systems that cannot be solved explicitly. a rotation about the origin. However. as a third possibility. and to study the stability properties of its solution.2. suppose that we wish to study the stability or instability properties of the system x = Ax of (6. Thus. the phase portraits of nonlinear systems such as (6. where A is a 2 x 2 constant matrix such that det A ^ 0. we can write (6.3.7) as where A is a constant matrix and h(y) is very small compared to y. as was done in chapter 2. In discussing the possible shape of the paths of the system x = Ax.

2(b).80 Differential equations. The matrix A has a repeated real eigenvalue A. then we obtain the y2 axis with the origin deleted and note that y2-* ±00 as t^> oo.10) yields the origin. if cl ^ 0 and c2 = 0 we obtain the _y. (i) Suppose A 2 < A ) < 0 : the origin is a stable tangent node.5) has two real and distinct eigenvalues A. See figure 3. < A 2 < 0 . If A. (iii) Suppose At < 0 < A2: the origin is a saddle point. In this case A is similar to the matrix (a) in (6. Case 1. From remark 7. and A2. Case 2. then the trajectories would be tangent to the y2 axis. See figure 3. If cl = 0 and c2 7= 0 in (6. we distinguish the following cases. The matrix A of (6.2(b) would be reversed. 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. This case can be divided into two subcases.1 of chapter 2. < A2: the origin is an unstable tangent node.2(a).10). If cl — 0 and c2 ^ 0 we obtain the y2 axis with the origin deleted and observe that . If cl — c2 = 0 then (6. The solution of this canonical form is Within this case we can further distinguish three subcases. This subcase is similar to subcase l(i) with the orientation of the trajectories being reversed. which means that A does not have a zero eigenvalue and that the origin is the unique equilibrium point. the trajectory in this case becoming tangent to the y^ axis at the origin.9) as was indicated in section 7 of chapter 2. the motion along an arbitrary trajectory consists of an asymptotic approach of the point toward the origin. (ii) Suppose 0 < A. When c^O and c2 ^ 0 then for any point in the first quadrant. recall that A is similar to one of the four matrices Therefore. stability and chaos in dynamic economics Consider x = Ax of (6. axis with the origin deleted and conclude that y} -» 0 as t -> oo. . Similarly.y^O as f-»oo.5) and recall the assumption that det A ^ 0. If A 2 < 0 < A 1 ? then the orientation of the trajectories in 3.

Stability methods: An introduction 81 Figure 3.2 .

or equivalently. see figure 3. if A < 0 the origin is called a stable improper (or degenerate or one-tangent) node and the phase portrait looks like 3.2(d) with the arrows reversed. provided c^O. In this case its canonical form is matrix (d) in (6. the phase portrait consists of straight lines y2 = (c2f c.12) given by In this subcase. If A < 0. If A > 0. Then A is similar to matrix (b) in (6.13) y1 and y2 tend to zero as t H> oo. then the motion moves towards the origin and the origin is called a stable (stellar or isotropic) node or stable focus.82 Differential equations. then the motion moves away from the origin and the origin is called an unstable node or unstable focus. Case 3. See figure 3. The final case occurs when the matrix A has complex eigenvalues. then its canonical form is like (c) of (6.2(d).2(c). stability and chaos in dynamic economics (i) Suppose the matrix A is diagonal. that y2 = (c2/c^yi.11) obtain immediately that y2/yi = ( c 2 / c } ) . This means that. in this subcase.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. 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. since from (6.9) and the system can be written as . then the origin is an unstable improper node. (ii) If the matrix A is not diagonal. )yl passing through the origin generated as C1 and c2 take arbitrary values. If A > 0 .

(ii) If a = 0. Suppose that a < 0. When a < 0.16) using (6. if w > 0 the arrows point in the clockwise direction and if w < 0 .15) with respect to time to obtain Solve this system of equations for r and 0. the phase diagram looks like 3. Observe that in 3. then r is a constant. The solution of (6.17). to get Substitute (6. We can summarize the above results and connect them with previous analysis in two remarks. r-> 0 and the phase portrait looks like 3. Furthermore.15) to conclude The last system expresses the velocity of a representative point in the polar coordinates system (r. 6 is the angular velocity about the origin.14) is now given in polar coordinates by the solution of (6. The trajectories are circles centered at the origin.14) in (6. then from (6.2(e).14).2(f) we assumed that a > 0 and w < 0. 0) in terms of r and 0. then either a < 0 or a > 0.2(f). The latter is Two subcases arise immediately. Differentiate (6. here r is the rate of change of the distance from the origin. the origin is called a stable focus or a spiral sink since the trajectories are spirals which approach the origin asymptotically as t -» oo. In this subcase.Stability methods: An introduction 83 To study system (6. If a > 0 then the origin is called an unstable focus or a source and the phase diagram is like 3. the origin is called a center or a focal point.18) as t -> oo. it is convenient to introduce polar coordinates. Let where r>0 and r-Vy2+y2.2(f) with the arrows reversed. (i) If a = 0. .

Finally. pp. stability and chaos in dynamic economics Remark 6. Remark 6. See Hahn (1967. x0) | -> 0 as t -> oo.4. then the linearized part can be analyzed using not only theorem 4.> R n and consider x=f(t. p. t1 E [0. Saddle points and unstable nodes (tangent. 27).2. but also the insights of phase portraits developed in this section. The 0-solution is called attractive if there exists a number 60 = 6o(t 0 ) > 0 such that |x0|< 60 implies |o (t. See Hale (1969. Miscellaneous applications and exercises Suppose f:[0. 7. The 0-solution is asymptotically stable if it is stable and attractive.84 Differential equations. 0) = 0 for t e [0. x) such that f:[0. oo) x Rn -> Rn and f(t.x) such that f(t. suppose that the 0-solution is stable at t0. (2) Consider x=f(t.2. Stable nodes (tangent. If the nonlinear part satisfies the conditions of theorem 4. There are systems that have no equilibrium solutions. oo). Furthermore. 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. Show that the 0-solution is also stable at t1 = t0. o o ) x R n . stellar and improper) and foci are asymptotically stable. 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). oo). stellar and improper) and foci are unstable. 0) = 0 for t e [0. An example of such a system is (4) . t0.5. Show that the concepts stable and attractive are independent of each other. oo).

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

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

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. The original ideas may be found in Bendixson (1901). For those interested in the study of differential equations through computer experiments. . For general details see Plaat (1971. Thom (1975) has applied structural stability to the natural and biological sciences and Fuchs (1975) uses structural stability in economics. 433448) and for proofs see Coddington and Levinson (1955. 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. 242-249) or Gandolfo (1980. chapter 16). R. Finally. pp. Kocak (1986) offers a manual and a diskette to help readers learn how to use a program called PHASER which runs on personal computers. chapter 16) or Peixoto (1962). Schinasi (1982) gives an application of the Poincare-Bendixson theory in economics.Stability methods: An introduction 87 for an introductory survey the reader is referred to Hirsch and Smale (1974. pp.

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Liapunov gave some very simple geometric theorems . 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.CHAPTER 4 ADVANCED STABILITY METHODS In his famous memoir. Preliminaries In this chapter we continue to investigate the stability properties of ordinary differential equations. For methodological clarity. 291) 1. Local results report on stability. While the previous chapter presented some elementary stability methods. 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. . we concentrate essentially on the autonomous case because . The global results refer to asymptotic stability at large for initial values in the whole of Rn. This distinction has already been made on several earlier occasions. for deciding the stability or instability of an equilibrium point of a differential equation. In this chapter. Hale (1969. this chapter exposits the Liapunov approach and some other recently developed mathematical methods that have been found useful by economists. primarily for linear and linearized systems. asymptotic stability and instability for initial values in a small neighborhood of the 0-equilibrium solution. .

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

represent a set of ovals or level curves surrounding the origin. Let us take one step further. for a positive definite V(x) on D. must intersect the level curve described by the set {x: V(x) = c} for 0< c< k. it has a gradient usually denoted by Vx or V V(x) or grad V. then use of the chain rule in calculus yields. 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. In other words. there is a neighborhood U of the origin x — 0. It is helpful to describe the geometric meaning of the function V(x). For concreteness. t0.1). The curves V(x1. . 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. take n=2 and assume that V(x l .Advanced stability methods 91 is positive definite on R3 and positive semidefinite on R4. Since V(x) has continuous partials. such that any continuous curve from the origin to the boundary of U. The function is positive semidefinite on R3 because for x1 — 0 and x2 = —x3 = 0. x2) is positive definite. with the closure of U contained in D and a constant k > 0.1) define If we let o(t. it becomes zero. The function V(x(t)) is called the trajectory derivative or the time derivative along a solution x(t). x 0 )= o(t) = x ( t ) be a solution of x = f ( x ) in (1. For f as in (1. Thus. The function is positive definite inside the unit circle but indefinite on R2 because it becomes negative for x outside the unit circle. x2) = constant. Assume that V(x) is positive definite on D < R n and further assume that V(x) is continuously differentiable. denoted by d U.

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

Since we assume that V(o(t.1) and consider. . t0. t 0 .1) Choose 8 > 0 such that if |x| < 6 then V(x) < V0. are crossed by the continuous curve F from the exterior and toward the interior. 292-299) and LaSalle and Lefschetz (1961. t0. Let e > 0 be given such that the closed ball of radius e is contained in D. the hypothesis that V(x)<0 implies that From (2. pp. 0 < 8 < e. t0. |x| = E (2. x2). and V(x) is negative semidefinite for x e D. 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.1.x 0 ) = x ( t ) be a solution of x = f ( x ) in (1. we conclude that the 0-equilibrium solution is asymptotically stable. Our analysis follows Hale (1969. a continuous curve F from the origin to the boundary of a set U containing the origin with U c= D. shrink towards the origin. . x0) of x = f ( x ) satisfies | x ( t . Therefore. Then the 0-solution of x =/(x) in (1. there is a 5 > 0 such that for |x0|<6 the solution x(t. Then if |x0|<6.2) conclude that | x ( t . recall that stability of the 0-solution implies. . x 0 )| < e for all t > 0. . x 2 ). Define V0 = min V(x). Proof. y2 = V(x1. since the motion in the phase space along the curve F is toward the origin. Such a 5. Such a curve may represent the path or orbit of the solution x ( t ) in the phase space as t -» oo. 2. y1 — V(x1. that is. automatically uniform stability and asymptotic stability implies uniform asymptotic stability.1) is stable. For autonomous systems. . x2). . . (Liapunov stability for autonomous systems. pp.Advanced stability methods 93 curves. We need to show that given an e > 0 and t0 > 0. See figure 4.) Suppose that there is a continuously differentiable positive definite function V(x):D c= Rn -> R. V(x(t)) decreases monotonically and that the level curves y1 = V(x1. Furthermore let o(t. in the special case of n = 2.1. x 0 )) = V(x(t))<0 for x = 0 and xED it follows that as t -» oo. exists because V(0) = 0 and V(x) is continuous on D. x 0 )| <e for t >0 and thus the 0-solution is stable. as t -» oo. x 2 ). t0. . where D is an open set containing the origin. 37-40). let {x: |x| < e}c D < Rn. Theorem 2. y2 = V(x1.

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

Advanced stability methods 95 Assuming the existence of a Liapunov function makes the stability and asymptotic stability proofs simple. See Hale (1969. this book uses the definition of V in (1.) Let D <= Rn be an open. Choose an open and bounded set D0 containing the origin such that D0=D. Let x(t) = x(t. Then the 0-solution of x=f(x) in (1.3. partially. However. Proof. (Liapunov instability for autonomous systems. Ultimately. such as for linear systems. Theorem 2. t0. a methodology is available to guide us in constructing a Liapunov function. V is continuously differentiable. Suppose that V is continuously differentiable on D. Integrating. The examples in this chapter and the applications in subsequent chapters will familiarize the reader with several useful techniques. and also that V — 0 on d U n D. in most of the applications. the critical question to be answered is how to construct such Liapunov functions. that V and V are positive definite on D n U. we conclude that . 293). Remark 2. In some special cases. Define Note that S is closed and bounded which makes it compact. constructing Liapunov functions is in general a rare skill that is acquired. 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. x0) be a solution which implies that V(x(t))>a for x(t)eS.6). Let U be an open set which contains in its closure the 0-equilibrium solution. p. Given 5>0. From the hypothesis we infer that V(x 0 )>0. Let Observe that a > 0 since d U n S is empty.3) instead of (2. choose x 0 eD 0 nU with 0<|x 0 |<6.1) is unstable. connected set that contains the origin. that is on that part of the boundary of U inside D.2. The topic is addressed later in this section. by having seen many Liapunov functions corresponding to specific systems.

there is a ft such that x ( t ) leaves D0n U at time t1.2 This last equation says that as t increases V(x(t)) eventually becomes unbounded. Let X(t1) E d(D 0 nU). stability and chaos in dynamic economics Figure 4. 0) = 0. Example 2.96 Differential equations. x ( t ) must eventually leave D0n U. 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. See figure 4. Consider the system with f(0. V cannot become unbounded for x e 5. However. Some independent possibilities include: . But x(t1) cannot be on the part of the boundary of U inside D because by hypothesis V = 0 there. we conclude that the 0-solution is unstable because no matter how close to the origin we start. Since D 0 nU is compact and V is continuous.1. since V is continuous and S is compact. Thus x ( t l ) is on the boundary of D0 inside U. solutions escape a bounded set D0 in finite time. y). Since X0 is chosen arbitrarily close to the origin.2. Therefore.

conclude by theorem 2. 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. A special case is reported in example 4. y) is positive semidefinite on an open neighborhood D c R2 of the origin.2. For example. 6) and g ( x ) > 0 for x E (-6. assume that f(x. Then. the 0-solution need not be asymptotically stable. if f(x. It is clear from (2.11). 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. that the 0-solution is stable but it is not asymptotically stable. First.5 of chapter 3. Note that if f ( x .8 of chapter 3 where f(x.8) can be computed to be ±i from which we can only conclude the stability of the 0-solution of the linear system. Second. This example illustrates the generality of the Liapunov method in deciding stability or instability. V is negative semidefinite on D and by theorem 2. 6) of zero. y ) plays a critical role.3 let U = R2 and conclude that the 0-solution is unstable. It is shown there that with f(x. assume that f(x. the 0-solution is stable.Advanced stability methods 97 First. Example 2.1. the three cases discussed here illustrate that. 6) observe that V(x) is positive definite and V(x) is negative definite and conclude from theorem 2. .8) cannot be studied conclusively by computing the eigenvalues of its linearization.8 it is shown that the 0-solution is asymptotically stable using a specialized analysis. y) = x2 + y2 is positive definite.2 the 0-solution is asymptotically stable. assume that g'(0)<0. The analysis of this chapter illustrates the generality of the Liapunov approach.0). Second. the eigenvalues of the linearization of (2. More specifically. y) is positive semidefinite. For x E (-6. suppose that f(x. y) = 0 on D. V is negative definite and by theorem 2. However. Then V is positive definite on D. V is positive definite. Consider the autonomous system and make appropriate assumptions to study the stability properties of (2.12) and the assumption that g'(0)>0. Using (2. In example 4. To apply theorem 2. y) = 0 on D. The nonlinear system in (2.3 that the 0-solution is unstable. Third.2 that the 0-solution is asymptotically stable. assume that g'(0)>0.10) that the nonlinear part f ( x . then this example reduces to example 2. y) is positive definite on D. in general. Let g(x) be a continuously differentiable real valued function on a neighborhood D = ( — 6. y) is negative definite in a neighborhood D of the origin.

that is. Assume that f(0) = 0.1. stability and chaos in dynamic economics Example 2. lim k->oo f'(k) = 0. In this example we establish the stability of the equilibrium solution of the neoclassical economic growth model.14) is multiplied by a positive constant A. In a later chapter. If this property is satisfied. K ( t ) denotes units of capital stock and L(t) denotes units of labor force. 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.L(t)). with 0 < s < l .3. then the dependent variable is also multiplied by the same constant. From the homogeneity assumption obtain (note that the variable t is dropped) where k = K/L is the capital-labor ratio. Example 2.4.98 Differential equations. stability issues of economic growth are presented in greater detail.f"(k) < 0. all at time t. L). the 0-solution of (2.f'(k)> 0. lim k->0 + f'(k) = oo. denoted by K. (2. Investment is defined to be the time derivative of K(t).14) where Y(t) denotes units of output. Consider a production function Y(t) = F(K(t).14) is called homogeneous of degree 1. . Equilibrium requires that investment must equal saving.13) is stable.14) satisfies the property: if each of the independent variables in (2. It is assumed that (2. and saving is defined to be sF(K. (2. Let Then Therefore by theorem 2.

The importance of this system has already been emphasized in the previous two chapters. Also. Actually k* is asymptotically stable for k>0.17) to derive the one-sector neoclassical differential equation of economic growth for the certainty case: Equation (2. The next logical step in the study of the Liapunov method is the analysis of the linear autonomous system with constant coefficients.4. This concludes example 2. Consider the system .18) has been the subject of much research in economics.Advanced stability methods 99 Assume that labor grows exponentially given by Under the above differentiability and concavity assumptions about (2.20) note that the inequality follows from the strict concavity property of f(k). V(x) is negative definite because k * f ' ( k * ) < f ( k * ) .15) through (2. The purpose of revisiting this topic is to illustrate a method for constructing a Liapunov function for an autonomous linear system with constant coefficients. Denote the equilibrium solution by k* and use the Liapunov function where x = k . By theorem 2.k*. Solow (1956) used equations (2.2 the k*-equilibrium solution is asymptotically stable for k in a neighborhood of k*. Compute: In (2. A useful reference on this subject is the book of Burmeister and Dobell (1970). Assume that and set k = 0 in (2.18) to obtain a unique positive equilibrium solution.14).

3 we need a Liapunov function. stability and chaos in dynamic economics with A being an n x n constant matrix. Then V(x) in (2. suppose that the eigenvalues of A have negative real parts and let C be a given positive definite matrix.1 of chapter 3 we conclude that the eigenvalues of the matrix A have negative real parts. Thus the integral in (2.25) converges and thus B is well defined. so that for any vector y € Rn.1. 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.2.100 Differential equations. Lemma 2.23) is negative definite. .1.24). y = 0. A has negative real parts there are positive constants K and a such that |e At | < K e-at. the 0-solution of x = Ax is asymptotically stable and from remark 4. Therefore. To apply theorems 2. by hypothesis. Proof. Suppose A in (2. by theorem 2.25). 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. Conversely. from its definition in (2. t > 0. Let C be a positive definite matrix and suppose that B is a positive definite solution of (2. Also. B is positive definite because by hypothesis C is positive definite.22) is positive definite and V(x) in (2.2 and 2. Recall that AT denotes the transpose of A and define Since.21) is a real n x n constant matrix such that det A = 0.

Since a1 = 2>0 and a 1 a 2 -a 0 a 3 . Next. Therefore.27) is also symmetric. B satisfies (2. Consider. consider the Routh-Hurwitz criterion of theorem 5. They are At = A2 = —1. 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 . The solution is Therefore. = (2 • 1)-(1 • 0) = 2>0 we also conclude that the 0-solution is asymptotically stable.24) since This completes the proof. for instance. the eigenvalues of the matrix in (2. B in (2. that is. To apply the Liapunov approach let C = I. 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.5.2 the 0-solution is asymptotically stable. Note that since I is symmetric.1 of chapter 3. In this example we reviewed two methods exposited in chapter 3 and the Liapunov method.Advanced stability methods 101 Finally. the 0-solution is asymptotically stable.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.1 of chapter 3. let C be the identity matrix and use (2. for B as above V(x) = xTBx > 0 and V(x) = -xrCx < 0 for x e R2 and x = 0 and by theorem 2. by theorem 4. Example 2.26).

stability and chaos in dynamic economics Routh-Hurwitz criterion. symmetric.3) of the previous section To determine that V(x) in (2. instead of considering a linear system as (2. and also let W(x) = o(|x| p ) as |x|-»0 be continuous. Let I be the identity matrix which is positive definite and suppose that the eigenvalues of A have negative real parts. Since Vp(x) is positive definite k > 0 and since Vp(x) is homogeneous of degree p. we apply the Liapunov method of lemma 2. it is a proof for theorem 4. Lemma 2. Let k = min |x|=1 Vp(x). there is a positive. Put V(x) = xTBx and compute V(x) for (2. definite matrix B such that ATB + BA = — I. The advantage of the Liapunov method becomes evident when.> 0 as |x|->0.10) of the previous chapter. using the definition in (1. Then. Let Vp(x) be a homogeneous positive definite polynomial of degree p. Note that W(x) = o(|x| p ) as |x|->0 means that ( W ( x ) / \ x \ p ) . the following analysis is more than an illustration.28) has continuous first derivatives in Rn with h(0)=0 and 6k(0)/dx = 0. Suppose that h(x) in (2.2. 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. From the hypothesis about W(x) for any given e > 0. Actually. Then is positive definite in a neighborhood of the origin. for any x = 0. 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.28) is the same as (4. there is a 6 ( e ) > 0 such that if |x|< 6(e) we have | W ( x ) | < e|x| p . Furthermore.1 to the equation Recall that (2.21).102 Differential equations.29) is negative definite we need the following lemma. .28). Proof. recall that a proof of theorem 4.28).2 of the previous chapter.2 is pending.

which has just been proved.2 the 0-solution is asymptotically stable.Advanced stability methods 103 With the help of lemma 2. If.2. To establish this result without loss of generality. Consider the nonlinear system . The first block A.31) for x as in (2. on the other hand. assume that the matrix A is in Jordan canonical form.28).29) is positive definite in a neighborhood of the 0-solution of (2. Thus.29) is negative definite and by theorem 2. we can restate theorem 4. as in theorem 4. Therefore for the 0-solution of (2. V(x) is positive definite in a neighborhood of the 0-solution of (2. as follows.3 the 0-solution is unstable. Computing V(x) of V(x) as in (2. that the 0-solution of (2. Define the Liapunov function where x = (x1. the 0-solution is asymptotically stable. as in section 5 of chapter 2.1 twice in the following manner.2. Since (2. Then (i) if all the real parts of the eigenvalues of the Jacobian f x (0) are negative.28) arises from the linearization of the nonlinear autonomous system x = f ( x ) .28).2. then we conclude. no eigenvalue of A has a zero real part and an eigenvalue of A has positive real part. Theorem 2. the analysis beginning after (2. we conclude that —V(x) in (2. This way we can apply lemma 2. consists of all the eigenvalues having negative real part and the second block A2 consists of all the eigenvalues having positive real part.6.28) establishes theorem 4.4.28) is unstable.2 part (ii) of the previous chapter. 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.2 of the previous chapter.28) obtain that By lemma 2. Example 2. with two blocks. the 0-solution is unstable.28) and by theorem 2. 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. (ii) if some eigenvalue of the Jacobian fx(0) has positive real part. x2) with x1 and x2 having the same dimensions as B1 and B2 respectively. V(x) = xTBx is positive definite and V(x) in (2.

Remark 2.32) is asymptotically stable by theorem 2.1.21) or (2.29) to obtain From lemma 2.27).32) can be put immediately in the form of (2.32) choose as V(x) the following: To compute V(x) use (2.28) From the analysis in example 2. Also from lemma 2. Therefore.5 we conclude that we can apply the Liapunov approach with C = I to solve for B given by (2.2. the Liapunov approach provides the researcher with a second option and indeed it is by the help of the Liapunov approach that theorem 4.1 observe that B in (2. Although it is usually easier to compute the eigenvalues of A and use theorem 4.104 Differential equations.2. p. for system (2.4 by saying that if the stability behavior of x = Ax is significant then for h(x) = o(|x|) the stability behavior .2 of the previous chapter or theorem 2. we can rephrase theorem 4.3. Hahn (1963. both the eigenvalue method and the Liapunov method for systems such as (2.2 of the previous chapter to obtain the eigenvalues of A and to check the properties of h(x). The same conclusion is also obtained from theorem 2.27) is positive definite so that (2. by using a Liapunov function obtained from the linearized part of the system via lemma 2.2 conclude that V(x)<0 for x = O and V(0) = 0. Of course.1. The same example can be worked out using theorem 4.28) are connected by lemma 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. This example illustrates the usefulness of the Liapunov method in determining the stability properties of a nonlinear system. Note that (2. stability and chaos in dynamic economics and study its stability properties. the 0-solution of (2.2 is proved. Therefore.4(i). Using this terminology.34) is V(x)>0 for x = O and V(0) = 0.

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.X1> 0 and also that x2 > 0. By assumption x1 >0. (0. Before we can determine the stability properties of this system we need to find the equilibrium states. 0) consider Note that for small values of xl. Thus.36) to obtain four equilibria: (0. 0) is unstable. often times. D is a neighborhood of the origin. 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. That is. it is called critical. for the equilibrium (0.. y2) = xl. 0).1 in this section where the nonlinear part plays a critical role in determining the stability properties of the entire system. V(x1.7.Advanced stability methods 105 of x = Ax + h(x) is also significant. Recall example 2. for all (x.{0}. [c11 .0) and ([c 22 -c 12 ]/[c n c 22 -c 12 c 21 ]. 0< c12< c22. the equilibrium (0. When the behavior of A is not significant. (l/c 1 1 . V(x1. Second. Then the closure of U contains the origin. y2) are positive on U n D . As was pointed out earlier. therefore.c21]/ [C11C22 . when A has a critical behavior we cannot automatically deduce the stability properties of x = Ax + h(x). l/c 22 ) is unstable. x2. Let V(x1.c22> c12. 0). l/c 22 ). Set x1 = x2 = 0 in (2. y2) and V(x1. (x1. x2) = (0.C 12 C 21 ])- First. cn > c 21 . y2) = 0 on the boundary of U inside D. l/c 22 ) apply the translation y 2 = x 2 (l/c 22 ).y 2 ) sufficiently close to the origin we get that X1 > 0. Example 2. . V and V are positive definite and therefore (0. for (0.

