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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

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8. 2. Basic properties of differential equations 1. 5. 2. 9. 5. 7.3. 4. Introduction Linear systems Basic results Linear systems with constant coefficients Jordan decomposition Miscellaneous applications and exercises Further remarks and references Chapter 3. Introduction 2.CONTENTS Preface Acknowledgements Chapter 1. 3. Definitions . 7. Stability methods: an introduction 1. 4. 6. . 6. Linear differential equations 1. 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.

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

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

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

successive approximations and dependence on initial data and parameters is given in chapter 1. The use of ordinary differential equations in economics. As the title of the book indicates. the . 1265) Differential equations. stability techniques and chaotic dynamics. Chapter 2 discusses linear differential equations with a balanced approach between their properties and solutions. uniqueness. business cycles. Debreu (1986. it was Samuelson's (1947) Foundations of Economic Analysis which firmly established the appropriateness of using ordinary differential equations in dynamic economics. This is done in chapters 1 and 2. macroeconomic policies. financial economics and many others. The applications selected to illustrate these methods are numerous and include microeconomic dynamics. capital theory. generality and simplicity are relentlessly pursued. an emphasis on existence. p. investment theory. However.PREFACE As a formal model of an economy acquires a mathematical life of its own. at least to L. During the past forty years. continuation of solutions. the mathematical methods presented are ordinary differential equations. 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. We note that although the classical approach to differential equations concentrates on methods and techniques for finding explicit solutions. dates back. it becomes the object of an inexorable process in which rigor. Walras in 1874. 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 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. Chapter 3 gives numerous definitions and examples of stability notions. Samuelson and others. An additional important contribution is chapter 5. In other words. However. Furthermore. chapter 5 surveys the stability contributions of mathematical economists. 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. all of which took place since the mid 1970s. the recent results of several mathematicians. 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. Liapunov theory for local stability and global asymptotic stability receive the bulk of our attention. While chapters 3 and 4 are a collection of stability results contributed by mathematicians that were essentially completed prior to 1965. 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. was not completely formulated until the late 1950s in the papers of Arrow and his collaborators. This chapter unites the economic analyst and the mathematician at the forefront of stability research and is used as a foundation for later chapters. The notion of stability in economics. such as Hartman and Olech (1962). This chapter surveys several important methods of stability analysis of optimal control problems. and discusses the stability properties of linear dynamic systems. Thus. introduced by Walras and Cournot and later studied by Marshall. chapter 3 illustrates the significance of linear systems. It also gives a comprehensive presentation of two dimensional systems and their phase diagrams.xii Preface modern approach endeavors to obtain information about the whole class of solutions and their properties. the linearization of nonlinear systems. The above is not all we have to say on stability methods. Although conditions of the . Chapter 4 continues on the topic of stability at a more advanced level. the counting and examination of roots of characteristic equations while chapter 4 is more topological in nature. The last thirty years have seen numerous papers on stability analysis applied to economic models. the emphasis of chapter 1 is on properties while chapter 2 balances abstraction with concreteness and illustrates some problem solving techniques. Hicks.

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

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

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

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

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

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

1) such that 0(t 0 ) = x0. x) e Rn+l to the vector x e R". To illustrate the concepts of a solution to a differential equation and the initial value problem. Integrating (2. Geometrically. x ( t ) ) at each point (t. (2. tel.1) is called a vector field on D because it takes the vector (t. In other words. Example 2.1) on 7. The space of the variables x which contains the paths is called the phase space of (2. x0). Such a curve is called a path. The point (t0. 0(0) for t e /. x 0 )e D. Let (t0. the paths are the projections of the graphs on any hyperplane with t being a constant.1) prescribes a slope f ( t . is a function whose graph has the slope f(t. Geometrically. 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. This problem is denoted by We say that t0 is the initial point or initial time and x0 the initial value. x) = ax so that the vector field depends only on the variable x.2) or (2. the solutions 0(0 of (2. See also section 6 of chapter 3. Consider the differential equation where a is a real number. a solution 0(0 is a curve whose direction at any point t e / coincides with the direction of the vector field. (2.5) means that we are searching for a solution passing through the point (t0. we consider two examples. Here/(t.4) can be pictured as curves in the x-space with t as a curve parameter. By graph we mean the set of all points (t. x0) is called the initial condition.Basic properties of differential equations 3 and also then we say that (f>(t) is a solution of the differential equation (2. In other words.1. An initial value problem for (2. The function / in (2. x ) e D and a solution (f>(t).6) we obtain a solution of the form . geometrically.4). In R2.1) consists of finding an interval / containing t0 and a solution 0(0 of (2. 0(0) for each ?e /.

11) is a solution of (2.10) in the following manner.9) is a specific solution passing through the point (0. the initial value problem (2. in addition to (2. Note that (2.10) for t G (-c. Example 2. so that the differential equation is autonomous. In the special case when t > 0 and a > 0. oo).9) yields at time t the total value of $1 earning instantaneously compounded interest for t periods. In this special case. Consider the differential equation Here f(t. Assume that c > 0.8) specifies both the instantaneous interest earned by x dollars and the initial amount of capital. Thus the 1 in (2.0 and x(t0) = x(0) = 1.2. Its solution in (2. Observe that (2. We find that -x l = t + c. assume that t0. oo) because it is continuously differentiable in this interval .10) for t G(-C. We write the initial value problem as and its solution is stated as The solution in (2. 1). its solution in (2. (2.6) because For the initial value problem. x) = x2.4 Differential equations. for c an arbitrary nonzero real constant and 0(0) = -1/c.6) can be used to denote instantaneous interest earned by an x amount of dollars. Assume that x 9=0 and integrate (2. As an illustration.7) denotes the current value of a sum of capital c with instantaneously compounded interest. Then is a solution of (2.6).9) denotes the initial amount invested. stability and chaos in dynamic economics where c is an arbitrary real number.7) is continuously differentiable for t e R and satisfies (2. we need to specify a certain point t0 and the corresponding value x(t0).