Also.1.2 and 2. A function V(t. with A being the linear part of this last equation we obtain that the eigenvalues of A have negative real parts. 0). Put (2.36) as with equilibrium (y1. rewrite (2. stability and chaos in dynamic economics Third. 2. 3. V(t. are unique and also depend continuously upon initial data. 0). the equilibrium (l/c 11 .0) = 0 for all f>0 and there is a positive definite function . x ) .37). Therefore the equilibrium (z1. oo) x Rn -» Rn is continuously differentiable so that solutions exist. oo) x D -> R is positive definite if V(t. Definitions 3.y2)->(0.0) is unstable using an analysis similar to the second case. solving det(AI-A). the only difference being that some attention is required to see that things happen uniformly in the time variable t. x):[0.38) in matrix form as in (2. Several useful definitions are collected below. z2) is stable. Let D be an open subset of Rn that contains the origin. This section collects the appropriate definitions and states theorems on the stability properties of nonautonomous systems. x) is continuous in ( t .1.106 Differential equations. The proofs are similar to the ones presented earlier. Local stability for nonautonomous systems Theorems 2.3 of the previous section can be extended easily to nonautonomous systems. For the fourth equilibrium point denote and apply the translation Using (2. Consider the nonautonomous system where f:[0.28) by writing Note that in this last equation the nonlinear term approaches zero as (y1. y2) = (0.

oo) x D for some r>0 with D c {x E Rn: |x| < r}. we define the time derivative along the trajectories of (3. x) E [0. x) given in (3. oo) denote an arbitrary continuous function that is strictly increasing on [0. x)| < U(x) for all (t. r] with g(0) = 0. Also. once again. Assuming that V(t.> R such that | V ( t . oo) x D. It is easy to show that a continuous V(f.1. More specifically.x)>W(x) for all (t. Remark 3.1) as Note. x)| < g(|x|) for all (t. A function V(t. x).2) is computed without having to solve the ordinary differential equation in (3. 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. Finally the function is positive semidefinite but it is not decrescent for (t. To formulate such equivalent definitions the key idea is the notion of a strictly increasing continuous function.1. and that for some r > 0 it follows that V(t. oo) x D. Note that D c {x E Rn: |x| < r}. x) > g(|x|) for all (t. that the time derivative of V(t. x) E [0. r] -» [0. the function is positive definite but it is not decrescent for (t. x): [0. x):[0. 0) = 0 for all t ]> 0 and V(t. x):[0.x) is continuously differentiable so that it has continuous partial derivatives with respect to both (t. oo) x D. oo) x D -> R is decrescent if it is continuous in (f. 0) = 0 for all t > 0. .> R such that V(t. oo) x D. oo) x D. The function is positive definite and decrescent for (t. x) and there exists a positive definite function U ( x ) : D . for some real r > 0 let g(x): [0. Example 3. A continuous function V(t. oo) x D-» R is decrescent if and only if | V(t. x) e [0. Let D< R2 be a small neighborhood of the origin. x) e [0. x)e [0. a continuous function V(t. oo) x D. x) e [0. On the other hand. x) > 0 for U x) e [0.1). oo) x D -» R is positive definite if and only if V(t.Advanced stability methods 107 W ( x ) : D . oo) x D. oo) x D-> R is positive semidefinite if V(t. x) e [0.

x(t.x) positive definite. 0) = 0 for all t > 0 we can choose 6 to be so small that if |x0| < 8 then V(t0. x0) < g ( e ) . This completes the proof.1. Theorem 3. Using remark 3. x ) > 0 with V(t. x ) < 0 so that V(f. oo) x D -> R such that V(t. Proof. oo) x D -» R such that in every neighborhood of the origin there are points x such that V(t. For the nonautonomous system . t 0 . x):[0. oo) be a continuous function that is strictly increasing with g(0) = 0. positive definite. x) < 0. such that V(t. The interested reader can find these proofs in Hahn (1967. x):[0. x) in (3. Let £ > 0 and t0 > 0 be given with e < r. t0.x) in (3.1) is stable. t 0 .x 0 )|< e because V(t. (Liapunov stability for nonautonomous systems.108 Differential equations. (Instability for nonautonomous systems. positive definite. 198-204).1. x) is continuous with V(t. x 0 )) is nonincreasing with V(t.) Suppose that there is a continuously differentiable.4. stability and chaos in dynamic economics Next we state theorem 3. x) > g(|x|) for 0 < | x | < r and t >0. Then the 0-solution of x = f(t. x 0 )| < e for all t > t0. Theorem 3.1) is uniformly asymptotically stable. Example 3. We need to show that there is a 8 = 8 ( e . x) in (3. t0.2. Then the 0-solution is unstable. Then the 0-solution of x = /(r. The proof is similar to the proof of theorem 2. Theorem 3.) Suppose that there is a continuously differentiable decrescent function V(f. x):[0. Theorem 3. t0) such that if |x0|< d then | x ( t .1) is uniformly stable. x(t. x0))<g(e) for t > t0.1. x): [0. r] -»[0. (Uniform asymptotic stability. x ) > 0 . (Uniform stability. For 8 thus chosen we conclude that | x ( t . Then the 0-solution of x =f(t.2. oo) x D -» R with V(t. The following three theorems summarize the stability and instability properties of the nonautonomous systems. Since V(t. To illustrate these theorems we present three examples.) Suppose that there is a continuously differentiable.1 in the preceding section with additional attention paid to the variable t. decrescent function V(t.) Suppose that there is a continuously differentiable positive definite function V(t. pp. let g(x):[0. decrescent function V(t. oo) x D-> R with -V(t.3. Proofs are similar to the ones presented in the previous section and are omitted. x) < 0.

3) is stable.3) is with eigenvalues A1 = 0 and A2 = —1. The linear part of (3.2 to conclude the uniform stability of the 0-solution because V in (3.5) is stable. xl. . It is given by Since V(f.4) is positive definite and V(t. Therefore (3. Furthermore.Advanced stability methods 109 consider the Liapunov function and compute the time derivative of (3.3) can also be established using exercise 10 of the previous chapter. X1.1.4) using (3. Furthermore since the nonlinear part of (3. x2) < 0. Suppose that a ( f ) > 0 and d ( f ) > 0 for t E [0. Let and compute Therefore by theorem 3. we conclude by theorem 3. We want to show that the 0-solution of the second order nonlinear equation is stable.x2) in (3.4) is not decrescent.1 that the 0-solution of (3. It may be instructive to note that the stability of the 0-solution of (3.3) is stable.3. the 0-solution is stable for x in a small neighborhood of the origin. oo). Example 3. observe that although V>0 and V<0 we cannot use theorem 3.2).3) is bounded and foo e-t dt = 1 we conclude by exercise 10 that the 0-solution of (3.

Our goal is to illustrate that the analysis of dynamic economic models benefits from the methods of stability theory. our study of stability is motivated by reasons that go beyond its intrinsic mathematical interest.1 of the previous section. In economic applications it is not difficult to find reasons to argue that asymptotic stability is more important than stability. If b ( t ) > 0 then the 0-equilibrium is unstable. For example. stability and chaos in dynamic economics Example 3.110 Differential equations. 4.4. If b(t)<0 then the 0-equilibrium is uniformly asymptotically stable. Actually. Actually. 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. p. suppose . As is mentioned elsewhere in this book.7) generalizes example (4. it is relevant for the economic theorist to reflect on the relative importance of the various stability concepts. The exposition of these theorems has been mathematical in scope and no emphasis has been given to an evaluation of the various stability properties. 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. Use and compute If b(t)< 0 then the 0-equilibrium is uniformly stable. how could such models be helpful in guiding the theorist's deductions and the policy maker's recommendations? Therefore. unless dynamic economic models are analyzed for the existence. uniqueness and stability properties of the equilibrium solution. Consider the system reported in Hahn (1967. 204) Note that (3.

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

0. the 0-solution is not globally asymptotically stable. in the simple two dimensional space (t. This behavior implies that the 0-solution is globally asymptotically stable but not stable. Therefore. However. then x(t)-> 0 as t-> oo and thus conclude that the 0-solution is asymptotically stable. stability and chaos in dynamic economics Example 4.0 and x(0) = x0 From (4. 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. because for any given e>0. oo). It is also true that global stability need not imply local stability. 0. x 0 )|> e for values of t in some subinterval of [0.2. From (4. to obtain which yields the solution for t . if we choose x0= 1 then it is not true that x(t) in (4. To proceed with various results on global asymptotic stability we need some topological definitions and a lemma about the limit properties of orbits.112 Differential equations. For x0 = 1 obtain from (4. Here we give an example of an ordinary differential equation in which the 0-solution is locally asymptotically stable but not globally asymptotically stable. . x).4) will approach zero as f-» oo. the solution | o ( t . 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.4) observe that as x0 is chosen close to the 0-solution. no matter how small an x0 we choose.4) that x ( t ) = 1 as t -> oo. For example imagine. for example. x0) grows rapidly before it decays approaching zero as t -» oo. local stability does not imply global stability.3) conclude that x = 0'and x = 1 are the two equilibrium solutions of that equation.

5) going through p at t0 = 0 can be viewed as a function of (t. p) = o(t. 2 and 3 hold. oo) x Rn and consider the function This function o(t. p) going through p at t0 = 0 is defined for all t E (-oo. 0. p) satisfies three properties: 1. For the purpose of analyzing the global asymptotic stability property of (4. y+ or y the orbit. similarly. 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. o(t + s. p). positive semiorbit or negative semiorbit with no reference to a specific point p. The solution o ( t . Here we review this notion by defining an orbit as the range of the solution o ( t . oo). p ) of (4. The reader may recall that the notion of an orbit as trajectory into R" is introduced in section 6 of the previous chapter. o ( t .Advanced stability methods 113 Definitions 4. . p ) ) for any real number s on G < Rn+l. 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. For a given point p. o(0.5) going through p at time t0.1. 3. let G be an open subset of (-00. o ( s . It is no loss of generality to let t0 = 0 and to write o ( t . p) is continuous on G C R n + 1 . More specifically. p) of (4. p) = p. Put differently. t0. 2. We denote y. no two orbits can intersect. p ) in the x-space. all p e Rn and properties 1. we define to be the negative semiorbit through the point p. p) which has certain properties. p) as o(t. there exists a unique solution o (t. Assume that for any point p E D. Consider the autonomous differential system where f ( x ) : D < Rn -> Rn is continuous and D is an open set in Rn.

These theorems follow either the Liapunov methodology or state conditions involving the Jacobian matrix J ( x ) of x=f(x) in (4. that is. . reduce to conditions involving one of the two inequalities or where a dot in (4. a set M c Rn is called an invariant set for (4.5) is closed and invariant. connected and the distance between o(t. . p) e M for all t e (-00. p). . j = 1. 2. 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. For a proof see Hale (1969. The w-limit set of an orbit y of an autonomous system (4. y+. The theorems that follow the Liapunov methodology rely on the concept of the Liapunov function.1. Having introduced the concept of global asymptotic stability and made several essential definitions we are now ready to state and prove a few theorems. . is a Liapunov function if V(x) is positive definite and its trajectory derivative V(x) is negative semidefinite for x e D. then o(t. if the positive semiorbit. .5). In other words. Also. stability and chaos in dynamic economics The positive limiting or w-limit set of an orbit of (4. Observe from the definitions given that any orbit is an invariant set. p. . Recall from section 1. Finally.5) if for any p e M. . n. Recall that if x = [x1.114 Differential equations. is bounded. The criteria for global asymptotic stability that make use of the Jacobian. The properties of the w-limit set are summarized in the following lemma. that a scalar function V(x):D<= Rn -> R. J ( x ) = [df(x)/dx] = [ d f i ( x ) / d x j ] . where i. . .5) is denoted by and defined as w(y + ) Similarly.11) and (4. then the w-limit set is nonempty. . 47). x n ]e Rn and y = [y1. compact. and w ( y + ) approaches 0 as f-»oo. Lemma 4. . 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 negative limiting or a-limit set is defined in the same way as (4.12) denotes scalar multiplication.10) with the only exception that t is replaced by -t. . oo). y n ] E Rn are n-vectors then the dot . 0 E D.

where e > 0 is small. However.1. This section draws heavily from Hartman (1964. From the continuity of the Liapunov function we get that uniformly for t e [0. e]. and Markus and Yamabe (1960). From the assumption that V(x0) < 0 conclude that The continuity of solutions on initial data theorem 7.> V(xo) as k-»oo and from the fact that V<0 conclude that To show that V(x0) = 0. pp. with o(t k )->x 0 as k -» oo. Without loss of generality suppose that tk < t k+1 .5) for all t > 0 and suppose that x0 is a point of the w-limit set of o ( t ) that lies in D.14) and (4. 56-71). Since x 0 is an w-limit point there exists a sequence { t k } . pp. . 296-299) and LaSalle and Lefschetz (1961.1 of chapter 1 implies that if | ( o ( t k ) .* x0 for k->oo. Suppose that o(t) is a solution of (4. Then V(x 0 ) = 0. Theorem 4. o ( t k ) ) . In particular as o ( t k ) . x0) for 0 < t < e. Hartman and Olech (1962).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.13). We need to show that if x0 E w ( y + ) then x0 E{x: V(x) = 0}. then | o ( t . pp. e] as k-»oo. x 0 )|->0 uniformly for t e [0. Proof. this last equation is a contradiction to (4. tk->oo. suppose that V(x 0 ) < 0 and consider the solution o ( t . 537-555). (4. Thus it is proved that x 0 e{x: V(x) = 0}.15) yield for tk>0. From the continuity of the Liapunov function obtain that V ( o ( t k ) ) . Let f(x) of (4.x 0 |->0 as k->oo.o(t. Hale (1969.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).

we conclude that independent of the initial point p e Rn all solutions o(t.1. all solutions exist on [0. 0. Then we could conclude that the 0-solution is not only globally asymptotically stable but also locally stable from theorem 2. and strengthen the hypotheses by assuming that V(x) is a Liapunov function.2.) Let f(x) of (4.2.2. under this added assumption. {x: V(x) = 0} = {x0}. 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. that is. (Global asymptotic stability. p)-» x0 which proves that x0 is globally asymptotically stable. However. This is true because as in the proof of theorem 4.2. and if there exists a unique point x0 such that V(x 0 ) = 0.116 Differential equations. Under the stated assumptions about f. Then all solutions of x =/(x) exist on [0. Thus. that is. The hypothesis that V(x)-> oo as |x|-» oo implies that V [ o ( t . by hypothesis there exists only one unique point x0 such that V(x 0 ) = 0.p)]. p)= o (t. p ) ] exists and because V(x)<0 we conclude that V [ o ( t . if M = {x0} then x0 is globally asymptotically stable. stability and chaos in dynamic economics Theorem 4. 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}. that is. Furthermore.3. and the other assumptions about f and V imply that these bounded solutions approach the singleton {x0} as t-»oo. by requiring that V is positive definite instead of positive semi-definite. 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. Again with reference to theorem 4. assume that {x0} = {0}. oo) and are bounded.2.5) 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. In the preceding theorem without loss of generality. V(x) < 0 for x e Rn and V(x) -» oo as |x| -> oo. Remark 4. Therefore. p ) ] < V[o(0. The boundedness of solutions means that there exists an to-limit set in Rn which by the preceding theorem 4. Remark 4. assume that {x0} = {0}. p) be a solution of x = f(x) for p e R". f and V are continuously differentiable on the whole R" space and let V ( x ) > 0 . Remark 4.1 is a subset of {x: V(x) = 0}.2) imply local asymptotic stability. this x0 is globally asymptotically stable. Proof. V and V in theorem 4. oo) and are bounded.1 of this chapter. Let o(t.

independent of the initial condition x0e Rn at t = 0. y) be given by and its trajectory derivative is obtained immediately by Assume that (1) xg(x)>0 for all x = 0.4. 298) let the Liapunov function V(x. V(x) < 0 for x = 0 and V(x) -» oo as |x| -» oo. 0. 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. Example 4. all together these hypotheses imply that. therefore the 0-solution is globally asymptotically stable. this implies local asymptotic stability and the assumption V ( X ) . imply that all solutions are bounded and converge to the largest invariant singleton set M = {0}. . x = 0.3. Thus.1 as follows: assuming V to be a Liapunov function such that V(x)->oo as |x|-»oo with V(x) < 0.» oo as |x|->oo implies boundedness of solutions. and (3) Jo g ( s ) ds -> oo as |x|->oo. Then the 0-solution of x =/(x) is globally asymptotically stable. the solution o ( t . p. (2) f ( x ) > 0 for all x = 0. 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. pp. These three assumptions imply that (1) V(x. y ) . 67-68) or Hale (1969. We can also reason in the language of remark 4. x 0 )-»0.> oo as |x|->oo.Advanced stability methods 117 for x = 0. Remark 4. V(0) = 0.

) Suppose that f(x) of (4. real. Then the 0-solution is globally asymptotically stable. real.11) and (4. Conditions (4.2 we also conclude that the 0solution is locally asymptotically stable. 0) is locally stable. symmetric positive definite matrix and let the Jacobian matrix J(x) satisfy for all points x = 0 and for all vectors y = 0. positive definite matrix. from theorem 2. If it can be shown that V is negative definite using (4. Observe that for V as in (4. Theorem 4. Let A be an n x n constant.2 to conclude the global asymptotic stability of the 0-solution of x =/(x). from theorem 4. symmetric. assume that A is a n x n constant. Specifically.20) in the calculation of V(x) and afterwards appeal to theorem 4. or remark 4.21) we can conclude from theorem 4. . (Global asymptotic stability.2.2 we conclude that the 0-solution is globally asymptotically stable and from remark 4.1 we conclude that the 0-solution (x.12).5) is continuously differentiable on the whole Rn space and f(0) = 0. y) = (0. Proof. Put and observe that such V is positive definite and V ( X ) .3 that the 0-solution is globally asymptotically stable.> OO as |x|-»oo.22).19) and (4.11) and (4.118 Differential equations.3.12) can be replaced by or by The theorems below make use of (4. The next two theorems make use of the Jacobian of f(x) and involve trivial generalizations of conditions (4. stability and chaos in dynamic economics Therefore.

> OO. the 0-solution is also locally asymptotically stable. Use as a Liapunov function and compute for x = 0 and V(0) = 0. Actually. (Global asymptotic stability.2 the 0-solution is globally asymptotically stable. Put (4.23) and use the hypothesis (4.5) is continuously differentiable on the whole R" space and furthermore suppose that |f(x)| -> oo as |x|-> oo.21) and the properties of the matrix A to conclude that if x = 0 and V(0) = 0. Proof. and from theorem 4. Thus the 0-solution is globally asymptotically stable.4.23) to the desired result that V(x) < 0 for x = 0 and V(0) = 0.26) conclude that V is positive definite and V-»oo as |x|->oo because |/(x)|-»oo as | x | .Advanced stability methods 119 To go from (4. From (4. 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. real. observe the following: for 0 < s < 1 use the chain rule to write which by integration yields because f(0) = 0. Since V vanishes at zero then f(0) = 0. Let A be an n x n constant.24) into (4. Theorem 4.) Suppose that f(x) of (4. .

548-554). 550-554).5 have found many applications in capital theory and several results are presented in chapter 9. let Du ={x: | X | > u } and assume that holds for x e Du and all y e Rn. t E [0. d E ] > a. Lemma 4. s ( b ) ) the following holds For a proof see Hartman (1964. stability and chaos in dynamic economics To state the next global asymptotic stability theorems we need a definition and a lemma from Hartman (1964.2 and theorem 4. 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. 0. x0) exist for t > 0 and o(t. x0) -> 0 as t -»oo. Then the 0-solution is globally asymptotically stable. 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. s(0) = 0 and for the right maximal interval of existence of w(t).5) is continuously differentiable on the whole Rn space with f(0) = 0 and f(x) = 0 if x = 0. pp. means the set of points x0 e D such that the solutions 0(f. 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. Suppose also that the 0-solution of x = f ( x ) is locally asymptotically stable. t e [0. where / is continuously differentiable on a domain D. Theorem 4. Both lemma 4. Suppose that f(x) of (4. 0. The domain of attraction of the 0-solution of x =/(x). satisfies d [ o ( t ) . Also. 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. b). pp. Then there are positive constants 8 and K such that for any solution w ( t ) of x = f ( x ) with |w(0) .o(0)| < 5 there is an increasing function s ( t ) .120 Differential equations. The next lemma and the theorem are due to Hartman and Olech (1962) and are reported in Hartman (1964).5. .2.

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 next theorem is due to Markus and Yamabe (1960). 310) use the following example to illustrate theorem 4. p. c2 such that Then each solution o ( t ) of x=f(x) the critical point as t->oo. Proof. Example 4.28) holds for xeE*.5) is continuously differentiable in the whole R" space.29) for (4. f ( x ) = 0. Using lemma 4.Advanced stability methods 121 Proof. Suppose that /(x) of (4. Since the domain of attraction of the locally asymptotically stable 0-solution is open. dE*]> a on the right maximal interval [0.27). that is E* = E . Then there exists a point XO E E* on the boundary of the domain of attraction of the 0-solution. Assume that each eigenvalue of is negative and also that there are positive constants cl. To compute (4. Consider the system for (x. This is a contradiction of the fact that x0 is on the boundary of the domain of attraction of the 0-solution. is bounded in Rn and it approaches See Markus and Yamabe (1960. Markus and Yamabe (1960. pp. 0.32) start with . y) E R2. In particular w ( t ) E E* on its right maximal interval of existence. x0) of x =f(x) be such that d [ o ( t . Theorem 4.B ( u ) .6.2 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. Let E* denote the open set obtained by deleting B ( u ) from the set E in lemma 4. Suppose that the 0-solution is not globally asymptotically stable.4. x 0 ). 309-310).2. X E E* and (4. From hypothesis.6. 0.2. The proof makes use of lemma 4. b).

6 every solution approaches the unique critical point as t -> oo. Here we present one typical result that is the direct analogue of theorem 4. there exist constants c1 and c2 so that (4.35) and apply the Routh-Hurwitz criterion to conclude that the eigenvalues of M are negative. Barbashin (1970). Chetaev (1961) and Zubov (1964) summarize these theorems which follow the Liapunov methodology and appeared in Russian journals during the 1950s.5. Remarks 4.33) conclude that |trace M| = 6.29) which considers a constant. Numerous theorems exist that establish the global asymptotic stability of nonautonomous systems. symmetric matrix B so that (4. They use a condition more general than (4. The interested reader is referred to these two papers for further details. (4. positive definite. by theorem 4.2 and remark 4.31) are satisfied.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. Furthermore. Actually. For detailed bibliographical references see Hahn (1963). |det M| > 4. Remark 4.122 Differential equations. .33) in (4. Russian mathematicians such as Krasovskii (1963). Hartman (1961) further generalizes JTB + BJ by considering a nonconstant matrix B.6. Therefore.30) and (4. y) observe that Use the computations of (4.6.3. stability and chaos in dynamic economics and obtain where as before JT denotes transpose of J. From (4. Economists have used these results as subsequent chapters illustrate. All the results in this section refer to global asymptotic stability of an autonomous system.

Also suppose that there exists a continuously differentiable. x):[0.f21. From theorem 3. Theorem 4.Advanced stability methods 123 In addition to the definition given in the previous section about V(t. x) is negative definite. Proof.3 of the previous section we conclude that the 0-solution is locally uniformly asymptotically stable. x) given in (3. x):[0.1) and suppose that f: [0. 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. U(x) > 0 for x = 0. Then the 0-solution is globally asymptotically stable.f12. Theorem 4. oo) x Rn -> R such that V(t. decrescent.f 2 are continuously differentiable for all (x. x) being positive definite and decrescent. . and use the fact that V is negative definite to conclude that bounded solutions converge to the 0-solution. Then the 0-solution is globally asymptotically stable. To do this. and V(t. and radially unbounded function V(t. positive definite. Finally. Suppose that the 0-solution is the only equilibrium of the nonautonomous system x = f(t.2). use the property that V(t. oo) x Rn -> Rn is continuously differentiable.f22 vanishes identically in R2. we also need the equivalent of V(x)-»oo as |x|-»oo used in this section. x) in (3. So it remains to be shown that the domain of attraction of the 0-solution is the whole Rn space. 0) = 0 for all t > 0 and there exists a continuous function U(x): Rn-> Rn with U(0) = 0. oo) x Rn -> R to be radially unbounded if V(t.7. y) e R2. We close this section with two theorems about the global asymptotic stability in the plane. The first one is due to Markus and Yamabe (1960) and the second is due to Olech (1963).8. x) is radially unbounded to show the boundedness of solutions. U(x) -> oo as |x| -» oo such that V(t. assume that one of the four partials f11. x) =» U(x) for all t > 0 and all x E Rn. Consider the two dimensional system and assume that f1. We define a continuous function V(t.

.124 Differential equations. Olech's theorem 4.9 contains theorem 4. Proof. For an extension of Olech's theorem see Meisters and Olech (1988).f21.8 by Markus and Yamabe.39) implies (4. stability and chaos in dynamic economics Proof. Observe also that theorems 4. pp.41). 311-314).8 and 4.0) = 0 and also suppose that the Jacobian matrix J ( x . Suppose that f1(0. Theorem 4. Consider the two dimensional system in (4.38). See Olech (1963. Example 4..0) =f 2 (0.41) to establish that the 0-equilibrium solution is unique.8) and then employs (4. Indeed.y)e R2 as assumed by Markus and Yamabe.41): Thus. y) e R 2 .36) and assume that f1. at each point in R2. assume that either or Then.9 are closely related. tion of To determine the global asymptotic stability of the 0-solu- compute (4. See Markus and Yamabe (1960. Thus.5.37) satisfies Furthermore.36) has.38) and (4.9. y ) in (4. if any of the four partials f11.39) to obtain that the Jacobian of (4.38) and (4.39). (4. the 0-solution is globally asymptotically stable. f 2 are continuously differentiable for all (x. the 0-solution is globally asymptotically stable.40) or (4. (4. Together these facts imply global asymptotic stability. Olech uses conditions (4.40) or (4. then this assumption with (4. characteristic roots with negative real parts (as assumed in theorem 4.f12.f vanishes for all (x.40) or (4. pp. 390-394).

explain the notion of a manifold. also. one could say that solutions. By implication.3. even if it is not true that local stability of an equilibrium holds. oo) x D-> Rn is assumed to be continuous in both (t. tend to the 0-solution as t -» oo. x):[0.2(b). and a diffeomorphism h: U -» V such that In other words. First. .0) = 0 for t > 0 and finally.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. To provide a geometric motivation of the theorem to be stated shortly let us refer to the two dimensional portrait 3. In other words for a given system. If U and V are open sets in R". The reader may recall that figure 3. starting in one dimensional linear subspace given by the y1 axis. To make these remarks more precise we need to first. We take these three steps in order. state the stable manifold theorem. 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. it may be true that a certain subset of solutions starting from a given subspace converge to this equilibrium. write the system of differential equations and third. then the property of the stable manifold may be worth investigating. the y2 axis is an unstable manifold because any solution that starts in y2 moves away from the 0-solution as t-> oo. oo) x D. h(t. there is an open set U containing x. Stable manifold In this section we return to local stability to introduce the reader to the notion of stable manifold. second. a k-dimensional (differentiable) manifold is a space which is locally diffeomorphic to the euclidean k-space. With this pictorial motivation one can understand that if local stability cannot be established for a given system. 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. x) e [0. The function h(t. Second. Therefore. an open set V<= Rn. a differentiable function h: U -> V with a differentiable inverse h-1: V-> U is called a diffeomorphism. given any e > 0. and call the y1 axis the stable manifold of this saddle. where D is an open subset of R" containing the origin. A subset 5 of Rn is called a k-dimensional manifold in Rn if for every point x E S.Advanced stability methods 125 5. to explain the notion of a manifold we need to define a diffeomorphism.

Miscellaneous applications and exercises (1) For the system use the Liapunov function V(x) = x2 to determine the stability properties of the 0-solution. in the (t. sufficiently small such that any solution x ( t ) near the origin but not on S at t . More specifically the following holds. 205). p. 6. 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.1) with the assumptions just stated seems more general than the two dimensional phase portrait 3. Proof. Having assumed A in 5.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.> 0 as t -> oo.1) satisfy the assumptions stated above and let k eigenvalues of A have negative real parts and n — k have positive real parts. 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. around a small neighborhood of the 0-solution. The books by Carr (1981). 330-333). pp. See Coddington and Levinson (1955. .1) starting on S at t = t0 for t0 sufficiently large. Theorem 5.x). the intuition is similar. The special cases k = n or k = 0 refer to asymptotic stability and instability. in a sufficiently small neighborhood of the 0-solution.1 to be an n x n noncritical. real matrix we distinguish between k eigenvalues with negative real parts and n . To repeat. The analysis is local. (ii) there exists an n > 0.) Suppose that the n x n matrix A and the function h(t. stability and chaos in dynamic economics there exists a 6 >0 and T>0 such that Although the system described by (5.t0 cannot satisfy | x ( t ) | < n for t > t0.x) of (5. satisfies x ( t ) .1.126 Differential equations. See Brauer and Nohel (1969. x) space. Guckenheimer and Holmes (1983). (Stable manifold.2(b). and Irwin (1980) discuss in detail the stable manifold theory.

p. 200). Can you use theorem 2. 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 . Also note that the Jacobian of this system evaluated at the origin is critical and therefore theorem 2. x2) = x2 + x2 is not helpful in deciding the stability properties of the 0-solution.4 to verify your answer? See Brauer and Nohel (1969. Can you use the theorem 2.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.x 2 ) = x1 + x2. Given the system use the Liapunov function (4) to show that the 0-equilibrium solution is stable.4 cannot be applied.4 to verify your answer? For the system show that the Liapunov function V(x1.

x 3 . x2> —1. Which of the following V( f. Let a.128 Differential equations. 105). Then V(t. x) is decrescent in [0.( 1 + x2)y. Let D be an open subset that contains the origin and suppose that the function V(f.0) = 0 for all t >0 and also V(t. y = . V(0)=0and V = 0. See Hahn (1967. c. Thus the 0-solution is stable. (10) Suppose that there is a positive definite matrix Q such that . 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): [0. Finally. stability and chaos in dynamic economics (5) for x1. b. Such a V is continuous for x1 and x2 and for e x1 > 1 + x.x):[0.x) has bounded partial derivatives with respect to x. 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. x = y. d be real constants and consider the system Use the Liapunov function V(x. V is positive definite because x 1 -ln(l + x 1 )>0 and x 2 -ln(l + x 2 )>0. ex2 > l + x2. p. oo) x D.oo) x D-» R satisfies V(t.

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

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

Without further ado. p. consider the following optimal control problem subject to measurable. 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. This raises the question of stability: under a slight perturbation will the system remain near the equilibrium state or not? LaSalle and Lefschetz (1961.CHAPTER 5 STABILITY OF OPTIMAL CONTROL A real system is subject to perturbations and it is never possible to control its initial state exactly. . 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. Introduction This chapter surveys various stability results of optimal control and indicates some possible areas of their application.

the technology function and transpose should not cause any difficulty because it is rather standard in the literature. 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.3) over some set 0 of instrument functions. T is the planning horizon.p>Q is the discount in future utility. ) E 0.1) somewhat. To specialize problem (1.1) is chosen as the vehicle of explanation of the results in this chapter because it is described in Arrow and Kurz (1970. that is.) and T(. the optimal v ( t ) .132 Differential equations. chapter 2). The choice of T to denote the terminal time. let Then. and. stability and chaos in dynamic economics where U is the instantaneous utility. under strict concavity assumptions on U(.5) denotes supremum which is taken over all instrument functions V ( .2) and (1. t is time. The objective is to maximize subject to equations (1. there is a function h(x) such that . W is independent of t0. v(t) is the instrument vector at time t. Problem (1. x ( t ) is the state vector at time t. As pointed out by Arrow and Kurz. which is usually taken to be the set of all measurable v ( • ) or the set of all piece wise continuous v( •). the problem becomes: subject to Note that sup in (1. is of the time stationary feedback form.). denoted by v * ( t ) . and x0 is the initial position of the state vector at time 0.

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

. 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 (1.8) at a steady state x* is subject to measurable. . 0). The linear quadratic approximation at a steady state (x*. the local results of Magill lead naturally to the global results of Cass-Shell. These assumptions are placed on problem (1. respectively. n) and is interior to any natural boundaries (this means that x f ( t ) > 0 for all t > 0. The linear quadratic approximation of equation (1.5). it is assumed that / is twice continuously differentiable and that the optimal plan is one with piecewise continuous time derivatives. 2. . Rockafellar. i = 1. . n). v*) for the general problem (1. which are discussed below.134 Differential equations. . and Brock-Scheinkman. These results go far beyond the simple checking of eigenvalues that most people associate with a local analysis. v*) = (x*.5) is presented in the next section. . Furthermore. 2. . where The symbols all evaluated at (x*. stability and chaos in dynamic economics exists and is unique for each x0 » 0 (note that for x e R". Furthermore. . x » 0 means that xi > 0 for i = l. .5) to avoid many tangential technicalities and are maintained throughout this chapter.

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

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

Stability of optimal control 137 When is the OLRP equation (2. If n(0) is administered today. and the larger p is. Change units to reduce the problem to the case 5 = 0. Note that since the left hand side of (2. if F is positive.2) is unstable. and Magill (1977a). Then in the one dimensional case. Consider the one dimensional case.1 S T are all positive definite. To sum up in words: why stabilize a highly unstable system (large F) when control input is ineffective (small |G|). However.5) is unstable if and only if equation (2. and stability will not be affected. The intuition behind this is quite compelling for.2) unstable? First. p. we see that instability is more likely the larger F is. then £ ( t ) Q e ( t ) will be smaller in the next instant.5) to explore when instability may be likely. put n2= -n1. is small then a lot of input n(t) must be administered in order to have much impact on g(t). the larger R is.2) with S = 0 becomes subject to Clearly. Q. put S = 0. equation (2. inputs n(t) cost n T ( t ) R n ( t ) to administer. the system is unstable. the smaller |G| is. If |G|. For if G < 0. 47). R. the absolute value of G. 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. Let us use equation (2.4) is positive definite. the smaller Q is. But the future is discounted by p. Defining the OLRP (2. . Following Anderson and Moore (1971. and Q-SR . Without loss of generality we may assume G > 0.

because a decrease in S makes F — GR . in the one dimensional case. since 0 is not a stable matrix. (x*(t). The paper by Magill (1977a) develops a rather complete set of results for all p. smaller (a stabilizing force). v*(t)) must converge to 0 as t-»oo. Here By the reasoning above from equation (2.8). but R--1STbecomes smaller (a destabilizing force). It is known that instability in the multidimensional case is related to the amount of asymmetry in the underlying system matrix. gained from the OLRP to the linear quadratic approximation (1. G. chapter 4) for the case p < 0.S. is intuitive from the existence of a finite value to the integral and the positive definiteness of the matrix Roughly speaking. Sufficient conditions for G.S.S.A. v)).A.9) to the neoclassical model of investment (1. however. Hence. roughly speaking.5). Note that when F = 0 and S = 0.A. an increase in S makes the underlying system matrix. If S — 0. This is so because.1 ST larger and makes smaller.S. or else the integral will blow up.-f*vvis large (it is positive by concavity of f in (x. .A. the underlying system matrix is not stable. a theorem to be proved below will show that G. instability at x* is likely when p is large.5) that when S < 0 a decrease in S is destabilizing. For S > 0.138 Differential equations. still holds. Let us apply our intuitive understanding of the determinants of G. and -f*xx+f*xvf*-1~f*xv is small (it is positive by concavity of f). provided that A>0. instability of A which is related to its lack of symmetry makes instability of the optimal path more likely. ambiguity is obtained in this case. stability and chaos in dynamic economics It is clear from equation (2. In the multidimensional case when p<0. of the OLRP are covered in detail in Anderson and Moore (1971.

1977a). expressed in current value. We are now in a position to state the G. p.S.Stability of optimal control 139 3. such that on each interval of continuity of v*(t). where W(x) is the current value state valuation function.A. 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). x*) is a steady state solution of the system equations (3. where v*(t) solves Arrow and Kurz (1970.3). Note further that Wxx exists almost everywhere and is negative and is negative semi-definite when U and T are concave. T for G.S. The first is given by where (q*. 47)) for equation (1.A. These results are based on two Liapunov functions. This is so because W(x) is concave in this case.2) and (3.5) Let v*( •) be a choice of instruments that maximizes subject to over all measurable v ( . Rockafellar (1976). The general nonlinear nonquadratic problem In searching for sufficient conditions on U. ) . . 35) have also shown that if Wx exists. p. p. Then Arrow and Kurz (1970. and Brock and Scheinkman (1976. results of Cass and Shell (1976a).

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

1).2. x * ( t ) ) solves equations (3. Also (S) is the same as Cass and Shell (1976a) also prove the following useful theorem. then it is trivial to show that H°(q. Theorem 4. in the set of all solutions of equations (3.S. x) such that (q. there is a 8 > 0 such that \x — x*\ > e implies Then if (q*(t). Proof.3) and if equation (4. See Cass and Shell (1976a).A. T are concave in (x.2) and (3. Assume that H°(q. (Cass and Shell (1976a). That is.2) and assumptions sufficient to guarantee that x*(t) is uniformly continuous of [0. x ( t ) ) of equations (3.) For the case p>0 assume that for every e > 0.x) = ( q * ( t ) . x) is convex in q and concave in x.1) holds. See Cass and Shell (1976a). Then for any solution ( q ( t ) . v). It should be noted that (S) is only required to hold on the set of (q. only a slight strengthening of equation (4.1.2) and (3. .Stability of optimal control 141 and interpret the economic meaning of the assumption They show that equation (4. then Proof.3) that satisfy equation (4. oo) allow them to prove that the steady state solution x* is G.3). x * ( t ) ) for some t >0.2) implies Thus. Note that if U. More precisely: Theorem 4.2) and (3. x) is concave in x Convexity in q follows from the very definition of H°.

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

The basic idea of the proof is just to show that (R) implies along solutions of equations (3. Theorem 5.3) that correspond to optimal paths.2) and (3. 1977a). Stability results based on V2 In this section we summarize the stability results of Brock and Scheinkman (1976. 1977a) based on the Liapunov function V2. The following sequence of theorems summarize the results in Brock and Scheinkman (1976.2) and (3. (which are positive semi-definite since H° is convex in q and concave in x) are evaluated at ( q ( t ) . x*(0)) be a solution of equations (3.Stability of optimal control 143 Proof. A more precise statement of theorem 4.3 is given in Rockafellar (1976) who works with a more general system. These results are developed rapidly with primary emphasis on contrasting them with the other theorems reported in this chapter.2) and (3.1. x ( t ) ) . We will return to some of the Brock and Scheinkman results in the next chapter where their applicability to capital theory is demonstrated.3) to yield where and where / denotes the n x n identity matrix and the matrices of partial derivatives H°gg _ H°xx.q ( t ) T x ( t ) along solutions of equations (3.3). Differentiate the Liapunov function V2 = . provided that . 5. See Rockafellar (1976). Then Let (q*(0).

2 gives a set of sufficient conditions for the Cass and Shell hypothesis.2) and (3.3) that are bounded for t >0 converge to (q*. x*( •)) is bounded independently of t or if then there is a stationary solution (q*. x*). Then all solutions of (3. The rest is a standard Liapunov function stability exercise. wTB(q*. (b) For all (q. Thus. x*)w>0.2. If (a) (q*. x*) of (3.5) is quite natural for optimal paths because if Wxx( •) exists it will be negative semidefinite since W( •) is concave for U and T concave. implies (c) For all w = 0.3) is obvious from equation (5. Here. Note that theorem 5. Inequality (5. Proof. x*) as t-»oo.3) such that Proof.A.144 Differential equations. x*). lim sup y ( t ) denotes the largest cluster point of the function values y ( t ) as t -»oo. x) = (q*. Theorem 5. x) = -(q -q*)T(x-x*) and use (b) and (c) to show that V1(q.3).5) holds automatically.1).2) and (3. The second part of the theorem is just a standard application of results on G.2) and (3. Assumption (5. x) = (q*. x*) is the unique stationary solution of equations (3. by means of Liapunov functions. stability and chaos in dynamic economics where Furthermore. x) < 0 for (q. if (q*( •). . Remark. oo) -> R.S. and equation (5. Put V1(q. given a function y( •): [0.

2) and (3. in some sense. We define a twice continuously differentiable function f: Rn-> R.3. (b) (q*. Assume (a) H° is twice continuously differentiable.7) holds for optimal paths. then The use of W x ( . This is an adaptation of Hartman-Olech's theorem in Hartman (1964.) in the last line exposes why the Liapunov function. and (e) H°(q. x*) is G. Let (q*(t).A. Then (g*. w = 0. x * ( t ) ) may be dispensed with provided that one assumes and refines the Liapunov analysis or one assumes that W x ( .3).x) is locally a-convex-B-concave at (q*. . Assume that W x x ( .5) that imply that Wx exists and that (5. complementary since each asks that Q be positive definite in directions which are transversal to each other. x * ( t ) ) where 4aB > p2.x*). (c) x* is a locally asymptotically stable solution of the reduced form system (d) H°(q. ) exists and is negative definite on Rn+. 548) to the system equation (5. to be locally B-quasi-concave at XO E Rn if for all w e Rn. Benveniste and Scheinkman (1979) provide a set of very general conditions on equation (1.2) and (3. 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. ) exists.( q . . Theorem 5.8) with their G( •) = . ) exists. x*) is the unique stationary solution of (3.3) that corresponds to an optimal path.q * ) T ( x . x*(f)) be a solution of equations (3.Wxx( •).x) is locally a-quasi-convex and H°(q. p. Also note that boundedness of ( q * ( t ) . Theorems 5.2 are. For if W( •) is concave and W x ( . Proof.1 and 5.Stability of optimal control 145 to hold.S.x * ) is natural.x)-pqx is B-quasi-concave along ( q * ( t ) .

10).A.S. x) has a lot of convexity in q and a lot of concavity in x relative to the discount rate p. are sufficient for G. but we do not have a useful set of sufficient conditions on U and T for this to happen. The last six theorems are all unified by the fact that they represent results that can be obtained from the Liapunov functions. Systematic study of economic dynamics under increasing returns is likely to change our view of how a dynamic economy functions. p. it is useful to look at the OLRP or the linear quadratic approximation to problem (1. However.) is negative definite which implies a form of long run decreasing returns. the Hamiltonian function H°(q. stability and chaos in dynamic economics Theorem 5.3 allows a weak form of increasing returns because we assume W x x ( . we record here the Hamiltonians for OLRP obtained by converting the OLRP into a maximization problem. the Rockafellar condition. More specifically. To sharpen our understanding of functions U and T that satisfy the hypotheses of the preceding G. Both this question and the question of stability analysis under increasing returns seem to be wide open and important fields of research. This we do in the next section.A. See next chapter.3 allows a weak form of increasing returns to the state variable.A. They are Brock (1977a.3 is in an unsatisfactory state of affairs at the moment since it requires Wxx( •) to exist and to be negative definite.146 Differential equations. and their analogues. In particular. the state valuation function is concave. For B-quasi-concavity in x of the imputed profit function. These results lead us intuitively to expect that G. or its analogues.5) as given in equation (2.1). 224) derives in detail equation (5. Theorem 5. Note that concavity of W does not imply concavity of U or T.S. .x) — pqx amounts to allowing increasing returns to x provided that the isoquants for each fixed q have enough curvature.S. is likely when H°(q. We say that theorem 5. theorems.

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

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

Turn now to the development of a test that uses information on F. 5. The objective of the work being surveyed in this chapter is to develop G. The tests proposed in the six theorems. results for a highly nonlinear multisector model under uncertainty. they indicate that G. x) is positive definite. 4.A. however.S. The problem posed by Had Ryder of finding a neat set of conditions on (L). One obtains Here G(q.S.2 and obtain G.2).S. 7.S. For example. Then.A. but the problem appears to be in developing a test that is efficient in the use of the structure of (L). x) space generate a linear space whose projection on x space is all of Rn. tests on U and T that work for nonlinear. provided that the corresponding eigenvectors in (q. Let us call this kind of test the ideal OLRP test. 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. is defined by .Stability of optimal control 149 and check whether half of them have negative real parts.A.1. However. provide adequate results for nonlinear problems and generalize easily to the case of uncertainty. G. for half of the eigenvalues of (L) to have negative real parts and for the projection property to hold seems to be open. 4. Look at Evaluate V3 along solutions of equation (7. Brock and Majumdar (1978) and also Chang (1982) develop stochastic analogues of theorems 4. there are Routh-Hurwitz-type tests for k< n of the eigenvalues to have negative real parts. This is another research problem of some importance. x).2.3.1 and 5. follows from just convexo-concavity of H° for the case p = 0. Results based upon the Liapunov function V3 Brock and Scheinkman (1977a) consider the class of Liapunov functions where the matrix G(q. the trajectory derivative of G. and that generalize easily to uncertainty.A. making full use of its structure. wasteful relative to the ideal test for the OLRP though they may be. holds. nonquadratic problems.

Let q( •).2.150 Differential equations. equation (7. test (7. Here . but the production function is not necessarily quadratic. 5.1.1. Theorem 7. 4.1 and 5.3.) exists. x).2) and (3. Obviously. x( •) be a solution of equations (3. ) . Let us apply equation (7.1. for quadratic problems. Theorem 7. See Brock and Scheinkman (1977a) for details and some extensions of theorem 7.3) that correspond to optimal paths.2) and (3. so that qTx < 0 along solutions of equations (3.3) suggests choosing Thus.A. We may now state the following theorem. See Brock and Scheinkman (1977a) for a wide class of investment models where equation (7. stability and chaos in dynamic economics Assuming Wxx( •) exists and is negative semi-definite. and especially for problems where H°qq is independent of (q. This term is hard to grasp.1 would be very nice if the term H°qq did not appear. However.2 may be sharpened in this way. x0) starting from x0 stays in M for t > 0. 4.S. 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 V3.7) is applicable. theorems 4.3) such that Assume along x ( .7) is useful. Recall from chapter 4 that M is future invariant under x = f(x) if for each x0e M the solution x(t.7) to the OLRP. 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. the G. Problems where H°qq is independent of (q. x) arise in neoclassical investment models in which the adjustment cost function is quadratic.Also assume that W x ( .

tests mentioned above make use of H°xx in a way that parallels H°qq in theorem 7.S. None of the G.1 regardless of the size of p and Q. if F is a stable matrix. we see that F<0 implies G. assume that is nonpositive definite. The Liapunov function V4 Consider the Liapunov function.S.2. 8.) Assume that are negative definite. Then G.A. then the OLRP should be G.A. Then If R and F are one dimensional. This brings us to one of Magill's (1977a) nice results for the OLRP.S. Theorem 7. since under Magill's hypotheses. then since R > 0 by convexity of the objective. Put Then. S = 0. independently of p.1.S. (Magill (1977a). Magill (1977a) shows that implies the following The rest is standard. Furthermore.A. by theorem 7.A. We state it for the case of certainty only. This is in accord with our intuition that. Proof.Stability of optimal control 151 To get some understanding for negative quasi-definiteness of equation (7.8) put G = I. . holds for the OLRP.

Suppose that A ( A ) > 0 . stability and chaos in dynamic economics which leads to the following: find sufficient conditions on H°(q. b > 0 such that 2b + ap > 0. Then since qTx< 0.x) such that V 4 <0 holds along ( q ( t ) .2) is nonpositive provided that However. Grouping the terms common to qTx in V4.3).3). The only case where we can get a new theorem. which is equation (8. . b E R. is when B is not positive semi-definite and A is not negative quasi semi-definite for all t > 0. therefore. x ( t ) ) and if we assume that q T x<0 along optimal paths. x ( t ) ) . choose a < 0. a<0 to get V4< 0 for all t > 0. x ( t ) ) .1) is derived by differentiating V4 along solutions to equations (3. One useful sufficient condition for V4 < 0 that emerges from this approach is holds along the solution ( q ( t ) . Relationship (8. Here A(A) denotes the largest eigenvalue of (A + A T )/2 and A the smallest. Similarly. for particular choices of a. we then get V4 < 0 for all t > 0 by putting a = 0. if A = H 0 . Therefore. The right hand side of (8. Note that the first line of V4 is just so if B is positive semi-definite along ( q ( t ) .1). oo). b > 0.1 H 0 q x + (H 0-1 qq H 0 qx ) T +(H 0-1 qq ) is negative definite along ( q ( t ) . for t > 0.2) and (3.152 Differential equations.2) and (3. x ( t ) ) to equations (3. t E [0. just put 6 = 0.

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

A discussion of the economic basis for these games and some very preliminary results is given in Brock (1977b). 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.5).A.S. For example.? A nonlinear version of the OLRP suggests that this problem may be difficult. and x i ( t ) .A.S. Now. x0). vi(f) e Rm denotes the vector of instrument variables under control by i. is not well understood at this point.A. should converge to the solution x(t. consider the problem (6) subject to Note that only F(x) is nonlinear. In particular. |R|-»oo.7) had only one rest point x* and assume it is L. p-»oo. arguing heuristically.A. This looks like a promising area for future investigation. then the optimal solution of equation (9. |Q|-»0.6) and (1. if we let |G|-»0. suppose that equations (1. Here xt(t)e Rn denotes the vector of state variables under the control of player i.S. What additional assumptions are needed on the Hamiltonian to ensure G. and G. x0) of . stability and chaos in dynamic economics (5) under adaptive expectations.2). call it x(t. The relationship between L. Vi(t) denote the state and instrument variables under control by all players but i. where the objective of player i is to solve subject to measurable.S. (1.154 Differential equations.

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

5) by p. let p-»oo. where Q is a fixed positive definite matrix. then the right hand side of (9. The task is to construct a matrix F that has all eigenvalues with negative real parts and to construct p. G so that F+ GR -1 G T W is unstable. stability and chaos in dynamic economics becomes using and the formula for the optimal control. This ends the sketch of the counterexample. Pick stable F and positive diagonal B so that the determinant of F-B is negative: To do this set FU + F 11 <Q. R. 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. and change Q so that Q/ p = Q. Q. Obviously. Thus for p large.8) is negative. . if b1 is large enough and b2 is small enough. Put so that BQ = B and A = F . The easiest way to do this is to divide both sides of (9.B.156 Differential equations.

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

Prescott (1973).7) is discussed in Benveniste and Scheinkman (1982) and Araujo and Scheinkman (1983). Brock (1987a) and Malliaris (1987b) offer a brief introduction to the deterministic and stochastic optimal control in economics respectively. Indeed. the role of the transversality condition given in (4. Gale. Fleming and Rishel (1975).158 Differential equations. so we will not spend time on it here. Friedman (1971). Radner. but this should be enough to convince the reader that the stability problem is of basic importance in a number of areas. this area is wide open for new researchers. Finally. stability and chaos in dynamic economics Shell (1976a. The specialized topic of the stability of optimal control is treated mathematically in Lefschetz (1965) and Roxin (1965a. The mathematical analysis of deterministic optimal control with numerous applications in economics is presented in Kamien and Schwartz (1981) or Seierstad and Sydsaeter (1987). A third area of applications of the results reported here is the dynamic oligopoly games of J. . Samuelson. No doubt there are many more applications. chapter 3). the optimal filtering problem reported in Kwakernaak and Sivan (1972). This application is developed by Magill (1977a). These games represent important new efforts to dynamize the field of industrial organization. basically. the extension of the well-known turnpike theory of McKenzie. and the integral convex cost problem of operations research discussed in Lee and Markus (1967.1) or (5. and others. and others to the case p > 0. 1976b). It is. A fourth area of applications is the optimal regulator problem of engineering reported in Anderson and Moore (1971). Bensoussan (1982) and LaSalle (1986) give a rigorous mathematical presentation of deterministic and stochastic optimal control. 1965b). For an illustration of the importance of stability in economic growth see chapter 9.

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

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

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. Moreover. Then perfect capital markets. concavity of the aggregate production function as a function of raw capital input is sufficient. then under general conditions on technology the F. if mode a is a first best mode of regulation then the first order necessary conditions (F. In general. Call such an economy a decentralized regulated economy. We define an a-competitive equilibrium to be a decentralized regulatory competitive equilibrium where all commissions use mode a of regulation. II. . of an a-competitive equilibrium are satisfied by two trajectories I. Energy firms are price takers in the capital market.C. Fourth. First. first best a-competitive equilibrium may not exist when Pareto optimum is II.C. Neoclassical firms are price takers in the goods market. Each firm buys capital input in the interregional capital market. Second best modes impose a wedge between price and marginal cost. the energy market and the capital market. In other words suppose one accepts the decentralized institutions described above as reasonable abstractions of observed regulatory institutions.N.O. 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). The conclusions of the analysis are fourfold. each commission also acts like a price taker in the capital market.) of an a-competitive equilibrium are not satisfied by a rest point or one of Skiba's trajectories I. such as an efficient multipart tariff. Each region has a regulatory commission that regulates its natural monopoly. In the examples. Energy production is a natural monopoly in each region. Since there are a lot of regions.N. Third. and there are a large number of identical price taking consumers in each region. Trajectory II cannot be supported by an a-competitive equilibrium. Capital is mobile across regions and firms. 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. 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.Microeconomic dynamics 161 company. if all commissions follow a second best mode of regulation such as Ramsey (maximize surplus subject to breakeven constraint). necessity of identical consumers' transversality condition at infinity. II.O. the economy as a whole may follow I when II yields more welfare. Second. We will examine two classes of modes of regulation of energy firms.

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

3) the optimal planning problem (2.1) may be restated thus: put The Euler equation and material balance equation are given by Figure 6. Digression on optimal growth under convexo-concave technology Using the definition of g(x) given in (2.1 . We digress to describe Skiba's results.1.1. 2.) is graphed in figure 6. Obviously the planning problem is a Skiba problem. Hence the Skiba (1978) results on optimal one sector growth under a convexo-concave production function may be applied to our problem.Microeconomic dynamics 163 Function g(.

AP(x). 536).2.7) are given by the two points x. (2. Then g' is given by where subscripts denote partial derivatives. Steady states of (2.164 Differential equations. x. The system (2.6).3).3 . stability and chaos in dynamic economics Let x0 denote the value of x1 that solves (2. Define average product. (2.3.7) is phase diagrammed as in Skiba (1978. and marginal product MP(x) by The convexo-concavity of g implies the relationship between AP and MP which is depicted in figure 6. p.6). The phase diagram is depicted in figure 6. Figure 6.2 Figure 6.

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

respectively.166 Differential equations. Apply lemma 2. by putting Ci(0)= c.10b) implies Apply (2. Skiba shows that (2.4. Lemma 2. One can show that x s < x by using a lemma of Dechert and Nishimura (1983). Then x* < xs < x* and If there is no point x* where II cuts x = 0 then for all x0 where both I.) If x ( . Proof. Corollary 2. along I starting at x0. Let x be the smallest positive solution of the equation g(x) = px. This ends the proof. and along II starting at x0. VII(x0) denote values computed at the steady state x.3. VI(x0).2.10c) to write.) is an optimal trajec- . II are defined. tory then (Dechert and Nishimura (1983). Let V. stability and chaos in dynamic economics Proof. The inequality follows from concavity of u and application of (i) or (ii).

Theorem 2.x ) e .) If x0 > x. where x is the smallest positive solution of g(x) = px.Microeconomic dynamics 167 Proof. In view of corollary 2.i = I. By Jensen's inequality Suppose by way of contradiction that Hence. (Dechert and Nishimura (1983). the constant path defined by x ( t ) = x 0 . we know that . we have Multiply both sides of (a) by e -pt and integrate to get (g(x0)-px0)/p foo (g(x) . Proof. t >0 generates more utility.3 we need only to examine the case x0<x*. Look at Skiba's phase diagram to see that Furthermore. To understand the Skiba-Dechert-Nishimura results look at figure 6. The interval [x*. This contradiction to the optimality of x(. > This contradicts (DN) and the proof is finished.px) e .p t d t = f o o ( g ( x ) .. II. Therefore along II since x0<x*<x. Hence. We find a contradiction to (DN) if II is optimal.p t d t .4. II. Notice that x <0 along II. The slope of Vi is given by the corresponding value of ph i = I. x*] is the common domain of definition of Vi. then I is optimal.x 0 .) completes the proof.5.

3 by pushing x to zero. Take the convex case first. 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 . Notice that if x0 < xs it is still optimal to stagnate and run the capital stock down to the origin. Doing this we obtain the standard phase diagram of the neoclassical growth model.2. stability and chaos in dynamic economics Figure 6. The phase diagram is qualitatively the same as that obtained from figure 6.4 The conclusion that there is a unique cutoff point XSE [ x * .168 Differential equations. Figure 6. The phase diagram for this case is obtained from figure 6. Turn now to the concave case. x*] follows.4 still describes the qualitative features of the solution. 2.3 by pushing the large steady state x off to +00. The cases where g is convex increasing and concave increasing are easy to analyze given the above background.

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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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Differential equations, stability and chaos in dynamic economics

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

This becomes. . Let us phase diagram the second best dynamics and compare them with the first best (see figure 6.25).16) to hold. A3. g 2 ( x .6). X 1 v ) ) and MP1(x. stability and chaos in dynamic economics Next.x 1 ) ] that will enable us to compare steady states.12) is given by Notice that Since x1 is the optimal choice of xt given x. Recall that x1 denotes the solution to The first order condition for (3.16) and bypass the routine job of locating sufficient conditions for (3. the dynamics are given by Here X1(P. it follows that Sufficient conditions on gt and g2 are needed so that the relationship between MP1(x. Inequality (3. for mode v. Therefore. We assume (3. we analyze the dynamics for each mode of regulation v. x1) satisfies the natural condition Inequality (3. 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[x1.16) 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.1.16) is assumed to hold.178 Differential equations.

7 .6 Figure 6.Microeconomic dynamics 179 Figure 6.

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

II. The terminology is motivated by Rostow's famous metaphor. We see from figure 6. In order to focus attention we assume the relationship between MP and p that is depicted in figure 6.10. The analysis of first best follows section two and is embodied in figures 6.9. The model of the previous two sections has only one development stage. III. The difficulty in decentralization discovered in section two emerges with a vengeance when there are multiple development stages.9. Call a zone of convexo-concavity a development stage.O.2 will allow us to determine the optimum. 6. and 6. Judicious use of Skiba's lemma 2. The model analyzed below has only two for ease of exposition. that is.10 that there are several trajectories that satisfy the Euler equation and the TVCco. The same decentralization analysis developed in section two may be used to show that each trajectory a. of first best regulatory institutions. a stage of economic growth.8 .8.Microeconomic dynamics 181 4. IV as well as the four rest points satisfy the F. Multiple optimal paths Here we analyze cases where the aggregate production function g has multiple zones of convexo-concavity. Since there are so many possibilities to screen out.N. it is useful to state the Figure 6.C. a = I. Turn now to determination of the optimum.

stability and chaos in dynamic economics Figure 6.10 .182 Differential equations.9 Figure 6.

I I > ( x 1 . Since there is no point in discussing two development phases when one is dominant.x 0 e[x 1 . that is. .x 1 ].*. . x1*).x 0 e[x l s . II> I. x 0 e(0. Turn to the dotted portion of IV. Skiba's lemma immediately implies that II > V at x 0 >x 2 . x2*)such that V°(x0) = Vn(xo). If at x0 you have two trajectories a. p1). Hence. In order to avoid this degeneracy we assume II cuts x = 0 at x*i as depicted in figure 6. on (x2*. Skiba's lemma implies IV > V at x0 > x2.1. II > I = IV at x1.10 as follows: Let V°(x 0 ) be the optimum value starting at x0. x 2 . there is no x1* > 0 such that II cuts x = 0.x 2 s ]. satisfies Pi(0) = V'i(*x0)» at x0. IV>(x 2 . . ft > a at x0 means the value of the discounted sum of consumption along ft is bigger than a starting at x0. II > IV at x2*. we assume that there is x* such that IV cuts x = 0 at x*. Hence. (ii) V°(xo)=V I (x 0 ). xf.x 0 e[jc 2 . IV cut x = 0 at x t *. (v) V°(xo)= Vv(x 0 ). Then (i) There are cutoff points x ls e (x^. and IV> III at x2*. As in the analysis of II.*. IV> 111 = V at x2. V.2 intuitively. xf. then the chain of inequalities derived above shows that II > i. (iv) V°(x Q ) = Vni(xo). x* such that I. . II > III = V at x2. III. x2].10.10 regular. . x2*. or (ii) initial investment on a is nonpositive and the initial price of investment on ft is smaller than on a then Hence. II. pi(0). we ignore x 1 . (iii) V°(x0) = V I V (x 0 ). Definition 4. at X1 and III. x1s). 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.Microeconomic dynamics 183 basic principle of Skiba's lemma 2. If the dynamics are regular then the optimum is constructed from figure 6. x2s E (x2*. We may now prove Theorem 4. at x. Since the initial price. x0e [x2s. II > III at x2*. Skiba's lemma shows that I. Suppose that II follows the dotted path in figure 6. Notice that initial investment on ft is positive in case (i) and negative in case (ii). x2*. x* respectively. oo). i = I . We need to dispose of some degenerate cases.10.1.oo). The dynamics are said to be regular if there exist points x. V. Call the case depicted in continuous lines in figure 6.P 2 ) at x 2 . IV> III.

2 may be realized by first best decentralization schemes. including the steady states xi. The method of construction outlined above may be applied to economies with any number of stages of growth. = l. stability and chaos in dynamic economics Proof.11. 2 is as depicted. The upper envelope will not be attained unless some centralized authority coordinates rate bases. . The values at steady states xi.11. i = 1. . for all i. The problem of the possible inefficiency of the first best mode regulatory equilibrium is worse.-*. . This ends the proof.184 Differential equations. We conclude that all of the possibilities depicted in figure 6. Recall that in this model the rate base is just x2. Furthermore. xi*) will be dominated by both choices. .11. i = 1.*. xf. Then use pi(0) = V'i(x0) to fill in the rest of the values of Vi as graphed in figure 6. Skiba's lemma shows that they are dominated as shown in figure 6. 2 are represented by open circles. . n that determine when to switch from one trajectory to another. The logic of the proof is contained in figure 6. 2 . i = 1.11. xi*). Apply Skiba's lemma to verify that the relationship between the value functions at x. the steady state xi E (xi*. In the n stage regular case there will be cutoff values xis E (x.

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

(2.24) and (2. stability and chaos in dynamic economics From (5. From facing r(t) parametrically it follows that x 2 ( t ) is the unique solution of (2.20). For the Ramsey regulation problem (3. let x2 denote the positive rate base that solves (5.1) becomes. Since ft > 1 the marginal incentive rises with the rate base for Ramsey and first best. For the AJ(v) regulation problem (3.186 Differential equations. To explain. The conclusion is that the global social optimum may be realized by regulated utilities and atomistic firms solving (2.1). Define r(t) by as in (2. Notice that (5. Let X i ( t ) . Let us look at decentralization. recalling that B denotes a 2 B l / ( l .13) with equality. y i ( t ) solve the optimum planning problem (2. AJ(v) regulation induces choice of x2 nearer to the social optimum than private profit maximizing monopoly. If B>1. .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. regulated utilities will expand their rate bases x 2 to infinity facing any interest rate r ( t ) parametrically. In the case B < 1.21) facing r ( t ) parametrically provided that B<1.3) is equivalent to 13 < 1. In this case there is no equilibrium. therefore. The marginal incentive to expand x2 is v. in the case /3 > 1 the Ramsey problem is unbounded and x2 = +00 is the solution. 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.24) when B>1.7) social benefits B falls in r and rises in x2.24) when B < 1 and x2(t) = +oo is the solution of (2.Johnson effect has not been theoretically justified under the assumptions that are relevant in regulation.27).X 1 ) Since l — al>ftl. The reader is encouraged to reflect on this problem and to read Dechert (1984) which shows that the Averch.

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

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

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

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

But at the same time.. 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.. Samuelson (1947) observes that one cannot consider the stability problem of the general competitive equilibrium without specifying a dynamic adjustment process. In a little more detail. 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. Recall that a matrix D is positive diagonal if its elements dii > 0 for all i and dij = 0 for i = j. 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.j = 1. i. then A is totally stable. (6) Of particular importance in economic theory is the notion of D stability and total stability. This condition is neither necessary nor sufficient for stability in Hicks' sense. The interested reader can review these ideas in Hicks (1946) and Samuelson (1947) or in books such as Quirk and Saposnik (1968). will illustrate how the stability methods in this book are put to use.. 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. Related to D stable matrices are totally stable matrices. every even order principal minor of A is positive and every odd order principal minor of A is negative. Negishi (1962) surveys the main stability results up to 1962 while F. Note that an n X n matrix A is quasidominant diagonal if there exist . the revised version of Samuelson's Correspondence Principle. In chapter 7. McKenzie (1960) shows that if a real nxn matrix A — [fly]. Arrow and Hahn (1971).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. has a negative diagonal and is quasi-dominant diagonal. Arrow and McManus (1958) give sufficient conditions for D stability. He formulates the problem as a set of ordinary differential equations and gives conditions for the convergence to its equilibrium.. 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. Metzler (1945) shows that if a matrix A is totally stable then A is a Hicksian matrix. Hahn (1982) gives a comprehensive survey of both local and global stability of competitive equilibrium up to 1982. or Takayama (1985).n. that is.

Scarf's instability example makes full use of the perfect complementarity case and supports. The mathematical theory of such matrices is presented in Gantmacher (1959).n. that is. (ii) case of two commodities. 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. stability and chaos in dynamic economics positive numbers c1. Takayama (1985). one of which is a numeraire both in a one-individual and the n-individual case... and (iii) all goods are gross substitutes at all prices that is.. . Khalil (1980) gives a new test for D stability. 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. (1959) investigate systematically for the first time the problem of stability of a competitive general equilibrium..|aii| > Tij^ibjlcijil for every i = l.c 2 .| > |Ej=i cj|aij| for every i = 1. In the first paper.. . Two kinds of the dynamic adjustment process called tatonnement are considered: instantaneous and lagged. . or if there exist positive numbers bl..bn such that b.. 2 . Hirota (1981) studies whether or not the instability of Scarf's system is robust against changes in the assignment .2. . three specific cases of the model are analyzed: (i) no trade at equilibrium. Also. (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.b2. c n such that ci|a.. if the price of one commodity goes up while all other prices remain the same. Nikaido (1968. (7) The two classic papers of Arrow and Hurwicz (1958) and Arrow et al. 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. The second paper extends the results of the first by establishing global stability when all goods are gross substitutes. they show that local stability holds. the traditional view that the phenomenon of instability is due either to the income effect or to the complementarity of goods.. then there will be an increase in demand for every commodity whose price has remained constant. . In words an n x n matrix A is quasidominant. .192 Differential equations. n. Scarf states that his instability example does not depend on a delicate assignment of values of initial stocks.. in general. . 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.

Hirota (1981) shows that most assignment patterns are stable. for a class of economies which includes Scarf's instability example as a limiting case. Bewley (1980a. 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. 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. That is. fits into the Morishima (1952) matrix pattern. both present and future are gross substitutes. 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. 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. See also Balasko (1975). By perturbing the assignment of initial holdings. both present and future. Bewley defines the permanent income hypothesis to be. provided the substitute-complement relationship of commodities. Such a modification of demand function eliminates the income effects which can cause the tatonnement price adjustment process to be unstable.Microeconomic dynamics 193 of initial stocks. (9) Arrow and Nerlove (1958) study the role of expectations on stability. that demand is determined by constancy of the marginal utility of money.1974. See also Scarf (1981) who points out the significance of Hirota's example. Keenan (1982) and Hirota (1985). They show that in a continuous time general competitive economic equilibrium model if all commodities. then stability with static expectations is equivalent to stability with adaptive expectations. 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. 1980b) studies the role of the permanent income hypothesis on short run and long run stability. while the globally unstable case emerges only in an extreme limited situation. The results of Sonnenschein (1972.1973). See also Burmeister and Graham (1973. Hirota (1985) gives an estimate of the fraction of initial endowment distributions which result in global stability of a tatonnement process. (10) In two papers. roughly. 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.1975). 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. More specifically.

or price net of extraction cost. 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. 1976) applies to the long run adjustment process assuming the permanent income hypothesis. perverse income effects reappear as a source of instability. Debreu (1974) and Mantel (1974.194 Differential equations. both along an efficient extraction path and in a competitive resource industry equilibrium. However. stability and chaos in dynamic economics holds for the tatonnement process. Producers will try to liquidate their resource deposits by increasing current production and by investing their revenues at the higher r%. Then resource deposit is not a good way to hold wealth. Put differently. to be the same in all periods. the undiscounted value must be growing at precisely the rate of interest. (11) According to the now famous Hotelling rule established in Hotelling (1931). The intuition behind the Hotelling rule is simple. initial pessimistic price expectations lead to current price decreases. Thus. is expected by producers to be rising too slowly. For the present value of price. If we assume that this interest rate r is equal to society's optimal discount rate between future and present. say below the interest rate r. Bewley (1980a) shows that an analogue of the results of Sonnenschein (1972. For an introductory survey of the . 1973). 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 current price must decrease along the demand curve. But as production increases. Similar reasoning suggests that if prices are expected to grow faster than the interest rate r. 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. (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. In fact. 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. Hotelling showed that the competitive resource owner would deplete at the socially optimal rate. or price net of extraction cost. For an introduction to the economics of exhaustible resources see DasGupta and Heal (1979) and their references. 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.

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

however. 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. 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. Let us attempt to explain what we think the relevance of this exercise is to practical problems of regulatory policy. 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.196 Differential equations. How might such a situation reveal itself in practice? Take the case of g(x) everywhere convex which is worked out in the examples. 7. To the extent our abstraction captures aspects of reality we have shown there is serious danger that the system will follow the wrong path. . 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. 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. 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. There would be less cause for concern if we had to go to a heterogeneous consumer multigoods general equilibrium model to generate the difficulty. g 2 ( x .x 1 ) ) = g(x) is concave increasing in x If. The piece meal recommendations to commissions made by devotees of Ramsey pricing are stimulated by partial equilibrium analysis. We found that no problem emerges when the aggregate production function maximum g1(x1. It seems that only control of rate bases will correct the problem. Such recommendations may be counterproductive if the economy follows a suboptimal path of development. Malliaris (1988a) presents three approaches to this problem and surveys numerous references.

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. The process continues. all can do. Perhaps an adaptation of a Brown and Heal (1980) equilibrium using the recursive structure present in our type of model may be fruitful. Future research should investigate the seriousness of the difficulty uncovered here in more disaggregated models. 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. Hence neoclassical firms keep favoring more expansion. However. 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. 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. 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. But what one region can do.Microeconomic dynamics 197 Suppose that r(t) is the current interest rate. 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. . The expansion occurring in all regions puts upward pressure on the cost of capital. lower unit costs of energy. and higher profits to energy using firms. Hence everyone is happier in the region under discussion. The cost of capital rises. (ii) the commission sees higher utility stock prices. 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. 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.

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This duality constitutes what I have called the Correspondence Principle. known by most economists as comparative statics or comparative dynamics. p. This chapter relies on Brock (1986b).. to show how the problem of stability of equilibrium is intimately tied up with the problem of deriving fruitful theorems in comparative statics. 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 . In such an exercise. is the main concern of this chapter. a revised version of Samuelson's famous Correspondence Principle plays an important role.CHAPTER 7 STABILITY IN INVESTMENT THEORY It is the central task.. Samuelson (1947. The various definitions and results which are needed are stated next. 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. 258) 1.

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

x0. In section 2 we discuss Samuelson's Correspondence Principle and offer a reformulation motivated by our problem.).a)-*x(a) as f-»oo.S. 5. Let (x. We denote by A"1 the inverse of a matrix A which we assume exists.x0.S.3) together with the natural structure of TT(X. q) be a steady state of (1. It is worth repeating that x(a) is L.A. we say that x(a) is G.S. Section 3 states an abstract result which is subsequently applied to economic models in section 4. was the first economist to recognize the importance of relating the problem of stability of equilibrium to the problem of comparative statics.A. or G. H°qq. where x(t.A. 1942.S.A. 2.x0. a) impose on dx(a)/da? To provide some answers to this important problem we proceed as follows. x. XX] (iii) R = (H°CICI)~lHqx is negative quasi-definite at (q.) or globally asymptotically stable (G. Chapter 5 reports that any of these three hypotheses is sufficient for the G. We are now in a position to state our Problem: What restrictions do the various sufficient conditions for L.A. 6 and 7. Recall that an n x n matrix A is negative quasi-definite if x T Ax<0 for all x 7* 0. where H°qx.S. a) = x0.Stability in investment theory 201 (L.A.3). it follows that x(t. in two articles and in his Foundations.A.A. This duality . Also.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. Consider the three hypotheses. Samuelson's Correspondence Principle Samuelson (1941. if for all x0e Rn. These three hypotheses-will be used in this chapter along with some structural assumptions to obtain results on 8x/8a. of x = x(a). H°xx is the usual notation for second order partial derivatives and /„ denotes the n x n identity matrix.S. where q is the costate variable at steady state x. x 0 . if there is an e >0 such that | x ( a ) — x 0| <e implies x(t. 1947). of a steady state solution x(a) of (1. and give some additional definitions.a) is an optimal solution with x(0.S. In the remainder of this section we state some recent results on G.

(£. See Samuelson (1947. After introducing (2.2) corresponds to the intuitive idea that price increases when excess demand is positive and vice versa. Research reported in Quirk and Saposnik (1968) shows that it is not possible in general to use the hypothesis of asymptotic stability of (2. i = 1 .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. Without loss of generality. given a complex system with certain properties. Equation (2.. where g.. 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".2) together with sign information on dE /da to get comparative statics information on 3E/3a. . Samuelson proposed the adjustment mechanism such that p i (Q)=p i o ) given. assume g i ( E i ) = E i .. n.. Equation (2. how to infer its qualitative changes analytically.(0) = 0. .2) together with a priori information on d E / d a gives rise to useful restrictions on dp /da. . for Ei < 0. . The hypothesis that all eigenvalues of 3E/dp have negative real parts . look at the case where a is one dimensional. For example. p.2) Samuelson studied its asymptotic stability and enunciated his Correspondence Principle: the hypothesis of asymptotic stability of (2. > 0. 257).)> 0.1) describes competitive equilibrium where excess demand equals zero. . The n + 1 good is the numeraire. 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.202 Differential equations.) < 0. . Differentiate (2. am). Note that there are only n independent equations by Walras Law. Note that the essence of this principle is. assuming there are no free goods. pn) and the parameter vector ( < * ! . . Samuelson applied his principle to other problems as well as general equilibrium but we shall concentrate on the equilibrium problem here for illustrative purposes. #.1) tells us what the equilibrium price is but does not tell us how the economic system arrives at equilibrium. and gi(£. for £. where p(x) is the equilibrium price as a function of a which is assumed locally unique. Mechanism (2. 2 . .

3) if this system is either one dimensional or if dE/dp has a lot of zeroes in it. But there are n2 elements in BE /dp. These findings led to a lot of research on the Correspondence Principle. in such examples. 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. reported in Quirk and Saposnik (1968). The papers by Gordon and Hynes (1970) and Phelps and Winter (1970) come to mind.Stability in investment theory 203 contains n restrictions. 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. Shortly after Arrow and Hahn (1971) was published. Arrow and Hahn (1971) in their chapter on comparing equilibria gave little credence to the hope that the . a priori sign restrictions on dE/da contain n more restrictions. Yet. "Whose maximizing behavior does such a mechanism describe?" They remark that it is mechanical and not based on rational behavior.2). 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. and also. the epitaph of the Correspondence Principle was written by Arrow and Hahn (1971. the Sonnenschein (1972)-Mantel (1974)-Debreu (1974) theorem appeared. Nevertheless. This was discouraging enough but while this type of research was going on the very mechanism (2. 321) in their chapter on comparing equilibria. After Phelps et al. (1970) was published. Gordon and Hynes (1970) argue that speculative activity would destroy any such mechanism as (2. p. there were several attempts in the literature to rationalize mechanisms of type (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. Hence. BE /dp is a stable matrix and dE/da has a priori sign restrictions.2) but no consensus seems in sight.2) came under attack as a description of an adjustment process. they also ask. Turn now to a closely related idea. In view of the Sonnenschein-Mantel-Debreu result. this principle in some form lurks in the underworld of economists of a more practical bent. Phelps and Winter (1970) develop the beginnings of an alternative disequilibrium dynamics. 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.

x. 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.A. Return now to the optimal control problem (1.3) play the role of (2. 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. of equilibria of (2.1) and let (1. can be fit into (1. a) lead to useful comparative statics information on dx/da. such as Cass and Shell (1976a) on optimal economic growth. and Lucas and Prescott (1971) and Brock (1972) on perfect foresight models. Observe that the Revised Correspondence Principle is stated as a methodological notion unlike Burmeister and Long's (1977) Correspondence Principle which is a theorem. stability and chaos in dynamic economics hypothesis of L. Let play the role of (2.2) in the Correspondence Principle. Consider the system mentioned in the introduction. 3. Many intertemporal equilibrium systems studied in the literature.2) such as all goods are gross substitutes yield useful restrictions on dp/da. the hypotheses of stability of the solution x(a) of (2. how sufficient conditions for L.4) with respect to (1. They did show. to name a few. Abstract results on comparing optimal steady states Here we develop some mathematical results which are used in economic applications in later sections.1).204 Differential equations. that is.2) alone would yield useful restrictions on dp/da.3). Lucas (1967). Treadway (1971) and Mortensen (1973) on adjustment cost models in the neoclassical theory of investment.1) together with the dynamics of the solution (1. A version of the Correspondence Principle is offered below which is somewhat immune to the cirticisms listed above.S.S. whose solution generates the equilibrium-disequilibrium adjustment process (1.3). We have a Revised Correspondence Principle. or G.A.1).A.S. .3) together with a priori structural assumptions which are economically meaningful on TT(X. however. For problems of type (1. of (2.1).

This can be seen immediately by premultiplying and postmultiplying the right hand side of (3. Hence equations (3. Recall that a e Rm.5) characterize optimal steady states. The transversality condition has been shown by Benveniste and Scheinkman (1982) to be necessary as well as sufficient for a general class of problems.8) pxlqa to get for a e Rm.8) by a vector a e Rm.4) and (3.4) and (3.2) are necessary for optimality in a large class of problems.8) is nonnegative quasi-definite because H° is convex in q and concave in x. we define The matrix Q(a) plays a central role in the stability hypotheses of Magill (1977a). Add to both sides of (3.5) with respect to a and drop upper bars to ease the notation. where.Stability in investment theory 205 with initial condition x(0) = x0.1) and (3. and Brock and Scheinkman (1976) as reported . Rockafellar (1976). and the cross product terms cancel. A steady state x(a) with its associated costate q ( a ) must solve the equations below The transversality condition (3.3) is automatically satisfied at a steady state. we obtain The right hand side of (3. The differential equations (3. for notational convenience. Totally differentiate both sides of (3.

13) become . The proof follows immediately from (3.1. Note that for the interesting special case when the Hamiltonian is separable in q and x. when H°xq .A. In chapter 5 the function V = qTx is differentiated with respect to / along solutions of (1. x). Magill (1977a).12) and (3. This will be presented in the next section.206 Differential equations.9). note that except for hairline cases Q(a) is always positive definite when p = 0. x)TQ(a)(q. q(a0)). Insert (3. shows that if Q(a) is positive definite at the steady state (x(a 0 ).7) for qa in terms of xa. then for all ytRm. In the spirit of the Correspondence Principle we have an abstract comparative statics result: Theorem 3. Hence the global positive definiteness of Q implies G. then x(a0) is locally asymptotically stable. for example. so that the positive definiteness of Q(a) implies that V acts like a Liapunov function. stability and chaos in dynamic economics in chapter 5.H°qx . that is.S. Also. g(«o). This theorem will be useful when we turn to a problem where a enters the Hamiltonian with a specific structure. Proof. Solve (3.6) to obtain Equation (3.13) 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.12) into (3.2) to obtain V = (q. Next we present another abstract result. equations (3.1) and (1. If Q(a) is positive semidefinite at x(a 0 ).0.

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

16).1.and postmultiply (4.14) by *«. We now arrive at Theorem 4.13) for a = al. Brock and Scheinkman (1977a) use as a Liapunov function V-xTGx.1 is a typical example of a comparative statics result derived from a G.S. with G=(H°qq)~l. Consider the quantity and assume that R is negative quasi-definite. and calculate . hypothesis.A.A. Theorem 4.S.H°xq. If p > 0 and ( H ° q q } . and manipulate to get Since xai is an n x n matrix equation (4. Pre. We must show that for all vectors y.A. To verify this claim. The signs in parentheses are the signs of each term in equation (4.16) are nonnegative by convexity of H° in q and concavity of H° in x Hence yTxlly<Q. y T x a1 y<0. By (4. Proof.12) we get Premultiply both sides of (4. then xai is negative quasi-semidefinite. as shown in Brock and Scheinkman (1977a) and Magill (1977a).15) is an n x n matrix equation. But (x a 1 y) T (H° q q r l H° q x (x a i y)<0 by hypothesis. But which completes the proof.15) by the n x 1 vector y to get Notice that we used (H°qx)T . stability and chaos in dynamic economics Examine (4.208 Differential equations.8) and (4. The other two terms of (4.S. It was noted in the introduction that this is a sufficient condition for G. We digress in order to sketch how R negative quasi-definite implies L.1 H°qx is negative quasi-semidefinite at the steady state x(a).

by (4. We conclude that (4. Turn now for similar results on xa2.10). Since ar is the vector of wage rates for x. x). Hence if it exists.19) and (4. therefore. It turns out to be very powerful in analyzing a large class of adjustment cost models reported in Brock and Scheinkman (1977a). (4.Stability in investment theory 209 Note that V<0 because G = 0 at steady states and qrx<0.S.18) simplifies down to . that is. Hence by (4. the negative quasi-definiteness of R plays a central role as a sufficient condition for L. for all yeR". Thus.13) and use (4. (/C)'1 = -/„„ so that Also.11). 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.12) to obtain But by (4. Replace a by a2 in (4.A. 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. We return to discuss xa. V is a Liapunov function.8) and (4. Thus V <0 and.17) says that the long run factor demand curve x(a) is downward sloping in a generalized sense.20).

then so is xa2 which gives another verification of theorem 4. Look at the steady state equations. xa. Xp. . Replace a by a.14)-(4.15). It is worthwhile and instructive to verify theorem 4. in (3.S.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. x) and a. Separability of H° occurs when H0xq = 0=H°qx for all (q. hypothesis for the Lucas-Treadway-Mortensen model as well as playing a central role in determining the sign of xaj and xa2. then xai. Notice how equations (4.12) to obtain Hence we have Theorem 4.pa2+a\ and differentiate totally with respect to B to get Now obviously.2. If p > 0 and H°xq = 0 for all x. stability and chaos in dynamic economics Follow the same argument which leads from equation (4. Hence if xaj is negative quasi-semidefinite and p > 0.14) to theorem 4. use (4. q. a.210 Differential equations. It is fascinating to note that the negative quasi-definiteness of (H°qq]~l H°qx is a very expeditious G. From these last three equations we obtain that the steady state x must satisfy Put ft . 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. are all negative quasi-semidefinite and symmetric.3.. x).A.2.2 in a different manner. Turn now to the comparative statics implications of the separability of the Hamiltonian in (q.1 to obtain Theorem 4.8) and (4. If p > 0 and (H°qq) lH°qx is negative quasi-semidefinite then xa2 is negative quasi-semidefinite.

hypothesis and strong comparative statics results. we use the abstract results of section 3. hypothesis. xB and jca. in (4. The theorem follows because xai is negative quasi-semidefinite and symmetric from (4. . Part (i) follows from (4. Proof.35) and the hypothesis that Q(a) is positive semidefinite. That Xp and xa.12) for the Lucas-Mortensen-Treadway model to obtain Pre. From (4. Again we see a close connection between a G.34) because H° is convex in q and concave in x. are negative quasi-semidefinite follows from (4. .S. is negative quasi-semidefinite. Before we complete the analysis in this section. With xa} negative quasi-semidefinite and (4.34).6) and (3.and postmultiply both sides of (4. x q 1^ (ii) if Q(a) is positive semidefinite.A. = 0 from (4.Stability in investment theory 211 Proof. q^] and rearrange terms to get Replace a by a. Part (ii) follows from (4. The separability of the Hamiltonian is Scheinkman's (1978) G.33) by y e R" to obtain Notice that the cross product terms cancel to give the right-hand side of (4.A.S. Use equations (3. are all negative quasi-semidefinite. use H°xai = -In.10).8) and (4. //J a .34) where Q(a) is defined in (3.29). (i) The matrix xlj + p T x .31) by [x^.32). then xai.29) we get the other results. We can now state Theorem 4.7) to write them in matrix form Premultiply (4.30).4.

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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

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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

oo). for almost all times. Write the integrand in (7. oo)-» R+ such that for almost all t e [0.1).oo). The market demand also depends on p ( t ) and we denote it by f o r P ( t ) > 0 . The problem of finding a continuous vector function x(t) such that is called the extended integrand problem. anticipated price is equal. The integral of the demand function. is given by for Q > 0. with d ( Q ) > O a n d d'(Q)< O for < > 0 .1) to an analysis of (7. t e [0.6) in the consumer surplus form and let us check to discover sufficient conditions so that . stability and chaos in dynamic economics problem in (7. Next. This result is useful because it reduces the study of problem (7. that is. Note that the firm's expectations are rational in Muth's (1961) sense.220 Differential equations. denoted by D(Q).6). the latter being determined by the market. to actual price. D"(Q) = d'(Q) < 0. so that D'(Q) = d(Q). we define a rational expectations equilibrium for the product market of the industry as a price path p(t): [0. Brock and Magill (1979) show sufficient conditions under which the price path p ( t ) is a rational expectations equilibrium.

and that the matrix C is symmetric. we obtain the necessary conditions andfxx(x) is negative quasi-definite.1 to the results of static theory. theorem 7.1) to the static case we want to maximize Carrying out the maximization. p ( t ) here is a rational expectations equilibrium instead of a constant vector as Lucas. Then both dx/d(al + pa2) and d x / d ( a l + pa2) are symmetric and negative definite. 320-323).1. Treadway and Mortensen assume. suppose that the matrix C of section 6 is symmetric.S. Note that in the static case. comparative statics results hold as theorem 7. Furthermore.1 is a generalization of the early literature on the subject as presented by Hicks (1946). . Assume that the optimal path of the extended integrand problem is L. The reader. that is.A. 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.8) will hold. fx = Q with no meaningful information available about d x / d ( a l +pa2). let x be the optimal path of the extended integrand problem in (7.9) and (7. Although this application is similar to the one in the preceding section. Despite this extension. Samuelson (1947) and later made popular by Henderson and Quandt (1971).A. It might be informative to compare the results in theorem 7.7) we compute From (7.S. the usefulness of the Correspondence Principle in obtaining comparative statics results in the cost of adjustment theory with rational expectations. Suppose thatj^x =fxx. Therefore. we conclude that d x / d ( a 1 + pa2) is symmetric and negative definite.6) and suppose that x is L. (2) Static vs dynamic theory. or equivalently. then (7.Stability in investment theory 221 From (7. Thus we have sketched a proof of Theorem 7.1 shows and are obtained easily because of the powerful technique of consumer surplus. it differs in one significant aspect. once again.10) we conclude that if fxx=fxx. The above result illustrates. Following Hicks (1946. pp. Reducing (4.

theorem 7.14) and (7. p. yields While carrying out the multiplication in (7. (3) We close this section with an illustration of the usefulness of our comparative statics results in theorem 7. stability and chaos in dynamic economics however. then What is the economic content of (7. Therefore.222 Differential equations. Then. Consider the simple case with x = (x1. Substitution between inputs is possible but it could not prevail.(a 1? a2) as the parameter vector denoting input prices. our comparative statics results of the dynamic theory of the firm are consistent with the results of the Hicksian static analysis.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. must be cautioned that the dynamic theory is not just a straightforward generalization of the static theory of the firm. and for factors jointly employed in the same firm to be complementary".13)? The negative definiteness of dx/da. "there is a tendency for products jointly produced in the same firm to be complementary.13) we get From (7.15) we conclude that complementarity is likely to be dominant in the production process. for an increase in the input price i. x2) as the output vector and a . More generally.13). denoted by Aat>Q.1. Hicks (1946. Treadway (1971) and Mortensen (1973) show that the dynamic theory yields results that are dissimilar to those of the static theory. which in our special case is the 2x2 matrix in (7. . if Aa1 = Aa2 > 0. When C is not symmetric as we have assumed. where i = 1 or 2. 98) points out.

which originated in F. Magill and Scheinkman (1979). Further remarks and references In this section we offer a few comments on the literature related to this chapter. to obtain comparative statics results by means of the equilibrium potential function. Another unresolved issue in capital theory is the Hahn problem. Araujo and Scheinkman (1979). we focus on the formulation of equilibriumdisequilibrium mechanisms (1. However.S. Indeed.6) and the extension of Samuelson's Correspondence Principle to such mechanisms. Magill and Scheinkman (1979) present a complete characterization of the L. their Correspondence Principle proves to be a useful tool in studying these two important issues in capital theory..5)-(1. they conjecture that a paradoxical steady state is in some sense unstable.A. 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. Some of the relevant papers are Mortensen (1973). 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. of regular steady states for a class of optimal control problems similar to ours. 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. under the assumption of symmetry and L. Magill (1979) and McKenzie (1983). In the spirit of Samuelson's Correspondence Principle. Mortensen (1973) and Burmeister and Long (1977) are the first to explicitly formulate questions of the type: What are the implications of the L. 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. In particular. Burmeister and Long (1977). namely. to be used as a methodological tool to get comparative statics results. Magill and Scheinkman (1979) are able. We continue to be interested . instead of increase. the paradoxical consumption behavior associated with alternative steady states when the interest rate changes as an exogenous parameter.A.Stability in investment theory 223 8. Furthermore.S. Hahn's (1966) paper.S. namely.A. The behavior is paradoxical because if the interest rate is above the exogenous rate of labor growth. Their conclusion is that the Conjecture Correspondence Principle holds only in some very special cases. and vice versa. per capita consumption. The Correspondence Principle of section 2 is different but the purpose is the same.

Brecher and Hatta (1987) have generalized Samuelson's (1971) Global Correspondence Principle with an application to international trade. 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. . and using different techniques. stability and chaos in dynamic economics in similar questions with more emphasis on G. 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.S.224 Differential equations. We note that Magill and Scheinkman (1979) is extended to the asymmetric case in Magill (1979). Recently.A. Furthermore. Bhagwati.

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

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

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

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

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

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

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

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

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

234 Differential equations. m. w. Determination of optimality conditions for households As indicated above. Perfect foresight equilibrium The perfect foresight equilibrium (PFE) we shall consider is defined as follows. Likewise. we shall focus our attention on these equilibrium quantities. which are also functions of w. First consider the household sector's maximization problem defined by (2. etc. the government policy decisions constrained by (2. etc. which firms also treat as parametrically given. rh. bp. the household sector's optimization problem is to choose c. E to maximize its utility function (2. although it would be straightforward to do so.5) generate supplies of money and government bonds and a demand for goods. the quantity m.1c) with Th defined by (2. labor. In this case md = ras. Substituting for Th enables us to define the Hamiltonian .4). rg.2a)(2.la). etc. Carrying out this maximization yields a set of demand functions for consumption and various securities together with a labor supply function. (2. Nothing will be done regarding the question of existence of equilibrium. 6a). Thus. subject to the budget constraint (2. la). the corporate sector's optimization problem defined by (2. and subject to the initial conditions (2. bg. say. and other parameters which consumers take as given. and where no confusion can arise we shall simply drop the superscript. will denote the real money supply in a perfect foresight equilibrium. In fact.6b) yields a set of demand functions for capital and labor.6a). The perfect foresight equilibrium is defined as a situation in which the planned demands for output. rh. with 7} defined by (2.1c). 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 new security creation is allowed. 3. Since such taxes do not generally characterize real world tax structures. lending. and in addition all anticipated variables are correctly forecast. in terms of p*. equilibrium may not exist under all tax structures especially when borrowing. Thirdly. with Th defined by (2.1b). we do not incorporate them. Henceforth. 4.1b) subject to (2. and the various securities in the economy all equal their corresponding real supplies.2e) and (2. and a set of supply functions for various securities together with output.

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

Conversely. 5.7). (4. I.3).2c).4). m. If any of these inequalities are met strictly. we shall assume in equilibrium c > 0. and (4. (4. if any of the decision variables are strictly positive in equilibrium. we begin by eliminating RE from the firm's financial constraints (2. (4.4). the optimality conditions (4. The Lagrange multiplier is simply the discounted marginal utility of consumption. 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. the corresponding constraint is satisfied with equality. These dualistic type relationships are reflected in the equations (4. bp and bg (which are identical) and E respectively.2).5). so that (4. Determination of optimality conditions for firms To derive the objective function for firms. (4.12). / > 0. (4. Throughout the analysis.12) can be simplified and interpreted more readily.2). (2.1)-(4.9). stability and chaos in dynamic economics Inequalities (4. Introducing the above equality conditions.2d) to yield .7) all hold with equality. (4.6). then the corresponding decision variable is set equal to zero. (4. (4. (4. 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. m>0.11) are the Euler inequalities with respect to c. (4.10). so that represents the rate of return on consumption.8).236 Differential equations.

in order for V(s) to remain .1) becomes We now define the firm's debt-to-equity ratio enabling us to write (5.6) can now be readily integrated to yield a general solution where A is an arbitrary constant. the superscripts have been dropped.5) can be written more conveniently as where 6* is in general a function of t.2). Equation (5. equation (5.3) in the form Next. and recalling the definitional relation D/qE = i.S0 0* df = 00. we obtain We now define the firm's real net cash flow y ( t ) to be That is. letting (5. y(0 equals the gross profit after tax.Macroeconomic policies 237 where. Now using the definition of 7} together with (5. but is independent of V.3) (and hence V).. Adding qE to both sides of this equation and noting the definition of V given in (2. Suppose for the moment that 0*>0 (an assumption which will be justified below and certainly holds in steady state) and assume that lim. because we are dealing with PFE. Then. less the cost of the additional capital purchased.

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

19).17). Given that the capital gains in the model really reflect accruals. But (5.Macroeconomic policies 239 These preferences. being expressed in terms of the firm's financial decision variables. together with other variables parametric to the firm is now suitable for determining the firm's optimal financial policies. i The optimal dividend policy and the optimal capital structure will therefore involve corner solutions.19) for consumers to eliminate rp and qE Substituting these expressions into (5.11) may also be written in the form The expression (5.11) or (5. As written in (5. the relevant cost of capital is equal to the consumer's rate of return on consumption 6. 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. (4. adjusted by the various corporate and personal income tax rates.8). This is done by calculating the partial derivatives with respect to A. Note that in the absence of taxes. Dividend policy is therefore irrelevant. whereas tax rates in reality .11). we invoke the optimality conditions (4. embodied in the optimality conditions (4. confirming the well known Miller and Modigliani (1961) proposition for this case.17) and (4. the adjustments themselves being weighted by the share of bonds and equities in the firm's financial structure.12). 6* is independent of i. To obtain an appropriate expression for 0*.

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

use has been made of (5.10). 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. we feel that the derivation we have given for the cost of capital. Instead of (5.15)-(5. This result follows immediately from the equality (1 — r y ) = (l —T P )(!-T S ). One special case of this arises when all tax rates are zero. Thus using (5. Our results are also consistent with Miller's (1977) extension of this proposition. The reason for the . These expressions are generally similar to those given by Auerbach (1979). although there is one difference. again in the case of a single agent. He shows that the value of any firm in equilibrium will be independent of the amount of debt in its capital structure.) = (1 -T p )(l -r s ). in terms of the underlying optimality conditions for consumers. when the conditions (5. 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.21). he finds that with all equity financing. 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.21). has merit in making explicit the role played by consumers in determining the optimality conditions for value maximizing firms.17) and (5. then the optimal debt to equity ratio is indeterminate.16) simply reduce to a statement of the familiar Modigliani and Miller (1958) no-tax case. If (1 -T V .9) and (5.18).Macroeconomic policies 241 requires ry to exceed TP by an amount which suffices to take account of the double taxation of income from stock. Thus while our conclusions for the firm's financial policy turn out 10 be familiar. and furthermore is less than (5.

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

24) and (5. Combining the optimality conditions in (4. Thus we may conclude by noting that if (5.18) applies qE = k. while in the knife edge case where (5.18) holds with equality.14)-(4. Hence we deduce V(f) = k ( t ) . bp and qE are indeterminate.17) holds bp = k. Equation (6.Macroeconomic policies 243 Now integrating by parts and cancelling. we obtain But the limit of the second term is zero. by the necessity of the transversality condition at infinity for infinite horizon concave programming problems of this type.2) equates the marginal rate of substitution . if (5.19).17)-(5.25) we may write Equation (6.1) simply defines a short hand notation for the marginal utility of consumption. Equilibrium structure and dynamics of system The optimality conditions for the households and firms. (5. 6. This completes the formal optimization of the firm. see Weitzman (1973) for the discrete time case and Benveniste and Scheinkman (1982) for the continuous time version. 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.

6)-(6. Once such a policy is chosen. Unfortunately.13).8) is the government budget constraint. then using the optimality conditions for consumers and the optimality conditions for firms. Equations (6.26). one obtains (6. pegging the real stock of government bonds. Essentially it is obtained by first substituting the tax functions (2. the initial nominal stocks are assumed to be given. 0* in. fc(0). in terms of the new notation. E(Q) = E0. Then in section 9 below. p.8). with the initial real stocks being endogenously determined by an initial jump in the price level. etc. The size of this initial jump. to simplify the resulting expression for the real deficit. being given by /c(0) = /c0.4) and (6. and the minimum cost of capital respectively. bp(0). (2. There are various policies which are traditionally chosen in dynamic macro models of this kind. we shall proceed directly to a discussion of the steady state. 6 g (0). The derivation of this form of the equation involves several steps. The final equation (6. The dynamics governing these latter variables are expressed in equations (6. a full dynamic analysis of the system turns out to be rather complex and not very enlightening.6b) into (2. and therefore the initial values m(0). m.244 Differential equations. The first of these is a restatement of (4. while (6. Rather than pursue it further with the model specified at the present level of generality.5). The first two of these are exogenously determined. something must be said about government financial policy. the dynamics is fully determined. This simplification suffices to give a good indication of the nature of the transitional dynamics for the general case.8). 6. . in terms of the dynamically evolving variables a. As part of the specification of the dynamics of the system.7) describes the rate of capital accumulation required to maintain product market equilibrium. In the case of money and bonds.5) restate the marginal productivity condition for capital. stability and chaos in dynamic economics between consumption and leisure to the after-tax real wage. while (6. k.6a). 6 P (0). bg. c. pegging the rate of nominal monetary growth. bg(Q) are obtained from the transversality conditions at infinity for households and firms. E(0). To complete the description of the system we must consider the initial conditions. These five equations may be used to solve for the short-run solutions for the five variables /. given the dimensionality of the system. m(0). we shall analyze a simplified version of the dynamics. together with the linear homogeneity of the production function and the balance sheet constraint (5. which arises when labor is supplied exogenously.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. They included pegging the real money supply.

26). 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.8). integrate the government budget constraint (6.18) and integrating. rp = rg. with all equity financing. we should also explain how the equilibrium stocks of bonds and equities and their respective rates of return are determined. lim. The argument may be sketched as follows. Note that with the nominal stocks of bonds given. a jump may occur at time zero.13) to yield Next. through the price level. the price of equities can be obtained by substituting known values into (4. the quantity of shares outstanding can be immediately inferred. 7.8). so that /c0 = bp (0) = B PO /P(0).16). With both the value of equities and their price determined. In this case the rate of interest on government bonds will again be given by (4. which is now qE = k. to obtain .Macroeconomic policies 245 But before concluding the present discussion. The requirement that bK = 0 is less immediate. that is. in order to satisfy the balance sheet constraint (5. However. since bg is determined residually by (6. Again an initial jump may be required in q. the balance sheet constraint (5.26) implies bp = k. Similarly. Obviously this implies that the rates of interest on private and public bonds must be equal. but now exceeding that on private bonds.16). First integrate (4. with their after tax real rate of return now equaling that on equities. In the case where firms find it optimal to engage in all bond financing. Steady state The steady state of the system is attained when The fact that steady state requires k = m = d=0 is readily apparent. which holds as an equality.-> U c ( t ) b g ( t ) exp(—Bt) = 0. The nominal rate of interest can then be determined by inserting the known values into the consumers' optimality condition (4.

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

p. conditional on these initially chosen real variables. in the consumers' utility function. then for given g and rates. On the other hand. the system dichotomizes into two recursive subsystems. 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. real production decisions and financial decisions are jointly determined. Thus.2)-(7.5) into the appropriate arbitrage condition for consumers (4.5) is interdependent. m. 8. the equilibrium rates of return on the financial securities can be obtained by substituting the solutions from (7. the system summarized by (7.1). This is determined by the inequality conditions (5. the following steady states may be characterized. Under certain conditions. 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. if the policy is specified in terms of the real stock of government bonds.2)-(7.Macroeconomic policies 247 real stock of government bonds to maintain the budget in balance.15)-(5. in general. however. The first determines the real decisions k and / while the second determines the financial variables m and p. We shall restrict most of our attention to the case in which the monetary authorities maintain a constant rate of the nominal money supply.17) and (4. and capital and labor on the other. it is necessary to introduce some government financial policy. I. It is also in part a consequence of the interdependence between real money balances m on the one hand. for the government monetary policy specified by (8. Finally. .16) and the corresponding minimized cost of capital. the four equations determine the equilibrium values of k. It is of interest to note that.19). Characterizations of alternative steady states In order to discuss the steady state of the system in further detail.

an expansion in real government expenditure will have real effects on output and employment. the two marginal rate of substitution conditions (8. stability and chaos in dynamic economics 8. as well as upon both the corporate and personal income tax rates. TP.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. (8. so that c .2). so that c and g enter as separate arguments in the utility function. This confirms the argument advanced by Fair (1978) that in a fully rational expectations model generated from underlying optimizing behavior. (8.5) have important implications for the debate concerning the effectiveness of fully anticipated government policies under rational expectations. Being a perfect foresight equilibrium. the range of effective government policies may be restricted. u TJL.1.3).248 Differential equations. Having determined k/l. /). The government budget then determines the real stock of government bonds necessary to balance the budget. TV. anticipated government policies are indeed able to have real effects. while the level of output y immediately follows from the production function. this establishes the capital-labor ratio. which in turn determines the real wage/J(/c. Also. All bond financing by firms In this case inequality (5. k. It is seen from these equations that the real productive decisions. are in general dependent upon the rate of growth of the nominal money supply. With k/l and now / fixed. and the real stock of money balances ra. For example. to the extent that public and private goods are viewed as imperfect substitutes by households. given the parameters B.4) yields the marginal physical product of capital. First. if public and private goods are perfect substitutes. equations (8. /. With the linear homogeneity of the production function. On the other hand. the real stock of capital k is known.2)-(8. together determine the employment of labor /.

Also. Also./ Uc is independent of m. From equation (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.r v ).2)-(8.2 below. is thus equal to [(1 . An increase in the rate of nominal monetary growth raises the nominal before tax interest rate by 1/(1 . This form of neutrality in a full employment model such as this is often referred to as super-neutrality.5) to the effects of tax rates and the monetary growth rate on the capital-labor ratio.ry}. and (ii) the utility function is separable in real money balances. These effects have been discussed extensively in the literature over the years and are among the more interesting. The effect on the after-tax real rate of interest to firms. we shall restrict our analysis of the comparative static properties of (8. which in steady state is rp = (ft + /i)/(l . In this case the only government policy parameter able to influence real activity is the personal income tax rate. when the results are compared to those we shall derive in section 8. although his analysis was not conducted within an optimizing framework. resulting in complete crowding out. In order for all bond financing .Macroeconomic policies 249 and g enter additively in U. so that the marginal rate of substitution U. which therefore provides the critical channel through which alternative tax structures impinge on the system. which with all bond financing is their effective cost of capital. This result is in agreement with the analogous property obtained by Buiter (1977). To preserve simplicity. They operate through the cost of capital.9). 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. g disappears from the expressions Uc.r p )/(l -r v ) — 1]. It will simply displace an equal volume of private activity. which does so by affecting the consumption-leisure choice. so that the effect on the capital-labor ratio depends upon (TP — r v ). etc.4) we may derive To understand these results it is useful to recall the expression for the nominal rate of interest (5. real activity will be neutral with respect to the monetary growth rate fji if: (i) the corporate and personal income tax rates are equal.

9). TC. Finally.250 Differential equations. An increase in the personal income tax rate raises the nominal interest rate 5 and hence the after-tax interest rate to firms.11).15) imposes a lower bound on this quantity. the implications for the other endogenous variables can be easily obtained by taking appropriate differentials of (8.6)-(8. (5. though the relevant cost of capital determining the capital-labor ratio is now given by (8. the marginal rate of substitution conditions (8. Thus for example. Ty. With k/l so given. again confirming the proposition of Fair. But the reverse cannot be ruled out. if the rate of taxation on capital gains and the required minimum rate of dividend payments are both zero. Given the effects summarized in (8. (8. the previous comments made with respect to the crowding out effects of increases in government expenditure continue to hold. On the other hand.8). It therefore leads to a reduction in the after-tax real interest rate for firms.2. 8. with the government budget constraint determining bg.10) determine /. 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.1. inducing them to increase their capital-labor ratio. 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).2)-(8. All equity financing by firms With all equity financing. then TP > ry and k/l will rise. (5.11) and have the . The exogenous government policy parameters u. an increase in the corporate tax rate TP has no effect on the nominal interest rate.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. TP. stability and chaos in dynamic economics to be optimal. all have real effects. thereby inducing them to lower their capital-labor ratio. m and hence k.

The reason for these results can be understood by considering the expressions for the equilibrium rate of capital gains. it follows from (6. exactly as in the FGS analysis. 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). we find that under both modes of corporate financing. On the other hand. depending upon the expression in (8. In fact. an increase in the corporate profit tax rate TP leaves equity costs unchanged. are opposite to those obtained under bond financing.ry)/(l Tp) while that on equities is — rc.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.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). In the latter. so that as rp increases. more general analysis. Finally. inducing firms to reduce their capital-labor ratio. the effect of an increase in the capital gains tax on the rate of capital gains is ambiguous. while with equity financing dd/dp = — rc. .16). 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. which from (5. With the capital-labor ratio and therefore 0*min fixed in the short run. these two rates of return equal (3 in steady state and therefore are independent of the inflation rate. (1978). The after-tax marginal physical product of capital must remain fixed. on the other hand. In our analysis.5) that under bond financing d6/dp = (TP — r v )/(l — r p ). 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. then the effect of an increase in the inflation rate upon the steady state net yield on bonds equals (rp . k/l must fall. it corresponds to our short-run value of 6.

in terms of a. Since this equation is a residual. as specified by (8. the marginal rate of substitution condition determining the labor supply is no longer applicable. Also. Given the tax rates. 9. Thus omitting I from the relevant functions. in which case A will be indeterminate. k. The monetary authorities maintain a fixed rate of growth of the nominal money supply.1). To keep things simple we shall assume that rv = TP( = T). the dynamics of the system (6. Dynamics in a simplified case Finally. we assume that the government maintains the real stock of government bonds fixed. This will arise only in the knife edge case where (5. in which case firms find it optimal to engage in all bond financing.252 Differential equations. 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. 6. in order to simplify the dynamics as much as possible. financing its deficit with an endogenous lump sum tax. it can henceforth be ignored.1)-(6. the final equation determines the endogenous lump sum tax JJL required to meet the government deficit. corresponding to the present set of assumptions becomes The first three equations determine c.3. stability and chaos in dynamic economics 8.8). monetary growth rate. p. . With labor supplied exogenously.15)-(5. 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.4)-(9.6). and g.16) is satisfied with equality. m the dynamics of which are then determined by equations (9.

8). we may argue that in response to any disturbance. Thus for ..Macroeconomic policies 253 The solutions for c. In addition. we find that its local stability depends upon the eigenvalues of the matrix where all derivatives are evaluated at steady state . Ucm > 0.4)-(9. By invoking the transversality conditions. From (9.7). introducing the mild restriction that consumption and money balances are complementary in utility. we also have c°m = -Ucm/Ucc>0.3). the system will jump so as to be always on the stable locus associated with the stable eigenvalue. possibly complex. and using properties of cubic equations. the sign restrictions we have imposed suffice to ensure that Thus we may deduce that there are two unstable roots.9).and Denoting the roots of (9. (9. and just one stable root. Now substituting (9. that is.3) into (9.8) we have c° =1/L/ C C <0.13) by A. (9. the dynamics of the system becomes Linearizing the system about its steady state equilibrium. p may be written in the form while 6 is given explicitly by (9.

10. the rate of monetary growth n will affect the speed of adjustment of the capital stock.13) and is rather tedious. The same kind of analysis can be carried out for the case of equity financing. (ii) depend critically upon the financial structure adopted by firms. several authors have considered the question of tax incidence using a dynamic growth model. Miscellaneous applications and exercises (1) The incidence of taxes has been a central issue in public finance for a long time. To calculate the response of the adjustment speed A! explicitly involves solving the cubic characteristic equation to (9. One can also use the above method to consider the case where labor supply is endogenous. 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. and (iii) . for example Homma (1981) and his references. despite its importance. and the firm's production decisions are derived from static optimization. the existing dynamic models suffer from at least three limitations: (i) they are variants of the traditional neoclassical one-sector 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. suffers from several limitations pointed out by McLure (1975). (ii) they abstract from issues related to the corporate sector and corporate finance.14). One would expect that this will lead to stable first order adjustment paths similar to (9. likewise for the other variables in the system. although the extent to which this is in fact the case remains an open question. However. stability and chaos in dynamic economics example. See.254 Differential equations. namely to invoke the transversality conditions to eliminate unstable adjustment paths. In all cases the strategy is the same. Recently. It is apparent that A. as well as its steady state level. will be a function of the various government policy parameters. 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. The standard framework for conducting incidence analysis has been the two-sector general equilibrium model of Harberger (1962) which. and (iii) the savings behavior is specified arbitrarily. In particular.

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

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

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

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

See also Stein and Nagatani (1969). in a model that considers only money and capital. neoclassical economic growth model. Malliaris (1982) and Hartman (1987). 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 . (8) Shane (1974) extends Tobin's (1965) model by introducing an equity security into money and growth analysis. Sargent and Wallace (1973) proposed an alternative view. continuous-time. instead of the more traditional treatment in terms of money and capital. thereby eliminating the excess supply of real balances without affecting the expected rate of inflation. 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. 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. First. Benhabib and Miyao (1981). the price of money falls instantaneously when at an initial price level the supply of real balances exceeds the demand.Macroeconomic policies 259 (7) Tobin (1965) introduced money in a deterministic. 1971b. in terms of developing a policy tool. 1979). Fischer (1972. Such an approach has two distinct advantages. that is. whereas the introduction of a financial market allows one to analyze directly the mechanism by which saving and investment are separated. according to which. In general. 1973. the wealth ratio and price expectations. Second. Shane's (1974) model consists of three differential equations in capital intensity. 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. Black (1974). 1979) and Hadjimichalakis and Okuguchi (1979) have studied the saddle point stability of the Tobin model. saving is merely a decision to invest directly in real capital or money balances. it is claimed that a once and for all increase in the money supply will set off a process of ever accelerating deflation. Nagatani (1970). such as Sidrauski (1967). If the system is initially in a steady state with zero inflation. The model is developed explicitly in terms of securities and capital. it is often claimed that versions of the Tobin (1965) model which assume perfect foresight are dynamically unstable. Hadjimichalakis (1971a. Benhabib (1980). What makes the equilibrium stable in the Sargent and Wallace (1973) model is that the price level rises. Several economists. 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.

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

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

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

Since firms would want to lever more. Sargent and Wallace (1973). If foreign countries. But undoubtedly the most important extension relates to uncertainty. Recent developments in stochastic calculus indicate that it might be possible to extend our framework to include various forms of stochastic disturbances. 11. 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. For a comprehensive text on dynamic equilibrium macroeconomics that stresses uncertainty see Sargent (1987). the quality of corporate debt will tend to fall. 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 . 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). We are only saying that models and techniques like those exposited in this chapter help the economist explain the real world. (which casually seems to be the case). Turnovsky and Burmeister (1977) and others. This increases the gains to leverage.1. 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. 1978).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. 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. Alternative assets such as rented capital. such as Japan. can be introduced. The model can be extended in different directions. This is so because the same capital stock is backing a larger stock of corporate debt.Macroeconomic policies 263 formula (5. This helps explain (ii).S. have not experienced as sharp a drop in 6* as has the U. the price will jump very fast in response to a change in the expected capitalized payoffs from a unit of capital. That is. then this helps explain (iii). We are not saying that taxes explain everything. Problems of corporate financing really become interesting only in a world of uncertainty. Burmeister and Turnovsky (1977.

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

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

But in our case. 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. perhaps. 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. the dynamics are derived from primitives like tastes and technology. For this reason.266 Differential equations. This is so because. For specificity take the Liviatan and Samuelson model.) at steady state x(a). p. Kurz and Liviatan and Samuelson show that examples of growth problems with multiple steady states can be constructed.S. The linearization of the system about an unstable steady state has two roots both real and positive. the unstable steady state can be ignored for the purposes of comparative statics. p(x). one can argue that the unstable steady state will never be observed. then standard Samuelsonian comparative statics and dynamics could be done.we gave up as a profession on the task of modelling out of equilibrium behavior. To get the local solution manifold take the eigenspace generated by the smallest root. 464) for the phase portrait in (c. If you follow the revised correspondence principle in chapter 7. This came at a price. a} = h(x. 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. we may expect to obtain a more powerful analysis given a smaller number of free parameters.A. The global solution manifold is tangential to this eigenspace at the unstable steady state. In any event let us explain the analysis. the rational expectations approach of Lucas replaced the earlier Samuelson-Hicks approach to economic dynamics. for the same reason as in the Samuelson Correspondence Principle. however . Follow the same procedure as for the case G(dx/dt. x) =f(x)-dx/dt to study equilibria and focus on an unstable steady state. The first question is: what happens if at date zero the parameter a changes to a{ and remains at a. Good examples of this technique are Wilson (1979) and Judd (1985) among others.a) was globally asymptotically stable (G. Hence. See Liviatan and Samuelson (1969. 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. x) space. stability and chaos in dynamic economics Liviatan and Samuelson (1969). unlike that of Samuelson. There are two main forms of analysis of rational expectations models that we want to stress here. x) = 6V.? This is called anticipated event analysis. In chapter 7 and in Brock (1986b) it was pointed out that when dx/dt = F(x. forever? This is called unanticipated event analysis.

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

For details see Judd (1985).268 Differential equations.4. . Working backwards as in dynamic programming we know that to be in equilibrium the system must be on £M(a 1 ) on [T. 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. Although it is beyond our scope to study learning and disequilibrium.1) where the RHS is evaluated at «0 over [0.1) at value « 0 over [0. oo). instead. the papers of Bray (1982). Blume et al. 1978. is a general feature of dynamic models involving expectations. It must start at x0 at date zero and follow the dynamics (11. Also. Hence p must change from the old value. p) and following the dynamics (11. a0) to a new value p so that starting from (x0. that is to take place T periods from now and to be permanent over [T. An earlier standard reference is Shiller (1978). while McCallum (1983) argues that the nonuniqueness of many macroeconomic models involving rational expectations is not properly attributable to the rationality hypothesis but. 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. T) we arrive at EM(a. Taylor (1986) reviews rational expectations models in macroeconomics. Marcet and Sargent (1988) draw heavily upon recent work in optimal control theory in their paper on learning. 11. p(x0. see also McCallum (1977. T). 1988c) for learning illustrations related to the quantity theory of money. Conditions for unique solutions in stochastic macroeconomic models with rational expectations are given in Taylor (1977). Attfield et al. We conclude this section with some additional references.) at exactly date T. Anticipated event analysis Consider a change in the parameter a from a0 to a. (1985) provide an introduction to the theory and evidence of rational expectations in macroeconomics. We close with a comment about disequilibrium behavior and learning. See Judd (1985) and his references. Learning and disequilibrium is an important research area in economics despite the fact that this book focuses almost entirely upon rational expectations models. oo). 1980). (1982) and Lucas (1986) contain references on learning where stability analysis is stressed. stability and chaos in dynamic economics This is all easy to see by drawing the phase diagram. the stability techniques exposited here will help researchers in this area. See also Malliaris (1988b. For example.

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. After all. must depend on the discount rate of the future in any sensible economic model of learning. . the rate of interest that agents place upon the future. because there is one parameter that plays a central role in the stability analysis of optimal dynamics. and hence the adjustment rate to equilibrium. The optimal rate of learning. 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. See DeCanio (1979) and his references for details. i. learning imposes costs that must be borne today in return for gains tomorrow.. This is so.e.

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

kj is stock of capital good j and qj is the price of capital good j. k) is independent of the initial condition (q0.1) such that (/>. However. See Cass and Shell (1976a) for a complete interpretation of (1. no general results on the convergence of optimal solutions . In economics. peculiar to economics. be optimal. The first branch of the literature is fairly complete and a brief survey is presented at the end of this chapter. provided the obvious changes are made.1) optimal if k ( t ) is the optimal solution of the optimal growth problem when k(0) = k0. A definition is needed. H turns out to be the current value of national income evaluated at prices q.1). and (ii) analysis of global behavior of solutions of (1. Concerning the second branch. The number p is a discount factor on future welfare arising from the structure of social preferences. Clearly not all solutions of (1. Find sufficient conditions on optimal solutions O. kQ). We call a solution [ q ( t ] .1) in a neighborhood of a steady state. in general. This process generates a type of differential equation system that Brock and Scheinkman (1976) call a modified Hamiltonian dynamical system. The literature on problem 1 has two main branches: (i) analysis of the local behavior of (1. call it an MHDS for short. The function H is called a Hamiltonian.1) which satisfy k(0) = k0 will. and p e R+. k(t)] of (1. The adjective modified appears because it is a certain type of perturbation. 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» (q. what follows only depends on H being defined on an open convex subset of R 2n .272 Differential equations. Problem 1. until the mid-1970s. k) as t -» oo. This chapter reports the Brock and Scheinkman (1976) approach to capital theory. (1962) to write down necessary conditions for an optimal solution. and it is well defined on R + x Rn+ for many economic problems. A modified Hamiltonian dynamical system. is a differential equation system of the form Here H: R+ x R+ -> R. of (1. Also find sufficient conditions such that the steady state (q. of the standard Hamiltonian system. The problem that we address in this chapter may now be defined.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. The solution x(t) = x of x=f(x) is globally asymptotically stable (G. Definition 1. Rockafellar (1976).(q0. Note that our definition of bounded solutions requires not only boundedness on the (q. k) space. Let be a differential equation system. k0)<=• K for all t.Stability in capital theory 273 of (1. Magill (1977a). ko) will be called a bounded solution of (1. The solution x ( t ) = x of x=f(x) is locally asymptotically stable (L. However.3.1. 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. Ot(g 0 . Let x satisfy f ( x ) = 0.A.2. For this reason we concentrate on the convergence of bounded solutions. Inada-type conditions guarantee that in fact optimal solutions will satisfy our boundedness condition. Definition 1.1) were available.1) if there exists a compact set K ^ Rn X Rn+ such that <j>. Under what conditions is the solution x ( / ) = x globally asymptotically stable for all x0? We recall two definitions. In this chapter we present results that build on the work of Cass and Shell (1976a). Thus. The following problem has been analysed extensively in the differential equations literature and has been reviewed in chapter 3.S. Definition 1.) if for all x0 the solution O1 (x 0 )-»-x as t-*oo.1). a natural question to pose is our problem 1 for MHDS. but also requires that there exists e >0 such that In many optimal growth problems.A.S. there was nothing done in the Brock (1973) paper on convergence. However. . See Kurz (1968a). new problems arise. In fact. little was known about sufficient conditions for the uniqueness of steady states of (1. In this case. if / is a modified Hamiltonian.) if there is e > 0 such that |x 0 -x|<£ implies (Ot (x 0 )-» x as t->oc. and Hartman and Olech (1962).

k) = (q. Denote by (q.S. Most of the assumptions in this chapter refer to the curvature matrix where H^(z) = ( d H 1 / d z l ) ( z + (q.1) as where F.(<7o. 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).1) if there is e > 0 such that provided that </>.::A<^ R2" -» Rn where A is open and convex. k ) ) . The steady state solution (q.A.1) and rewrite (1.1) is said to be globally asymptotically stable for bounded solutions of (1. that is.A. The steady state solution (q. and L. ^o) is bounded. by letting Here again a bounded solution means a solution which is contained in a compact set K c A.274 Differential equations. The result is obtained by using the Liapunov function F[(z)F 2 (z). those who satisfy definition 1. In section 2 we show that if F ( z ) Q ( z ) F ( z ) > 0 for all z such that F ( z ) * 0.(q0. H22(z) = (BH2/dz2)(z + ( q . k) = (q. k) of (1. k ) ) . then every bounded trajectory converges to a rest point. k) some rest point of (1. We will sometimes call MHDS saddle-point systems when we want to emphasize their saddle-point structure.S.3. stability and chaos in dynamic economics Definition 1.1) is said to be locally asymptotically stable for bounded solutions of (1. will always apply to bounded solutions alone in this chapter. implies that all solutions of x = f ( x ) converge to a rest point. For MHDS the words G. k) of (1. if for all (q0. . for all x with f (x) = 0. ^o) is bounded. and /„ is the n x n identity matrix.5. fc0) such that 0.4. then f T (X)/(X)/(x) < 0. we have Definition 1.1).

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. The proof is inspired by the elegant proof of a Hartman-Olech type of result obtained by Mas-Colell (1974). in section 4 we outline the method of proof of a more general theorem. In particular. 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. 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).S. Hence H11. The curvature matrix Q is a natural economic and geometric quantity.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. It is easy to show that ( R ) . As a by-product of the proof. Furthermore. A notion of a-quasi-convexity is introduced to provide a geometric interpretation for the case where p > 0. which is Rockafellar's . if the Hamiltonian is quasi-concave in the state variable. we show that for the case p = 0. Geometric Content of Q. — H22 are positive semidefinite matrices. and placing conditions on the Jacobian matrix of F so that all trajectories of the original field come together monotonically as f-»oo. which is the Cass and Shell hypothesis. we show that the above conditions are sufficient for the function z|z2 to be monotonically increasing along trajectories. although in this case optimality may not make sense.2) converge to the origin. Note that the assumptions of sections 2 and 3 are somewhat complementary.A. the Hamiltonian is convex in q and concave in k for optimal control problems with a concave objective function. in the metric induced by the arc length measure along the orthogonal field of trajectories. then every solution to x =f(x) converges to the origin provided that 0 is L.A. The method of proof of section 3 does not. unfortunately.S. holds. For this reason. definite provided that For the one-dimensional case. then G. 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. As Cass and Shell (1976a) point out. then all bounded trajectories of (1.

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

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

and such that solutions of are uniquely determined by initial conditions. It is.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). k) be a rest point of (2.278 Differential equations. results for a discounted linear quadratic problem.A. 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. Consider a trajectory z ( t ) = Ot(q0.1 of chapter 4. Arrow and Hurwicz and Markus and Yamabe prove. Lemma 2.S. Optimal growth paths will have this boundedness property under reasonable conditions. Here XT denotes x transposed.1) where q0 is chosen so that Ot (qo. therefore. that x(t)->0 as f ^ o o along trajectories. p.S. roughly speaking. results for (2. thereby. Rockafellar (1973) and Samuelson (1972a) have used the same function to investigate stability for the case p = 0. Let J ( x ) = df/dx. We will make use of the result in Hartman (1964. Cass and Shell are the first to obtain G.A. We present an analog of this type of result for Hamiltonian systems. where W(z) is the trajectory derivative of W(z) for any z e E.1) and let Then (2.1. Magill (1977a) used V to obtain G. by differentiating (x) T x = W with respect to t and showing. 539) which is also theorem 4. that the negative definiteness of JT + J is sufficient for global stability of x =f(x). (b) 0 < W(z). . Cass and Shell (1976a) prove global stability of such a trajectory by differentiating the Liapunov function V = zTz-2 with respect to t. Let F(z) be continuous on an open set E c Rm. rephrased for our current need. stability and chaos in dynamic economics Let (q. natural to ask what may be obtained by differentiating the closely related Liapunov function F[F2.1) by use of the Liapunov function V = zTz2 for the discounted case. k0) is bounded. ko) of (2.

Proof.3) and (2. there exists a rest point z. and solutions are continuously dependent on initial values. Proo/ Let y+ = {ze Rn : z = <f>t(z0) for some t > 0}. H22= -dF l /3z 2 .1. z(t n )->z 0 as n -> OO.2) are isolated. and this contradicts W[z(0]^ W^(z 0 ). there exists by the mean value theorem e > 0 and d > 0 such that for 0< t < e and. Since W is continuously differentiate and W(z0)>0. Then W[z( tn)]-»• W(z0) as n-> oo.(z 0 )-> z as t-»oo. are contained in the set E0 = {z: W(z) — 0}. and if the rest points of (2. Then the limit points of z ( t ) for t > 0. The continuity of W guarantees that for 17 sufficiently small. and by (b) W[z(t)] < W(z0) for f >0.Stability in capital theory 279 Let z(t) be a solution of (*) for t >0. We can now prove Theorem 2. in particular. Suppose z 0 /£ 0 so that W(z 0 )>0 by (b). This completes the proof. and In denotes the n x n identity matrix. if any. If F T (z) Q (z)F(z) > 0 for all z with F(z) = 0. and w ( y + ) = {z E R": there exists an increasing sequence {tn}OO=0 such that limn->oo Ot n (z 0 ) = z}.(z0) is bounded. Let tn<tn+l^><x>. And in particular. there exists N(rj) such that for n > N ( n ) ) . given any 17 > 0.4) imply that W[z(e + tn)]> W(z0). Let where Hn=dF2/dzl. . in E. Inequalities (2. then given any z0 such that 0. Since z(tn)->z0. which may depend on z0. and z0e E. Let z 0 (t) be a solution of (*) satisfying z 0 (0) = z0. such that lim 0.

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

Theorem 3. that is. Convergence of bounded trajectories In this section we shall present a general theorem closely related to Hartman and Olech's basic theorem (1962. . Thus. 157). Let f:E u Rm . p. it is natural to search for sufficient conditions on the Hamiltonian that imply V is increasing on trajectories.1.) is concave. (B) all trajectories that remain bounded. Inequality (ii) is well-known for concave functions.Stability in capital theory 281 Remark 2.> R m be twice continuously differentiate. are contained in a compact set k c E.1 below and many other results will follow as simple corollaries. 3. and the matrix Q plays an important role in such sufficient conditions.2. Theorem 3. for t > 0 converge to 0. 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. 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. It holds with strict inequality for strictly concave functions. Furthermore. E open and convex. for all k. The Liapunov function V= z^z2 = (q — qY(k — k) amounts to Since the value function R ( .

and g(y) = 0 implies g ' ( A ) < 0 for A > 0 . Hartman and Olech . and get an immediate contradiction. x = 0 is the only candidate. and (b). But this. This completes the proof. By lemma 2. (At this point. Note that to get global asymptotic stability results for bounded trajectories. By continuity of g" in A.) Calculating. Hence $. Also. We do this by showing that g(0) = 0. all the rest points of 0.282 Differential equations. Also. f(O) = 0. Let us calculate g'(A). e0]. we get Now A=0 implies /(Ax) = 0.(x0) must have a limit point. Finally. and (b) imply But this is negative by (a). Furthermore.(x0) satisfy [VV(x)] T /(*) = 0.(x0) is bounded. it must be true that there is e 0 >0 such that g ( A ) < 0 for A e [0. 0. g'(A) > 0. a contradiction to g'(A)>0. g'(0) = 0. so g(0) = 0.1. Now g(A) = 0 implies [V V(Ax)] T /(Ax) = 0. Then there must be a smallest A>0 such that g(A) = 0. Let x ^ 0. and so. and put We shall show that g(l) <0 in order to obtain (a).(x 0 )-»0 as t-»oo. From (3a.Suppose now that there is A >0 such that g ( A ) = 0. show that g'(A) < 0. g"(0)<0. 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}. Therefore. Also g'(0) = 0 from/(0) = 0. stability and chaos in dynamic economics Proof. Thus g'(A)<0. implies that AxTV2 V(Ax)/(Ax) = 0 by (c). But if <£. This result is important for global asymptotic stability analysis of optimal paths generated by control problems arising in capital theory.3). in turn. 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. (d) implies that [V V(Ax)] T x J(Ax) x (Ax)<0.

Proof. Then VV(x) = 2xV2V(x) = 2Ia where /„ is the nxn identity matrix. If J ( x ) + JT(x) is negative definite for each x. Remark 3. This ends the proof. Put V = xTx.oo. Assumptions (a)-(d) of the theorem are trivially verified. and the rest of the proof proceeds as in corollary 3. Corollary 3. Assumption (a) becomes But this follows because Assumption (b) trivially holds since W(x) = 2x. Then 0 is globally asymptotically stable. The following corollary is a stronger result than Hartman and Olech (1962) in one way and weaker in another. Therefore. dV/dt <. We explain the difference in more detail below. some already mentioned in chapter 4. Let f: Rm -» Rm. It is easy to use V = XTX decreasing in t in order to show that all trajectories are bounded. Thus all bounded trajectories converge to 0 as t ./(0) = 0. Assumption (d) obviously holds because 2x T J(x)x < 0 for all x ^ 0.1. The condition .1. Consider the ordinary differential equations x=/(x). We demonstrate the power of the theorem by extracting few corollaries.Stability in capital theory 283 (1962) type results emerge as simple corollaries. Assumption (c) amounts to 2x/(x) = 0 implies x T (2/ n )/(x) = 0 which obviously holds.1. then 0 is globally asymptotically stable.

Furthermore. . and it is assumed to be locally asymptotically stable. So he places the restriction on a much smaller set of w.3. Let G be a positive definite symmetric matrix. there is a potential F: R" . condition (3a. and let 0 be the unique rest point of x =/(x). but negative definiteness of J(0) + JT(0) does imply negative real parts for /(0). w T f (x) = 0 implies w T [/(x) + / T (x)]w<0 for all vectors w. But on the other hand. that is. It is possible to obtain general results of the Hartman and Olech type from the theorem. Hartman and Olech (1962) make the assumption: for all x=0. Corollary 3. Note that Mas-Colell only assumes X T f (x) = 0 implies xT[J(x) + J t ( x ) ] x < 0. A result similar to corollary 3.lO) amounts to pseudoconcavity of the potential F.ll) is just Thus. On the one hand. the proof of the Mas-Colell result is much simpler than that of Hartman and Olech. MasColell puts the stronger assumption: x[/(0) +J T (0)]x<0 for x 7=0 on the rest point.R such that for all x. Assume that and Then x = 0 is globally asymptotically stable for bounded trajectories. and note that (3a. A function F: Rn -> R is said to be pseudoconcave at x0 if Put x0 = 0. assume that F is maximum at x0 = 0.284 Differential equations. but he requires the strong inequality.2 is reported in Hartman and Olech (1962) and in Hartman (1964) where 0 is assumed to be the only rest point. stability and chaos in dynamic economics has a natural geometric interpretation when x =f(x) is a gradient flow. It is well-known that negative real parts of the eigenvalues of J(0) do not imply negative definiteness of J(0) + JT(0). For example.

Thus.oo.b (b) for all z=0. w t q(0)w >0. Since a2v(0)= A+At = 2A and (wtA)t(J(0)w)=-wtQ(0)w. p. k).3 is closely related to a theorem of Hartman and Olech (1962. 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. Let where I„ is the n x n identity matrix.Stability in capital theory 285 Also. We turn now to an application of the general theorem 3. proof let v = 2t az where wher in is the n xn identity matrix.3. their different methods of proof yield theorems that the methods presented in this section are unable to obtain. We have not been able to obtain their result for nonconstant G as a special case of our theorem. theorem 2. we have that (c) .2ztz2. theorem 14.bb (c) for all w = 0 . Note that zt az = . and rewrite it as We now state and prove Theorem 3. Hartman and Olech also treat the case of G depending on x. p.2.1 to modified Hamiltonian dynamical systems. 549).1. Corollary 3. The rest of the proof is now routine.b Then all trajectories that are bounded for t > 0 converge to 0 as t . 157) and to a theorem in Hartman's book (1964. Assume (a)h0 = F(0) is the unique rest point of z = F(z). Assume that the MHDS has a singularity (q.

/c) in q. It is worth pointing out here that the hypothesis has a geometric interpretation for the case p . of local form such as the Q condition of theorem 3.2 gives conditions for the trajectory derivative of V = z|z2 to be positive for all z = 0. then Q is positive definite.0.1 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. If H is convexo-concave. stability and chaos in dynamic economics implies (a) of theorem 3.2 is a local sufficient condition for the hypothesis of the Cass and Shell stability theorem to hold. The proof of theorem 3. V < 0 except at the rest point 0.286 Differential equations. The rest of the proof is routine by now. k respectively. (d) amounts to " But (3b. as an easy calculation will immediately show. 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. Theorem 3. Thus. p. for positive trajectory derivative are useful for computations. . Therefore. VV(0) = 0. For the special case These statements may be easily checked by referring to the definition of pseudoconcavity in Mangasarian (1969.2. Also [W(z)] T = zr(A + AT) = 2zTA.4) is identical to (3b. Sufficient conditions. and hence. k) of H(q. Remark 3. (b) of theorem 3. There is a neat sufficient condition for the positive definiteness of Q. The hypothesis aB > p2/4 is the basic curvature assumption in Rockafellar's (1976) analysis. which is trivially true. It implies pseudoconvexity.3).1 follows. 147). pseudoconcavity at (q. This is so because theorem 3. and that is the Cass and Shell hypothesis.1.2 also yields the result that the Liapunov function zT1z2 = (q — q)T(k — k) is monotonically increasing along trajectories. Now (c) of theorem 3. Furthermore.2. the matrix Q is clearly positive semidefinite for p = 0. Applications and economic interpretations of local conditions for stability to the adjustment cost literature are discussed in Brock and Scheinkman (1977b). Furthermore.

almost contained in theorem 3. on convergence of bounded trajectories of MHDS that is related to a theorem of Hartman and Olech (1962). k'] as p varies is equivalent to capital deepening response in the BurmeisterTurnovsky sense for each value of p. . A more general result In this section we present a result. the positive definiteness of Q in the directions [q'. q'] to get But the quantity is the Burmeister-Turnovsky (1972) regularity quantity. that is. theorem 4. We start by presenting a sketch of the proof of a result. Furthermore.2.Stability in capital theory 287 The positive definiteness of Q is also related to the Burmeister and Turnovsky (1972) regularity condition. Burmeister and Turnovsky use the quantity 6 as an aggregate measure of capital deepening response. theorem 4. 4. k(p)] be the steady state associated with p. Let [q(p). in fact. Thus.1. 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'.2 below.

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

Consider the following differential equation (we drop transpose notation except when needed for clarity). .Stability in capital theory 289 Let yp(t. and denote (d/dp)x(q. if a solution exists. that it is natural to construct trajectories of type (4.p) be a solution. They are not the same kind of orthogonal trajectories as in the original Hartman-Olech result.8) and the method of constructing the transverse trajectories (4.p]^x(q. u2)]/dp. The reader will recall Notice here that both the Liapunov function (4.4) are different from HartmanOlech. Consider It is natural to look at w of (4.4). The method of proof is also different.6) for our type of problem.6). however. q).6) Hamiltonian orthogonal trajectories. We call the system of trajectories satisfying (4. We shall see. p) = d$ r [z 0 (/>. A theorem may now be stated.7) is identical to (4.p) by xp. Let y [ T ( p . Observe that The last follows from the definition of Hamiltonian orthogonal trajectories in (4. Note that Also note that The latter follows from But (4.8) in light of the previous results and the Hartman-Olech technique.

we have Since if a*id only if (/gc2)TF2 + c^JgF2 = 0.290 Differential equations. Remark 4. we could have stated the stronger hypothesis that for all zetf 2 ". and is. That is. Notice that although in hypothesis (d) of the theorem we used information on the Jacobian matrix of g. for z2 = F2[g(z2). = /gc2 where Jg = g'(z2). c7F2[z(0] + clF. z2]. c T Q[z(0]c>0 for all c satisfying (d) of theorem 4. if a value function R exists and is twice continuously differentiable. Hence. all bounded trajectories of z=/(z) converge to 0 as f-»oo.[z(r)] = 0 implies c T Q[z(f)]c > 0. As in remark 2. suppose Jg is symmetric and that the Hamiltonian function satisfies for all z = (g(z 2 ). Consequently G. Corollary 4. must hold. for all ce/? 2 " with |c| = l.S. z ( t ) is a bounded trajectory and (4. we have Then z2 = 02 is G. The reason theorem 4. (d) of theorem 4.1. c = (c l s c2). (c) z2 — 02 is a locally asymptotically stable solution of ^2= F2[g(z2).1. z2) Then global asymptotic stability of bounded trajectories holds. Jg = R".l) under hypotheses (a)-(c) of theorem 4.1 only the fact that Jg is symmetric was used.A.1.2) holds. Proof.A. .1.S. and (d) for all bounded trajectories z ( f ) . c 1 F 2 [z(f)] + c2Fl[z(t)] = 0 hold. thus.1. F ( z ) ^ 0 for z 7^ 0. c. In corollary 4. which does not use any properties of Jg. By (i) and (ii).1 holds if and only if cjFj = c]"F2 = 0.1.1 is stated in the form above is that one can obtain the following corollary. (b) F(0) = 0. Given a MHDS like (3b.1. Since in theorem 4. stability and chaos in dynamic economics Theorem 4. symmetric. 22]. for all vectors ce R2n such that |c| = 1. Assume that (a) F is continuously differentiable.

the equivalent bordered matrix conditions so beloved by economists may be written down in place of (i) and (ii).S. Put a(z)=jG + (jG) . Theorem 4. furthermore. in fact. in the sense that the linearization of z2 = F2[g(z2). This generalizes the result of Rockafellar (1970a) on the G. the trajectory derivative of the matrix a(z).S. z2] at z2 = 0 has all eigenvalues with negative real parts.3. and. Let H(z) = H(z + (q.A. Now consider the system We now state the following theorem.12). Let where a'( z ) = Z r = i (d<*/dz r )F r . Let where /„ is the n x n identity matrix. Given a function F: R" -» R we say that F is a-quasi-convex at x if for any c ^ O .Stability in capital theory 291 Remark 4. (b) 0 is L. of convexoconcave Hamiltonians to the quasi-convex-quasi-concave case. For all WE R2n. Suppose that (4. Note that p introduces a distortion that vanishes at p = 0. fc))-p(zl + q)Tz2. Inequality (i) of corollary 4. (JzeK U*>o </>.12) obeys assumptions (a) 0 is the unique rest point of (4. Assumption 1.2. The general result is now stated. Remark 4. Therefore. we have . cTD/(x) = 0 implies cTD2f(x)c> a\c\2. In what follows G(z) will be assumed to be continuously differentiable.1 simply says that the Hamiltonian is a-quasi-convex in zl. always a convex function of q. Let G: R2" ^ M[R2n.A. Then (ii) says that H is /3-quasi-concave in z2. R2"] (the set of all 2n x2n real matrices) be such that G(z) is positive definite for all z.2.( z ) is bounded. the following basic property holds. (i) and (ii) can be interpreted as quasi-concavity of the Hamiltonian function H. (c) Let K be a compact subset of the bounded manifold. The Hamiltonian is. Define aquasi-concavity in the obvious way. w^O for all z ^ 0. For p = 0. Then.

292 Differential equations. For a proof see Brock and Scheinkman (1975). Assumption 1 becomes Note that where We have reported in this chapter some recent progress toward providing a comprehensive analysis of G. stability and chaos in dynamic economics implies Then all trajectories in the bounded manifold converge to 0 as / -> oo. Assumption 1 then becomes Hartman and Olech's (H-O) assumption.(z0)^0 as /-»oo}) is not all of R2n. cycles and tori can be attractors. Theorem 4. Miscellaneous applications and exercises (1) A more general notion of long-run behavior needs to be formulated.A. The proof of this theorem is long and involved. and is done in a sequence of lemmas. for example. Several topics for future research follow in the next section. theorem 14. and find sufficient conditions on preferences and technology for a minimal limit set to be stable in some sense. Its interest lies in applicability to systems where the stable manifold W (where W={z0:</>.2 would not be interesting if all it did was restate Hartman and Olech. . the important special case of MHDS that we are interested in generates systems where W is n-dimensional. the 2nx2n identity matrix. It is. put a(z) — — 2G(z).1) is closely related to this theorem.S. necessary to build a theory that allows more general limit sets than rest points. For example. 5. There is really no economic reason to rule out limit cycles. To see this. of optimal controls generated by MHDSs. This kind of theory where sets more general than points. let G(z) = / 2n . will be treated in the next chapter. Hartman and Olech's basic result in Hartman (1964. In particular. therefore.

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

is well understood. Samuelson (1972a) and Levhari and Liviatan (1972) are some representative references.A. 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. the one good optimal growth model. Further remarks and references The qualitative study of optimal economic growth has attracted the attention of economic theorists for a number of years. (7) 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. 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. 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. 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. Kurz (1968a). Cass and Shell (1976a) present the Hamiltonian formulation of competitive dynamical systems that arise in capital theory. Koopmans (1965) and Burmeister and Dobell (1970). but G. This class is basically the class where the Liapunov function V = k^H^k together with concavity of the value function yields V < 0.1) for n -1. Eigenvalues have a well-known symmetric structure that determines the local behavior.1. for discrete time models that are independent of the discount rate.A. Standard references are Cass (1965). (6) Araujo and Scheinkman (1977) obtain conditions for G. 6. except around the steady state. does hold. Ryder and Heal (1973) analyze a case of (1. The simplest case with n . Although the amount of literature on problem 1 is extensive there are no general results on global stability. The first branch of the literature on problem 1 is fairly complete.S. that is. It studies the linear approximation of (1. 1969) studies the general instability of a class of competitive growth and the inverse optimal control problem respectively. 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.1) in a neighborhood of a rest point.S. Chang (1988) extends the inverse optimal problem to the stochastic case.294 Differential equations. They generate a .

p. studied first by Ramsey (1928) for the one good model. . Benhabib and Nishimura (1981).Stability in capital theory 295 variety of examples of different qualitative behavior of optimal paths.1988).1) that are optimal converge to a unique steady state (q. that if H(q. DasGupta (1985). McKenzie (1982). 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. These results state. roughly speaking. Chang (1987. Some additional recent references are Becker (1980). then all solution paths of (1. See Burmeister and Graham (1973. then by Gale (1967). k) as tH»OO independently of (q0. k0). 1986b). Epstein (1987) and Becker et al. McFadden (1967) and Brock (1970) for the n goods model in discrete time and by Rockafellar (1970a) for continuous time. k) is strictly convex in q and strictly concave in k and p — Q. 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. Boyd (1986a. the value of q along an optimal path is independent of k. McKenzie (1968). Burmeister (1980) gives a comprehensive exposition of dynamic capital theory. The case p = 0 is the famous Ramsey problem. Feinstein and Oren (1983). (1987). 149).

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

the long run behavior of the system becomes more complex in many cases. Experimental work discussed by Roux et al. in his example of a period doubling route to chaos in an economic model. After this experimental evidence appeared. For example. c y c l e . where x is the state of the system and u denotes a vector of slow moving parameters.. a point in an infinite dimensional space. 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 . dx/dt= F(x.298 Differential equations. or. if anything looks stochastic it is turbulence. to a four-cycle. the parameter. As you increase the parameter. 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 chaos. An example is the difference equation. to a 2". After all. The idea that a system with only a few active modes could generate such complex behavior actually observed in nature was rather controversial. . (1983) and Swinney (1983) has documented the existence of chaos in nature. the long run behavior progressively passes from a fixed point. . 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. u. u). to a two-cycle. back to Poincare's work in the late 1800s. u. The Ruelle and Takens (1971) proposal was radical. This is the period doubling route to chaos.. at least. It was the discount rate on future utility in the Boldrin and Montrucchio and Deneckere and Pelikan models published in Grandmont (1986).. The second step was to study the long run behavior of the system. 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. . . in the case of a fluid.. 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. The state may be a finite dimensional vector. As you increase the parameter u. interest in the study of chaos was greatly increased. might be the Reynolds number in a fluid flow experiment. 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.

For example. A good example in finance is the excess volatility debate (Kleidon (1986b) and references). 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.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. This . The criteria of what constitutes a successful direct argument and what is a rebuttal have changed. 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. Recall that Lucas. Successful attacks in this area replace the target model with another model. rather than postulated reduced forms of the IS/LM type. that is a priori. Another example of the style of rebuttal of classical theory is Shiller (1984) and Summers' (1986b) attack on the efficient markets hypothesis. Barro. An example of this style of rebuttal is Summers' (1986a) attack on real business cycle models. Barro. especially to Sims). 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. can account for a collection of stylized facts about business cycles. 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. reasonable theoretically but accounts for a much wider spectrum of facts by paying a low price in terms of additional parameters. 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. To put it another way. and others. 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. Prescott and others (see for example Lucas (1981) on monetary misperception models. Sargent. Just showing existence of logical possibilities is not enough for such skeptics. parsimoniously parameterized stochastic economic models built on rational economic behavior. To expand upon this point. McCallum's (1986) review and other papers in Barro) opened a debate by showing that a class of tightly specified. Prescott. to rebut the new neoclassicals such as Lucas. Sargent. 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.

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

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

ergodic. i. 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. In general the long run fraction of x ( t ) in some set S converges to u ( S ) . . one only knows that x ( t ) lies in [0. absolutely continuous with respect to Lebesgue. The measure u is an invariant measure for map f if u(/~'(S)) = u(S) for all measurable sets 5. Care must be taken with invariant measures in chaos theory. This is the meaning of (1.. trajectories such that That is to say the map (1. First. initial conditions x0 e (0. invariant measure in the sense that we have a unique u such that for all measurable sets S. and others that are used in macroeconomics. for a given map f. invariant measure. there are many of them..e. for almost all in the sense of Lebesgue measure.3): the long run fraction of x ( t ) contained in [a.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). i. 1).e. 1]. this recursion generates. i. the ordinary Lebesgue measure on [0. Almost all trajectories converge (in the sense of (1. Eckmann and Ruelle (1985) discuss criteria for selecting particular ones and conditions for convergence of time averages to that particular one. In general. Kydland and Prescott (1982).l).302 Differential equations. 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. Second. stability and chaos in dynamic economics The case a ..\ is especially striking.1). For simplicity. In this case the autocorrelation function and the spectrum generated by most trajectories are the same as that of white noise. we will assume that we have a unique ergodic.1).4).3)) to it. one must forecast x ( t ) based on the knowledge (1. 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. b] is just b — a. 1]. the long run fraction of x(r) in S is u(S). Two basic properties of deterministic chaos are well illustrated by the simple tent map recursion (1. the IID sequence {u(t}}. Collet and Eckmann (1980) discuss sufficient conditions on maps for the existence of a unique. 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. In the case of (1. 1]. 1].

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

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

i. and the randomness in u is small relative to the apparent randomness in trajectories generated by G(-.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. 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. 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. a. G is chaotic when u is fixed at its mean. and Grandmont) believes that strictly deterministic models like those discussed in Grandmont (1985) and references generate observed macroeconomic time series.. for example. Theories that support the existence of endogenous propagation mechanisms typically suggest strong government stabilization policies. a). the views of Granger (1987) who has done substantial work in nonlinear time series analysis. In reality we doubt that anyone (including writers such as Day. For large q this puts in so many "wiggles" that the estimated dimension will approach that of an IID process. say between 3 and 6. Benhabib.e. 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. Hence. 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. A potentially serious issue is whether actual data is generated by a stochastic model of the form. 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. for example. It is explained in Brock (1986a) that this diagnostic may reject deterministic chaos too many times when in fact it is true. 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. This is aptly called noisy chaos. in the . Generalizing. Theories that argue that business cycles are. 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. Study.

ergodic. h. = h(xt). such that h e C 2 maps R" to R. to the observer. and x0 is the initial condition at t = Q. Statistical theory for nonlinear dynamics We begin with a definition. a. The local divergence property is formalized by requiring that the largest Liapunov exponent. time deformations models (Stock (1985. The scientist is trying to learn about F by taking observations using a measuring apparatus. The next section of this chapter explains tests for nonlinearity that were inspired by concepts in chaos theory. at best. Fe C2 maps R" to R". be positive (Brock (1986a)). GARCH models (Bollerslev 1986)).1. We shall also assume that F has a unique. 2. and modelling nonlinearity with normal polynomial expansions (Geweke (1987)). invariant measure on A.} lies in A. where L is given by . 1987). and to get the property of chaos it is required that any two nearby trajectories generated by F on A locally diverge. at worst. an exercise in futility and. Think of h as being a measuring apparatus and F as an unknown. Definition 2. 1986. These tests for nonlinearity. L. semi nonparametric models (Gallant and Tauchen (1986)). See Lucas (1981) for a strong statement of the exogenous shock view.} has a C2 deterministic chaotic explanation if there exists a system. law of motion. ARCH models (Engle (1982)). (h. xt+l = F(x. indecomposable chaotic attractor A for F such that the trajectory {x.). low dimensional deterministic chaos. The vast bulk of econometric methods in macroeconomics use linear models after appropriate units changes and detrendings. x0). 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. We need to expand on the meaning of this definition. The series {a. Exceptions are bilinear models (Granger and Andersen (1978)). caused by exogenous shocks suggest that government stabilization policies are. Here the map F is deterministic and the state space is ^-dimensional. Here C2 denotes the set of twice continuously differentiable functions. F. stability and chaos in dynamic economics main. In order to make statistical analysis valid it is required that all trajectories lie on an indecomposable attractor A. The map F is chaotic in the sense that there is a unique.306 Differential equations. harmful.

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.

308

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

310

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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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

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

.1 so that you get the situation in figure 10. u. whenever cycles like those in figure 10. (Caution: Grandmont's u is our limiting value of {x(t}} and his a2 is our u. deterministic chaos. 3.2. p. 1030) displays a period doubling cascade generated by letting the relative risk aversion parameter. Notice how cycles appear when the offer curve is bowed out to the left more than in figure 10.316 Differential equations. 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.) Let us explain how Grandmont generates the Feigenbaum scenario. figure 4. and. a2. that is. equilibria that are random. stability and chaos in dynamic economics Figure 10. of the representative old person play the role of Ruelle and Takens' parameter. hence. even though the model is deterministic.2 of Azariadis and Guesnerie (1986) shows that there are sunspot equilibria. 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. We are not concerned with sunspot equilibria here.2 are present. Indeed Grandmont (1985.

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

a set of positive weights exist. However. 7. 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. Commodity money. 7.3.318 Differential equations. stability and chaos in dynamic economics 5. 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. 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. and 9 of this book to argue that optimizing agents. Woodford (1987) has built a class of models where one type of agent is liquidity constrained and the other type is not. to our knowledge. 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. Epstein's results show that when markets are complete (so that for a given competitive equilibrium. 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 . Hence. and 9 of this book. This strategy was pursued by Bewley's paper in Sonnenschein (1986). E. 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). 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. 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. 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. One way to do this is to introduce restraints on borrowing and lending. He constructs examples where equilibrium trajectories are chaotic. 3.

However. This is an example of how limited liability assures Pareto Optimality. eliminates the inefficient equilibria in the Samuelson (1958) and Gale (1973) overlapping generations models. z ( t ) denotes the quantity of the asset demanded by the young at date t. Think of changing y from 0 to a positive value in Gale's model.. no matter how small y may be. Let us explore the logic of this proposition. cannot be equilibrium. If free disposal of the asset obtains then any path. if the asset is like a nuclear plant that yields earnings of y each period that is perfectly safe.e. The reason for Scheinkman's result is intuitive. the first order necessary conditions for a perfect foresight equilibrium are: In the same manner as earlier.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. However. For the separable case. There is one perfectly divisible share of the asset outstanding at each point of time. 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. 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). where q(t) < 0 at some finite t. 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. i. 3. But Pareto Optimality alone is not enough to eliminate chaotic equilibria as we shall see below. This is so because once the asset goes negative in value the owner can harvest his y and throw the asset away. a new twist now appears. Free disposal of the asset. The inefficient equilibria are overaccumulative in that the interest rate is negative enough of the time to fail the Cass (1972) . This brings us to Proposition. paths {<?(/)} are equilibria provided they can be continued indefinitely. by hindsight. limited liability eliminates equilibria where the value of the asset goes negative. 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.4.

3.5. Just draw the offer curve of the young through the same endowment point (wy. A payment of y > 0 of earnings on fiat money. The offer curve diagram for an asset market The offer curve apparatus can be easily amended to depict equilibria when y > 0. with Ry = {(cv. and a sequence of equilibria that converge to the lower steady state L" where the value of the asset is negative. Also. R. but replace the PPF. Recall that free disposal eliminates these and that they are the analogues of Gale's hyperinflationary equilibria when y = Q. no matter how small is y. stability and chaos in dynamic economics and Benveniste and Gale (1975) efficiency criterion. tends to force efficiency of all equilibria in overlapping generations models provided that free disposal or limited liability obtains. L. under limited liability.4 depicts three positive steady state equilibria and a continuum of positive Figure 10. c0): cy + c0=wy + w0 + y}. This finding allows us to state Proposition. forces the interest rate to be positive enough of the time to force efficiency by the Cass-BenvenisteGale criterion. recall that the case y = 0 is the case of pure fiat money. But introduction of a market for claims to y > 0.3 depicts steady state equilibrium. Figure 10.320 Differential equations. w0) as before. Figure 10.3 .

First. the Great Depression. seems to be moving toward a consensus that there is more evidence of a return to trend rather than divergence (cf. a period doubling cascade can be constructed. World War II. even though y > 0. We have cited several papers that have established theoretical examples of chaotic rational expectations equilibria. in the U. Cochrane (1988) and references).Chaos and other aspects of nonlinearity 321 Figure 10. etc. the two oil shocks. This shows that y > 0 will not get rid of the possibility of a continuum of equilibria.S. shocks to development along trend such as World War I. 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.. . 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. seem to wear off as the economy returns to trend.4 equilibria. rather than transitory. These equilibria are robust in the sense that they cannot be perturbed away by a small perturbation of tastes and endowments. Intuitively you would construct an offer curve that bows out to the left around Ry as Grandmont did for case y = 0. Even the unit root literature which argues that many shocks are permanent. More examples are surveyed in Baumol and Benhabib (1988).

and McCallum's review (1986) of evidence for and against the real business cycle paradigm. stochastic processes. See P. 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). Fama (1976) has adduced evidence that the expected real return on T-bills is constant across time. stability and chaos in dynamic economics Second. and applications to macroeconomics. A dramatic graph that shows the historical movement of real interest rates is in Rostow (1983. Applications to finance In the first three sections we outlined some concepts from chaos theory. The behavior of nominal and real interest rates will be discussed in section 4 of this chapter. Automobiles might be a good example.322 Differential equations. 34). A graph of auto sales in Rostow (1983. Pent up demand for automobiles after World War II in the U. As we have said before.e. Scadding (1974) and references for discussions of the strong evidence supporting Denison's Law. In summary. is a natural place to look for cycles and chaos in auto sales. What is potentially resolvable is whether the fluctuations are generated by a low dimensional deterministic chaotic generator or a stochastic generator. i. some concepts from empirical nonlinear science. 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 .S. Third. savings as a fraction of GNP seems to be a rather stable fraction of GNP over time. real interest rates do not move much across time except for the recent Reagan period. David and J. it is difficult to formulate a chaotic model in macroeconomics that is consistent with the existing evidence already mentioned. p. 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. known as Denison's Law. Lucas (1987). Fourth. 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). Low dimensional chaos involves instability and overshooting. p. 4.

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. For short time intervals first differences in the logarithm of stock prices should not be very predictable in a frictionless market. The same issue arises in finance. Scheinkman and LeBaron (1987) have documented dependence in weekly aggregate stock returns that does not appear to be just autoregressive conditional heteroscedasticity. Since business cycles have a modal length of about 3 and one half years. Below we review possible explanations for this finding as well as other evidence for intertemporal dependence in stock returns. 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)). 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. then. at this stage. They get an estimate of the correlation dimension of about six. We saw in section 3 how important the issue of time scale was in the debate on whether chaos was theoretically plausible in macroeconomics. This is currently an active area of research. It only serves. But. It is important. this issue is not resolved. Let us explain. 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. 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). At this point in time. (1985) have documented: (i) . 4. At the minute to minute level Wood et al. however.Chaos and other aspects of nonlinearity 323 applications to finance. Returns on stock i over time period [t. An attempt is made to link evidence on dependence in returns to the business cycle but the attempt is only speculative. the demonstration that chaotic equilibria exist in a two period overlapping generations model was not a theoretically convincing argument to macroeconometricians. as a logical possibility.1. t + h] are defined by.

} is an increasing sequence of sub sigma fields of a master sigma field.a 508 point drop accompanied by a huge volume of trading. "for an instantaneously unpredictable process prediction error is the dominant component . The volume of 1.r. such as the stock markets. and rise in the last 20-30 min to the close. See Marsh and Rock (1986) for details.3 billion shares traded during this week was more than the total number of shares traded during all of 1964. Details of market micro structure are very important at this frequency. /..2. Similar patterns emerged in most of the world's major stock exchanges during the same week. we will not spend any time analyzing stock price dynamics for chaos in this case. is taken w. (ii) trading volume and price volatility follow the same pattern near the opening and the close. This is formalized by Sims' (1984). Actually.74 at Monday's close . the information set /. For reasons of measurement error problems as well as a theoretical presumption that chaos should not be likely at the minute to minute frequency.324 Differential equations. The whole week of October 19-23 was turbulent with the Dow falling from 2178. 1987 might generate evidence of chaotic dynamics. Measured returns may show spurious dependence due to measurement difficulties such as "bid/ask bounce". Definition. Incidents like these are worth keeping in mind as we discuss the standard theory of unpredictability of stock prices. 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.) In words. fall over the first 20-30 min. A process {P(t}} is instantaneously unpredictable if and only if. ({/. Here E. stability and chaos in dynamic economics returns tend to be higher at the opening of the exchange. Markets seesawed while volume skyrocketed.69 at Monday's open to 1738. 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. look unpredictable in the middle.t. almost surely. an apparent disequilibrium panic like the Monday Massacre of October 19. 4.

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). In practice (4. s^O. Malliaris (1981) gives a detailed mathematical description of (4. The martingale hypothesis is Notice that (4. 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.S.3). over the period [t. Short periods for Sims are daily to weekly. R2 = Q. regressions of Pt+s — P. t+1]. He then argues that this is consistent with empirical evidence in finance.2) is exactly 1". stock returns index for the mid 60s. and net cash flow. y(t+l). nonlinear dynamicists sometimes say that chaotic dynamics are unpredictable. The discount process {G} and the net cash flow process {y} can also be random.3) with illustrations from financial economics. 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. Hence.3. After all. G(t+l).Chaos and other aspects of nonlinearity 325 of changes over small intervals.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. under (4.2). arbitraging on the part of traders should destroy it provided it is easy to be recognized by traders over very short time intervals. and adjusting P. the subjective discount rate equal to zero. the ratio in (4. This is the intuitive content of the Sims argument.3) below with finite second moments. He also points out that (4. Sims points out that. if a predictable structure is present. on any variable in It have R2^> 0. Of course. But if you measure the state today with error. Recall that chaos theory teaches that trajectories generated by chaotic maps are potentially perfectly predictable provided that you can measure the state perfectly.3) is adjusted for discounting. Under (4.2) doesn't rule out predictability over longer time periods. They calculate another estimate of dimension due to Takens (1984) which is also close to 6. for a martingale (4. They . for any dividends paid out. They find roughly 6. then forecasts of the future state become worthless at an exponential rate. 4.

(c) BLVW = Weekly returns on the Value Weighted CRSP index used in the Scheinkman and LeBaron (1987) study. The Brock. 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. stability and chaos in dynamic economics get correlation dimension estimates between 6 and 7 for daily. Gennotte and Marsh (1986) calculated Grassberger Procaccia plots for this same data set after taking out the January effect and taking out linear structure. 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. Look at table 10. especially for EW. and biweekly series. 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.9". 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.2. Both EW and VW are CRSP indices taken from the Gennotte and Marsh (1986) study. Dechert and Scheinkman statistics were highly significant. They find significant evidence of nonlinear dependence. Here shuffling refers to the process of creating an IID series with the same stationary distribution as the original series. We have succeeded in replicating the Scheinkman and LeBaron study. It is significant because they calculate Brock. Put SC is an estimate of the empirical derivative at 0. The dimension of the shuffled series is surely bigger in both halves of the data set. Notice that they display similar behavior to the weekly BLVW data set. 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. (b) EW= Monthly returns on the Equation Weighted New York Stock Exchange index for the same period. Recall that the Grassberger Procaccia (GP) diagram is I n ( C m ( e ) ) plotted against ln(e). We then compare this series of empirical derivatives for the shuffled counterpart. By way of comparison we looked at the monthly EW and VW indices. We deliberately make the analysis difficult by estimating correlation dimension and by reporting step wise empirical derivatives of the Grassberger Procaccia diagram.326 Differential equations. This is comforting. It is striking that the .

9 7.6 0.98 0.97 e 0.0 0.6 7.8 8.913 7.5 10.1 7.2 0.8 0. residuals of an AR(8) fit to first difference's of tbill returns.0 327 0.8 7.3 0.1 7.97 e 0.99 0.911 8.3 BLVW[ 1:600] : N = 600.96 3.3 BLVW[ 601: 1226]: N --= 626. modulo estimation error.97 0.6 8.911 8.7 7.912 7. m = 10 0.913 9. But Gennotte and Marsh took out the January effect.910 4.913 8.915 9.0 7. Dechert .7 0. next 626 returns on SIB's value weighted index.98 0.9 7.8 0.6 1. m = 10 0.9 6.Chaos and other aspects of nonlinearity Table 10.9 0. N equals number of observations.97 e 0.3 7.911 5.39 for VW for the whole sample.97 e 0.1 0.96 1.3 0.99 0.7 0.9 6.2 SCsf 6.2 9.915 6.0 9.1 5.6 5.98 0.910 7.912 2.96 0.1 0. m = 10 0.9 0.7 DSE8TBLM: N = 628 .912 6.4 6.6 7. The Brock.96 0. SC.1 0.8 7.0 5.914 1.0 0.0 5.99 5.4 19. 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.7 9.6 6.9 KODAK: N == 720.2 4. This table is drawn from Brock (1987b).915 7.9 10.0 6.2.99 4.915 1.6 SC 5.5 0. m = 10 0.910 1.6 0.5 3.9 7. m = 10 0.4 4.1 8. the 5% level of the Brock.3 8.0 5.3 0.7 5.914 9.6 7.1 12.2 4. BLVW[601:1226]. respectively.4 0.2 7.6 0.98 0.98 0.0 6.7 SCsf 6.3 0.912 8.5 6.910 5.2 8.8 5. and returns on Kodak stock.6 0.7 0.6 SCsf 5.914 0.4 4.911 4. m = 10 0.1 8.99 0.8 10.96 7.910 7.1 5C 3. All data were divided by the standard deviation and multiplied by 0.45 for EW and 1.2 EW: N = 696.97 e 0.4 7.1 SC 5.4 SCsf 3.8 Code for Table: EW.3 4.0 0.01 for VW in contrast to 7.9 5.5 645.915 8.6 3.4 SC 1.910 7.0 11.7 644.7 14.7 0.5 SC 5.1 0.4 0. 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. VW.8 7.9 SC 4.6 VW: N = 696.2 0.96 7.914 0. DSE8TBLM.3 6.5 10.0 9.911 7.98 0.913 1.1 0.914 8.0 9.5 8.0 6. SCsf denote the empirical slope of the GP diagram for the original series and the shuffled series.0 0.914 7.6 7. Gennotte and Marsh looked at the subsample January 1942-December 1971.8 1.7 10. BLVW[ 1:600]. Dechert and Scheinkman statistic fell to 2. first 600 returns on SIB's value weighted index.5 SCsf 6.9" 1.23 for EW and 4. returns on value weighted CRISP index.9° 7.9 0.0 SC 2.9 4.912 7.912 5.7 0.9 8.915 9.3 0. m equals embedding dimension.913 6. KODAK equals returns on equal weighted CRISP index.97 e 0.

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

{Rit can be written as a linear factor model: Here the sum runs from k = 1 . e are random and independent of each other at date / and have conditional mean 0 at each date t. . L0.l) into the pricing equation below where the discounting process is {G} to get Assume that K « N and the structure in (LFM. Movements in this tradeoff have the potential for explaining the findings in table 10. It states that expected returns on stock /. The meaning of the (APT/CAPM) equation is intuitive. of systematic sources of risk. .__l[G(T}eil] = 0. It is typical in finance to search for an explanation in terms of systematic movements in risk return tradeoffs. say 3 to 5. . Assuming that the E. Note that Ait is expected returns on asset i at date t conditional on date t — 1 information.4.l) allows enough diversification opportunities so that the market acts as if E.Chaos and other aspects of nonlinearity 329 watches the central bank very carefully. B are deterministic at date t. Arbitrage Pricing Models (APT) adjust returns for a small number. 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. 8. Let us explain. Insert (LFM. Ait. As a quick idea of how the CAPM and APT models work assume returns on stock i at date f. Form widely diversified portfolios to diversify away the unsystematic risks {ejt}.2) gives.covariance with the market as a whole._}[G(t)eit] terms are zero and rewriting (LFM. 4. K « N. plus . A.1 as well as the Scheinkman and LeBaron findings. 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. This tradeoff depends upon the state of the economy. . What may explain the evidence for nonlinearity There are well known anomalies in finance. Let's take a brief look at this theory. is the sum of the risk free return. The Capital Asset Pricing Model (CAPM) adjusts returns for one source of risk . Thus government activity in the financial markets makes it even harder to interpret the evidence.

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

5%/day and —0. Researchers are looking for a source of systematic risk that differentially impacts upon small firms during the December-January period. long term bonds.5.3. rather it is the low return of T-bills relative to stocks. Most of the research uses a context like APT/CAPM to search for plausible explanations.t. see also Prescott and Mehra (1985). 4. and Frank and Stengos (1986) that is dependent upon the consumption beta model. This is dramatically vivid on page 3 of Ibbotson and Sinquefield (1977). are 90. The CAPM risk premium for January was 3. Scheinkman and LeBaron (1987).25. yielding a real return on T-bills of about 0 during 1947-1975.5. Consumption beta models are more consistent with data when nonstationarities and business cycle effects are accounted for (Person and Merrick . 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.31 respectively.2. For example.3. that is the CAPM/APT is not wildly rejected across risky portfolios. This is so because Gennotte and Marsh (1986) took out the January effect and still got similar results. The January average daily excess return falls as value increases. From 1947-1975 inflation and T-bills march in tandem.r.S. small firms are a factor. theory. Cumulation of an initial investment of $1 on common stocks.02% in comparison with 0. This is so because the consumption beta model is soundly rejected by data. The puzzle is not so much that stocks behave oddly w. See Person and Merrick (1987) and references especially to Hansen and Singleton.Chaos and other aspects of nonlinearity 331 and beta also changes in January. T-bills. and inflation over 1925-1975 in the U.1. It is approximately 0%/day for all other months for all value classes. We doubt that the January effect can explain the dimension findings of table 10.57. 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. More puzzles and anomalies It seems risky to construct an explanation for the findings of table 10. 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. It is fair to say that the January effect is striking.3%/day for the largest ranking 10% of stocks. robust.44. and has stimulated a lot of effort in finance to explain it.

4. Here y. Autoregressive conditional heteroscedasticity Even though returns may not be predictable on average it still may be true that their variances may be predictable.6. is monthly returns on the S&P. it appears that volatilities move together across financial assets (even exchange rates) at a point in time.\t-i.332 Differential equations. stability and chaos in dynamic economics (1987)). 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. dependent upon current conditional volatility. Lehman's results appear to contradict many versions of the CAPM/APT equation because his portfolios are wealth free. Bollerslev fits the model. 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. There is sure to be controversy whether Lehman controlled for all sources of systematic risk. Lehman's findings are a potential explanation for the Scheinkman and LeBaron (1987) results. This is an example of a Generalized Autoregressive Conditional Heteroscedastic (GARCH-M) model with conditional mean. Furthermore. (ii) volatilities are persistent. . appear to have no systematic risk in them. Turn next to evidence of mean reversion in stock returns at the weekly frequency. 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". but yet earn significantly positive returns when closed out. Furthermore. y. (iii) large linear forecast errors tend to come together but appear unpredictable in sign. stylized facts dating back to Mandelbrot and others are these: (i) unconditional distributions of stock returns are fat tailed. The GARCH-M class of models is an attempt to parameterize this kind of data in a way to do statistical inference.

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._. Second. The fit is quite good. 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. Summers (1986b) has shown that adding a slowly mean reverting measurement error process (say zt = 0z. {n. 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. all this is conditional on the GARCH-M being the correct model for S&P returns. Fourth. A reading of Shiller's (1984) list of fads and fashions does not contradict this. we have no idea how fast the distribution converges to the asymptotic distribution. Montroll and Badger (1974) suggest that many fads and popularist movements seem to last for a similar length of time. Miscellaneous applications and exercises (1) Evidence of mean reverting fads and long term dependence.} IID with mean 0 and finite variance. Third. + «. The weekly and monthly levels are a good place at which to search for evidence of complex dynamics in stock returns for several reasons. This might be false.5 years. Also. 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. 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. It is fat tailed to the right . The fitted log normal peaks at a frequency between 3-3. 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. Of course.. 5. We continue with more examples in the next section. First.

that whatever it is that causes the 3-5 year mean reversion in stock returns._. Furthermore. These rejections are largely due to small stocks.[G(t)] (cf. He also argues that social pressures influence investors in much the same way that social pressures influence teenage kids (and the rest of us). 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. the Fama and French evidence is consistent with slow movements in the discounting process. stability and chaos in dynamic economics however. it is suggestive that the modal length of business cycles matches Fama and French's 3-5 year interval for negative autocorrelations. it impacts widely across all stock groups. over time as well as with a Shiller and Summers mean reverting pricing error process. 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. 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. Fama and French (1986) present evidence that suggests. They construct another test for random walks driven by heteroscedastic innovations (ARCH innovations are included). Given Lo and MacKinley's claim to reject the mean reverting pricing error model. 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. G(t). 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. Nevertheless. What are we to make out of the somewhat confusing collection of evidence presented? It appears worthwhile. So 6-8 year cycles are not all that scarce. Since returns on nearly risk free assets move like l/E. Therefore. Shiller argues that interest in the stock market waxes and wanes much like interest in fashions. in the context of APT/CAPM. Therefore. that a chaos with 3-5 year swings could be consistent with this data.334 Differential equations. is not constant over time. 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. the APT/CAPM formula) and since T-bills did not move like stock prices. Turn back to Shiller's (1984) suggestive article. (2) A wildly speculative story consistent with the evidence. They investigate a version of the Shiller and Summers mean reverting fads model and reject it. even though the surface behavior of T-bills may contradict the . including T-bills.

Corporate profits covary with general activity such as real GNP but are more volatile.Chaos and other aspects of nonlinearity 335 story that we are going to propose. We have an overlapping generations structure much like those discussed and referenced in Baumol and Benhabib (1988) and Grandmont (1985). Profits power the ability to pay dividends on corporate stock. N ( t ) . the details have not yet been worked out. Their evidence from 1925-1946 is not. Let each investor plan as if they live for two periods and let all active investors have identical tastes to keep the analysis simple. T-bills cumulated much faster than inflation during this period. Now contrast this with investors at the peak anticipating a fall in economic activity. in equilibrium. Hence this cyclical change in the attitudes toward risk bearing should magnify swings in stock returns over the cycle. Swings in the public's tastes for risk bearing may be tied to the business cycle. However. 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. than in the pre World War II period. 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. 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. the contradiction may be resolved when government activity to control interest rates and when government monetary and fiscal policy is taken into account.S. N ( t ) . It seems possible to get chaos or complex dynamics for plausible specifications of N ( t ) . The 1947-1975 Ibbotson and Sinquefield evidence on T-bills and inflation is consistent with the close substitute view. makes G(t+l) a function of the current number of investors this period. 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. (3) Another story for the evidence: the business cycle. . 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. 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. Modest conditions show that G(t+l) is increasing in the number of active investors. The marginal rate of substitution between this period's consumption and next period's consumption determines G(t + l).

business cycle evidence. . (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. 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. 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. There is also the problem that this is a consumption beta type of story. a pure fads interpretation of the Fama and French findings is not very attractive. "We close this historical review of speculational orgies with a brief summary of the mechanism behind practically all these events. This is an attempt to capture the mean reverting idea of Shiller. but the basic ideas are general and. We have the problem of explaining when fads start and when they die. can be translated into other examples of public hysteria quite easily. The fundamentals themselves move over the business cycle. The model of Scheinkman and Weiss (1986) generates equations related to CAPM/APT but contains two agent types. After all. in fact. We will entertain the notion that the theory describes a central tendency for stock prices over time. 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. We use the words of the stock exchange. If this is completely random then we have a reconciliation problem with the stock market . French and Summers. Fama.336 Differential equations. 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). So we are going to identify "fad" with magnification effects ignited by the business cycle. We quote them verbatim. 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. It also links swings in asset prices to relative swings in generalized profitability or generalized productivity across the economy.

The excess volatility literature flounders on the fundamental measurement difficulty: the scientist can never capture all the information . in stocks. etc.) becomes widely used so that the demand for stock increases more rapidly than the rate at which real money is put into the market. They know they want to get out while they are ahead. 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. has not kept up with the inflated values of the stock. ". The sensitive people react. Furthermore.. The investor is buying only to sell soon after profits are made. This.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. Those already committed become more sensitive. but they also become a little greedy so that they stay in as long as there is some rise. etc. Montroll never discussed such a scheme elsewhere. in the case of real estate booms. (VIII) Since new buyers are few. group observes that the original reason for the excitement. binders in Florida real estate. more knowledgeable. It should not be difficult to make a mathematical formulation of this mechanism. or the actual value of the use of the object being invested in. prices go down somewhat as these sales are made. 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. industrial production and its future prospects.. (IV) The small down payment (margin. swamp land. (VI) As values skyrocket. (V) Success and demand for stock breed enterprises which have nothing to do with production. The stock held as security is sold in a market of few buyers and the panic is on. is a simplified model but still it contains most of the main ideas. of course. for example. As the continuous drop occurs. the behavior of the market becomes practically uncoupled from industrial production. the installment (or margin) buyers are in trouble. essentially ignoring the activity of the companies whose stock they purchase. investment trusts or. the number of new people entering the speculative orgy decreases. Apparently. (VII) A small. We hope to discuss such a scheme elsewhere . Much has been written in economics on bubbles and excessive movements in asset prices. They start to sell out. We buttress this conjecture below.

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

(6) Multivariate test. This nonlinearity may have been channeled into stock returns through this equilibration of the market. 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. and (iii) Brock (1987b) discusses conflicts between GARCH and ARCH models as currently applied and theory and evidence in macroeconomics and finance. futures or options . Shiller (1984) and Montroll and Badger (1974) deserve as much attention as investigation of dependence upon conditional variance (ARCH and its cousins). (ii) Brock. (b) civilian employment. Nothing said here proves that there are chaotic dynamics driving stock returns at business cycle frequencies or that business cycle data are chaotic. (d) pigiron production. Dechert. 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. transformation of variables. This test has been generalized to multivariate series by E. (c) unemployment rate.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. Investigation of dependence of stock returns on variables like measure of the "depth of interest" in the market. Back's test has excellent size and power characteristics. 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. (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. and Scheinkman (1987)) for nonlinearity and intertemporal dependence that has good power against alternatives for which many tests have weak power. This new perspective has already led to a new statistical test (Brock. and detrending) do not account for all of the temporal dependence in these data. (5) Brock and Sayers (1988) have presented evidence of strong nonlinear dependence in (a) industrial production. Real GNP failed to show nonlinear structure but it may have been eliminated by aggregation. deseasonalization. But the best fit linear models (after reduction to linearity by units changes. (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.

disequilibrium. For a brief survey of existing theories of trading volume behavior and for random walk tests see Malliaris and Urrutia (1988). 1986 did a full length article on this topic.340 Differential equations. An October. A somewhat controversial example is the output of the Brussels school (e. the American Santa Fe Institute hosted a conference . especially in Europe. This view received a chilly reception in the scientific community until evidence adduced by Swinney (1983. non-linear relationships. serves us by shifting the attention of scientists and intellectuals to disorder. Several speakers. and the importance of time". 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. 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. instability. He said. Not to be outdone by the Europeans. 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.. (Prigogine and Sanglier (1987. 6. cold. 1985 conference at the Palais des Academies in Brussels on theoretic ideas on chaos and their applications. Substantial frictions and market imperfections will have to be present to get around the randomness inherent in the logic of frictionless asset markets. Prigogine and Stengers (1984) and Prigogine (1980)). p. stability and chaos in dynamic economics markets at various time dimensions. 1985) and others made the case for the presence of strange attractors in data generated by real physical systems. at the Brussels conference argued that Western science has been dominated for three centuries by the Newtonian paradigm which Toffler called "the bloodless. "the new science of instability. diversity. One scientist was quoted in Business Week as saying that the study of chaos "is as important historically as the discovery of the wheel". Interest in the general theory of chaos has even stirred up the world community of intellectuals and literati.g. machine model taught by classical science". attracted such notables as Jonas Salk and Alvin Toffler. In the meantime.) Business Week... 330). August 4.

. Devaney (1986). However. For the reader who wishes to study further the mathematics of nonlinear dynamics and chaos we suggest Guckenheimer and Holmes (1983). 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. the really exciting work for economics remains to be done. The proceedings are being published in David Pines (1988). It is not an exaggeration to say that activity in this area is feverish at the present time. Some early economic applications of chaos are presented in Brock (1985). Chaos. For a historical survey see Gleick (1987). This chapter gives a survey of the relevant natural science literature and offers some extensions and adaptations appropriate to economics. Special acknowledgement. Percival (1983).Chaos and other aspects of nonlinearity 341 organized by two Nobel Laureates. and Patterns: Aspects of nonlinearity" (NAS (1987)). It also outlines some preliminary approaches to detecting the presence of noisy nonlinear dynamics in economic data. 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. Jordan (1987) and the readings in Holden (1986). Meanwhile the American National Academy of Sciences National Research Council issued a public research briefing on "Order. Thompson and Stewart (1986). Kenneth Arrow (Economics) and Philip Anderson (Physics).

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

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

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

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

is denned to be the n x m matrix whose first column is the first row of A. . whose second column is the second row of A and so on with its final column being the last row of A.y. 7). (Ascoli lemma. If G is a bounded set. 51). This is the case if. 4. A useful result is the following: Theorem 3.1. written in an array of m rows and n columns. Let F be a family of real valued functions defined on an interval /. This is the case if. . m and j = 1 . and only if. where x varies in I. . For a proof see Coppel (1965. For mxn matrix A. there exists a positive constant M such that f(x) < M for all x G I. . for all x e I. F is called uniformly bounded if there is a positive constant M such that |/(x)| < M for all x e / and / in F. An mxn matrix consists of mn elements a(j. Then every sequence {/„} of functions in F contains a subsequence which is uniformly convergent on every compact subinterval of /. there exists a constant N such that /(x) < N. Theorem 3. Let I be a continuous function on a closed and bounded interval [a. . and /) such that \f(x)-f(y)\<e whenever |x —y\ < 8 for all x and y e / and for all / in F. with i = 1 .Appendix 347 Let /(x) be a function denned on an interval I. . For a proof see Friedman (1971.2.) Let F be a family of functions which is bounded and equicontinuous at every point of an interval /. Consider the set G of its values f(x). p. then we say that I is a bounded function on I. p. denoted AT. . Then f is bounded. A key result used in the theory of ordinary differential equations is the famous Ascoli lemma. then we say it is unbounded. b]. The numbers in the array are called the entries in the matrix. F is called equicontinuous on / if for any e > 0 there is a 5>0 (independent of x. Results from linear algebra Put rather simply. the transpose of A. n. . If/ is not bounded. a matrix is a rectangular array of numbers. If G is bounded above then we say that I is bounded above. . and only if.

that is AA-1 = I = A. For example.1 A. In fact. one subtracts corresponding entries. The identity matrix. in matrix algebra the product of a matrix A and its inverse A-1 is the identity matrix /. is an n x n matrix with ones as the elements on the main diagonal and zeros elsewhere. (iii) A matrix A is invertible if. is defined by Thus. However. 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 product BA may not be capable of being formed. 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). is performed by multiplying every element of the matrix by k. denoted by /. Thus. 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. to subtract two matrices. Multiplication of a matrix by a scalar k. and only if. 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. although AB can be formed. Now consider two matrices A and B with A an m x p matrix and B a p x n matrix. det A = 0.348 Differential equations. Division is not defined for matrix algebra. A matrix A that does not have an inverse is called singular. The product of AB is an m x n matrix defined by with It is not in general true that AB = BA. to add two matrices. . one simply adds the corresponding entries. Matrix multiplication is possible only when the number of columns of A equals the number of rows of B.

we have a nonzero solution if. However. and only if. at least one of the vectors is a linear combination of the remaining vectors. Therefore. then a nonzero vector x in R" space is called an eigenvector of A if Ax is a scalar multiple of x. namely k1 = k2 = • • • = kn = 0. that is for some scalar A. Therefore. then A is called a linearly dependent set. The scalar A is called a characteristic value or an eigenvalue of A and x is said to be an eigenvector corresponding to A. is linearly dependent. and only if. pp. (ii) A set of two or more vectors is linearly dependent if.Appendix 349 has at least one solution. then A is called a linearly independent set. we say that B is similar to A if there is an invertible matrix P such that B = P-1AP. Letting Q = P~l yields A = Q~l BQ which says that A is similar to B. If A is an n x n matrix. For A to be an eigenvalue. We also offer two more definitions of linear dependence: (i) A system of equations A. and only if. 279-280). A is similar to B. B is similar to A if. which has and consequently is not invertible. If this is the only solution. If A and B are square matrices. An important result is this: Theorem 4. To find the eigenvalues of A we rewrite Ax = Ax as Ax = \Ix or equivalently (A/ — A)x = Q. there must be a nonzero solution of this equation. If there are other solutions. Similar matrices have the same characteristic polynomials and the same characteristic values. The characteristic roots of a triangular matrix are the elements along the principal diagonal. Note that the equation B~ P-1AP can be rewritten as A = PBP. It is particularly useful if a similar matrix is triangular. 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. for a given .1 orA = (P~l)~lBP~l. This last equation is called the characteristic equation of A and the polynomial obtained by expanding det(A/-A) is called the characteristic polynomial. For a proof see Paige and Swift (1961.1.

2. For an n x n matrix A with elements aij we define the trace of A. stability and chaos in dynamic economies matrix A. Then It follows that The integral of a matrix is defined as Suppose o is a scalar function of vector x. The square matrix D with elements dij is called diagonal if dij = 0 for all i=j. A key theorem is the following. in the sense that each entry of A is a function of t. If A is a real symmetric matrix it has an orthogonally similar diagonal matrix. It is however possible to get close to a diagonal form using the Jordan canonical form as is explained in chapter 2. A matrix A is called symmetric if AT = A. A matrix A is called orthogonal if AT = A. j ) entry is d^/da^. the characteristic roots of A can simply be read off the diagonal of the similar triangular matrix.1 . Not all matrices are diagonalizable. pp.D where D is diagonal. If a square matrix A has distinct characteristic roots there is a similarity transformation P-1 AP . if it is possible to find a similar triangular matrix. as In stability analysis we often use the fact that the trace of a square matrix is the sum of its characteristic roots. Let . Then d0/dx is a vector whose ith entry is dfi/dXj. Theorem 4.350 Differential equations. Suppose 0 is a scalar function of matrix A. If A is a real symmetric matrix it has only real characteristic values. denoted by tr A. For a proof see Paige and Swift (1961. Then d</>/dA is a matrix whose ( i . 287-289). A special case of a triangular matrix is the diagonal matrix. Suppose A is a function of a scalar variable t.

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

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

the fourth follows from the integral mean value . the second follows from the following principle called the principle of optimality: to maximize a total sum of payoffs from x(to) =y over [t0.3)-(6. The terminal conditions (6.6) are the workhorses of optimal control theory. Equations (6. Equation (6. We briefly explain their derivation and meaning here following Brock (1987a) and other standard references such as Athans and Falb (1966) or Miller (1979).Appendix 353 Under regularity assumptions by dynamic programming the value function V satisfies the Hamilton-Jacobi-Bellman (HJB) equation. and the function H* is called the Hamiltonian. the third follows from the definition of the state valuation function. T]. furthermore the state and costate necessary conditions must be satisfied with p = Vx: The variable p is called the costate variable. These variables are introduced for the same reasons and have the same interpretation that Lagrange-Kuhn-Tucker multipliers have in nonlinear programming. or dual variable. T] you must maximize the subtotal of the sum of payoffs from x(t0+h) over [t0+h.1) may be written: The first equation is obvious.6) are sometimes called transversality conditions. adjoint variable.

T) takes the form p(T)x(T) = Q. This follows directly from equation (6.3). assume the state valuation function V(y. For any date T with terminal date in (6. t0) and future instantaneous value px — pf(y. p = Vx.3) is nothing but the principle of optimality in differential form. The quantity p. tQ+h)) in a Taylor series about x(t0) = y and t0. The control u must be chosen to maximize H* along an optimum path. The condition p(T)x(T) = Q means that nothing of value is left over at the terminal date T. So (6. It is instructive to give a rough heuristic argument to motivate why (6.4) is just a definition. the transversality condition. T) is . and Weitzman (1973) show that (6.3) wrt x into the expression for d/Vdf = (d/dt)V x . Equation (6. u. The relation x = H*° follows from x=f(x.9) might be necessary for optimality. To motivate this definition rewrite equation (1.9) is necessary and sufficient for optimality for a large class of problems. then. The principle that the optimal control u0 must maximize H* is important.354 Differential equations. If there is an inequality constraint x ( t ) > b for all t.6) is simple. Araujo and Scheinkman (1983). for a large class of problems the condition takes the form and is called the transversality condition at infinity. p ( T ) = Bx(x.5) is easy to derive. is the marginal value of the state variable. Equation (6. When T is infinite. 0 and the envelope theorem.1) set equal to infinity. It is called the maximum principle. Here o(h) is any function of h that satisfies Subtract V(y. t0) from the LHS and the extreme RHS of the above equation. but B = 0. M°. divide by h and take limits to get (6. Observe that the Hamiltonian function H* just collects the terms that contain the control u. t0). thus putting p = Vx. Finally (6. the fifth follows from Ax = x(t0 + h) — x(t0) = fh + o(h).7). It measures the incremental sum of payoffs from an extra unit of state variable. stability and chaos in dynamic economies theorem and expansion of V(x(t0+ h). called the costate variable.7). One chooses the control to maximize the sum of current instantaneous payoff v(y. The relation p = -H*° follows from substitution of the derivative of (1. Benveniste and Scheinkman (1982). u.

Examples exist where (6. t0). f0) = es' V(y. the transversality condition becomes .9). If x(T) >0 and p(T)>Q (more x is better than less) then which is (6.10) will go to 0 as 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 (6.1) may be written in the time stationary form By the change of units W(y.Appendix 355 concave in y. q = e5'/>.1) here. W becomes independent of T so that W. (Note that t0 is replaced with T and T is replaced by x in (6. TH-x for any state path z.oo. = 0. T) to get the bound Now suppose that the distant future is insignificant in the sense that V ( z ( T ) .3)-(6. See Benveniste and Scheinkman (1982). H = e s 'H* and we may write the optimality conditions (6.) Use concavity and p(T)= V x ( x ( T ) .0 . 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 ) . and Araujo and Scheinkman (1983) for the details and references.9) is not necessary for optimality.6) in the form: When the horizon T = oo. Then it is plausible to expect that the LHS of (6.

. Brock (1987a).17) is necessary as well as sufficient. The condition (6. Turnovsky (1974) and B.356 Differential equations. Friedman (1975) apply control theory to stabilization policies. Arrow and Kurz (1970) or Kamien and Schwartz (1981). 9 and 10 use elementary notions from measure theory which are presented in Royden (1968). (1987) use monotone control methods to solve certain problems in economics. stability and chaos in dynamic economies and (6.15) to be optimal. for a solution of (6. Barron et al. chapters 5. For further details see Mangasarian (1966). Pindyck (1973). 7.17) determines q0. Finally.

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

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

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

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

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

5-11. 5. 125 Differentiability of solutions. 123. 195 manifold. 307 Global asymptotic stability. 275 economic meaning. 324340 Debt-equity ratio. 74.384 Index of chaotic rational expectations. 111. 258 Current value Hamiltonian. 150 Gale equilibria. 27. 107. Polygonal path] Euler's relation. 41. 329-331 Excess demand function. 276 geometric meaning. 249. 266. 127 Denison's Law. 105. 192-193. 169 Euler polygon. 10 continuity and. 42. 32 Function bounded. 110 [see also Global asymptotic stability] General competitive equilibrium. 190-193. 336 Exchange rate. 299. 32 Picard-Lindelof theorem of. 196. 153 D-stability. 190. 7 of linear systems. 317 First best regulation. 79. 195 Dynamical systems. 33. 23-25 Destabilization. 346 Evidence for nonlinearity. 105 existence of. 7 Cauchy-Peano theorem. 57. 265. 316 Equilibrium manifold. 203 Excess volatility. 161. 174. 200-201. 190 Critical behavior. 204. 50 Future invariant. 227. 68 EM. 139-140 Generic. 29 and discontinuity. 272 e-approximate solution. 353-354 Cost of adjustment theory. 123. 9 [see also Cauchy polygon. 221 Cost of capital. 188. 343-344 uniformly bounded. 98. 344 Fundamental matrix solution. 238. 139. 249. 153 Differential games.A. 129. 7 Domain. 306 Diffeomorphism. 262 Cournot oligopoly. 154 Dirichlet function. 139 Curvature matrix. 275 Curvature assumption. 141. 241 Decentralized regulated competitive equilibrium. 120. 299 Eigenvalue. 314-318 G. 241 Equity value. 241. 347 Equilibrium-disequilibrium adjustment process. 157 Deterministic chaotic explanation. 294.. 344 Domain of attraction. 42. 83 Forcing function. 232. 313. 261 Existence of solutions. 19 Exp(AO convergence. 318 definitions. 5 as a local property. 326 Equicontinuous sequence. 146 Decrescent. 123 Dominant diagonal. 188. 265-267 . 202 General nonlinear nonquadratic problem. 63 Fads.S. 347 continuous. 160. 2. 172 Decreasing returns. 237. 286 Daily and weekly stock price changes. 336 Feedback form. 273 Correspondence principle. 127 Crowding out. 321 structure. 7 and initial value. 234. 282. 147. 133. 39 definition. 347 uniformly continuous. 51 Exponential asymptotic stability. 300. 260 informational. 73. 232 [see also Steady state] examples of. 139. 272 modified Hamiltonian. 39 examples. 161-176 Focal point. 243-245 sunspot. 132 Feigenbaum cascade. 157 [see also Samuelson's correspondence principle] Costate variables. 207. 274. 169. 267 Equity-debt ratio. 265 [see also Equilibrium manifold] Empirical derivative. 191 Duration. 110-124. 7 Efficient markets. 24. 237. 219 Equilibrium solutions. 322 Dependence on initial data and parameters.

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

32 Lipschitz constant. 201 limiting set. 46. 62. 201 nonsingular. 127 theorems. 259 Mortensen's theorem. 324-340 Macroeconomic modelling. 314-318 stock market prices. 66. 60. 247. 51 initial value problem of. 33. 15-18. 293 Local instability (Liapunov). 218. 305 anticipated event analysis. 118. 101. 32 fundamental matrix solution. 32 and input function. 255 perfect foresight. 97-98. 347 triangular. 268-269 characterizations of steady states. 225-269. 32 examples of. 350 dominant diagonal. 350 transpose. 153 exponent of. 36. 234. 69. 200-201. 263-265 steady state. 57 for autonomous systems. 332-333. 272 Monetary growth constant rate. 93-94. 189. 228-234 optimal conditions for households. 99. 38 with constant coefficients. 190 similar. 239. 299. 108 Local stability vs. 106-110 Local stability (Liapunov) definition. 39 fundamental. 71-72. 43. 32. 97. 230-233 government sector. 33. 45. 2. 105 Macroeconomic chaos. 113 Linear systems. global stability. 65 principal matrix solution. 190-192 Lotka-Volterra system.236 optimal conditions for firms. 133. 27.386 Index Macroeconomic structure. 57. 234-236. 276 Martingale. 301 Macroeconomic policy. 44. 351 negative definite.28 Modified Hamiltonian dynamical system. 273 examples. 228-230 Magnification effects. 90. 114 semidefinite. 89. 59-67 two dimensional. 74-76. 58. 103. 325 Matrix curvature. 33 stability of. 71-72. 350 principal. 228-234 corporate sector. 32. 94. 47 existence of solutions of. 312-322 offer curve and Gale equilibria. 354 Mean reversion of stock prices. 43. 57 examples. 37. 338 Microeconomic dynamics. 134. 159-197 Modigliani-Miller propositions. 274-276 diagonal. 50 homogeneous. 249 optimal rate. 256 stability of rational expectations. 349 Maximum principle. 77-84 uniqueness of solution of. 106. 109. 154-155. 69. 20. 38-46 Lipschitz condition. 248. 32 variation of constants for. 63. 233-234 household sector. 43. 243-245 macroeconomic structure. 68. 33 orthogonal. 241 Modern approach to differential equations. 32-39 adjoint equation of. 227. 267-268 . 66. 136. 51 perturbed. 58. 181-184 Multivariate test. 43 nonhomogeneous. 247-252 equilibrium structure and system dynamics. 50 Jacobian. 215 Multiple eigenvalues. 236-243 perfect foresight equilibrium. 103. 93-106 for nonautonomous systems. 32. 68. 245-247 unanticipated event analysis. 70. 350 trace. 37 and forcing function. 260 Multiple optimal paths. 127. 90 semiorbit. 257-258 theorems. 110. 33 quasidominant diagonal. 339 Market value. 318-322. 231 Marshallian demand curve for capital services. 41. 339 Negative definite. 348 symmetric. 50 Multiple equilibria. 15-18 Local asymptotic stability (Liapunov) definitions. 260 Tobin's. 348 singular. 336. 33.

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

273 Speculation. 336 Speculative bubbles. 232 existence of. 89-130 notions in rational expectations. 306-312 BDS test. 87. 298. 131-158 of two dimensional linear systems. 129 Routh-Hurwitz criterion for. 174. 161. 25. 98. 147 State space. 333 Solutions attractive. 49 Simple zero. 199-224 in oligopoly. global. 210. 23-25 differentiability of. 57 . 149. 201-204 Stability in rational expectations. 201-204. 57. 175 Statistical theory for nonlinear dynamics. 80 Stability and continuous dependence of solutions on initial data. 247-252 Samuelsorfs correspondence principle. 204-206. 105. 70 Slow moving parameters. 130 perfect. 79. 32. 221. 261. 268. 7 Simple eigenvalue. 273 continuation of. 352 vector. 24. 59-66 of optimal control. 129 local vs. 271-295 convergence of bounded trajectories. 104 Simple discontinuity. 110. 7 equilibrium. 313 Saving rate. 86 total.326 Significant behavior. 11-13 continuity with respect to initial data and parameters. 56 and permanent income hypothesis. 66-67 uniform. 57-58. 206. 13-19. 260. 202 revised. 120 definition. 132 Static first best regulation. 153 structural. 204-206 Samuelson's correspondence principle. 157. 266 as a methodological principle. 18-23. 75-77 saddle-path. 84. 147. 131-158 Stationary solution. 53-87 successive approximations. 308-312 Steady state. 261 stochastic. 258 Second best regulation. 281-287 Stability in investment theory adjustment cost model. 212-214. 191 expectations and. 27 nonequilibrium. 62. 287 optimal steady states. 337 Spiral sink. 89. 215. 224.388 Index asymptotic (global). 211 Shuffling. 82-83 Stable tangent node. 67 weak. 43 of nonhomogeneous linear system. 265. 193 hypothesis. 226 Separable Hamiltonian. 191 uniform asymptotic. 263-265 of competitive equilibrium. 125-126 Stable node (or focus). 110-124 D-stability. 245-247. 154-155. 77-84 orbital. 157 imperfect. 259-260. 190 in the first approximation. 176-180 Self-fulfilling expectations. 11. 190-193 of linear systems. 66-75 Stability of optimal control. 83 Stable improper node. 153 e-approximation. 190-192 methods. 55. 5-11 infinitely many. 27 uniqueness of. 53-87. 271-295 in investment theory. 123. 65. 71 Lagrange. 193 asymptotic (local). 3 dependence on initial data and parameters. 115. 43 optimal. 190 Poisson. 298 Social dynamics. 214-219 capital deepening. 207-212. 186 nonuniqueness of. 130. 84 bounded. 129 Stability in capital theory. 73-74. 64. 134. 57-58. 130 practical. 204 Sarkovskii sequence. 155. 272 stability methods of. 199. 14 maximal. 268 of homogeneous linear system. 24. 190 in capital theory. 263-265 Stability of linear systems with constant coefficients. 77 variable. 153. 82 Stable manifold theorem.

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

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