then (2.11) is a solution of (2. In general. However. Note that if c = 0.11) is not a solution for the differential equation for t G R because <fr(t} = —\/1 is not continuously differentiate on the real line. oo) since c = 1. we conclude this section with a useful lemma. 4>(t) . we conclude that is a solution for t e (-1. x) = x2 is a continuous function on the whole real line. Therefore. the method usually followed consists of replacing the differential equation by an integral equation. If we change the initial value problem in (2. This example illustrates that. the continuity of f(t. then (2.-1/t is discontinuous and does not qualify as a solution. 1) since now c = — 1.6) and (2.12) to then the solution becomes for te(—oo.10) for t£ (-00. x) is defined and continuous on some domain D for t G / and that . Actually at t = 0. (2. if c = 0.10) allows us to integrate in order to find a solution to the differential equation. This illustrates that a change in initial values may affect the interval of the existence of a solution. in order to establish the existence of solutions. although/(f. Assume that f ( t .Basic properties of differential equations 5 and also If we assume that c<0. x) in (2. -c). consider From the preceding analysis. its solution is restricted to a subset of the real line which depends on the value of the constant c. For an example of an initial value problem. In the two examples above. This observation suggests that existence of a solution is a local property.11) is a solution for f > 0 .

then the initial value problem x-f(t.15).15). by putting t . we obtain Volterra's integral equation Note that x ( t ) in (2. We summarize this analysis in Lemma 2.15) yields the initial value problem. stability and chaos in dynamic economics (t0. for any continuously differentiable function x ( t ) of the form (2.2) between the limits t0 and t. x(t0)-x0. t E I is equivalent to Volterra's integral equation 3. By integrating (2. all theorems and proofs can be generalized by essentially replacing absolute values by vector norms.6 Differential equations.5) since x ( t ) is continuously differentiable and satisfies (2.1. Xo) ED. The analysis in this section proceeds in terms of the first order differential equation. we know that by differentiating (2.5) on some open interval I including the point t0. x) is continuous. that is. No loss of generality is suffered by treating this simple case. x) results and thus (2. x=f(t.t0 we immediately obtain x(t0) = x0. If the function f ( t . Furthermore. Existence Consider the first order differential equation where / is a real-valued continuous function on a domain D c R2.15) is a solution of the initial value problem in (2. x). Conversely. . From the continuity of f we know that its integral exists.

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

8 Differential equations. Let and set Furthermore. Then there exists an e-approximate solution (f>(t) on some interval / that satisfies the initial value problem in (3. such that if (t. t0+ a]. (s. that is. R is compact and we know that a continuous function on a compact set is actually uniformly continuous. X) E R. depending on e. y) . 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. the rectangle R is closed and bounded. stability and chaos in dynamic economics The first lemma establishes that an e-approximate solution exists for the initial value problem Lemma 3. One can proceed in a similar manner to construct a solution for . Proof. From the assumed continuity of f in the rectangle R. t0+a] of the form in such a way that An e-approximate solution can now be constructed for the interval [to. Thus given e > 0 there is a 5.1. we infer that / is bounded there. x) is continuous on the rectangle R and let e > 0 be given.3). Choose a partition for the interval [t0.

t0+a]. x 1 ). . t0]. t 0 + a ] t o a. Repeating the same process a finite number of times.6) by definition of a and the fact that |/(f. n — 1. Furthermore. where the first line ends.3). . Furthermore. Then construct another straight line starting at (t 1 . Let {en}. 2 .0 as n-»oo. The e. with slope f ( t 1 .3) on | f .Basic properties of differential equations 9 [t0 — a. This concludes the proof of the lemma.t0\ < a. or Cauchy polygon. this construction specifies the interval of existence which is \t . X1) up to its intersection with t — t2.8) yields which means that the sequence {<£„} is uniformly bounded. . By the Ascoli lemma in the appendix. limit function . x0) until this intersects the line t = t1. be a monotonically decreasing sequence of positive real numbers such that e n . construct a straight line with slope f(t0.t0 + a. k = 1. .7) for s = t0 we get since \t-t0\<b/M. x0). This follows immediately from the construction of (j)n because for t and se[t 0 . we plan to use lemma 3. lemma 3. For each en. The path will lie between the lines in (3. . converging uniformly on [t0 —a. One can verify that 4>(t] is the required e-approximate solution. Of course. t0+a]. the resultant path <f>(t] will meet the line t . 2 . deduce that there is a subsequence {<pnk}. . Let us move on to the second step towards establishing an existence theorem. Our goal now is to construct a sequence of e-approximate solutions and show that these solutions converge to a solution of (3. Thus {</>„} is a sequence of en-approximate solutions that is both equicontinuous and uniformly bounded on a bounded interval [t0-a.1 and we do so immediately. We wish to conclude that the sequence {</>„} is equicontinuous. From the initial point and the initial value (to.f 0 | < o such that tf>n(t0) = x0. :c)|<M. Such a finite number of straight lines is called a polygonal path or an Euler polygon. of {</>„}. tQ+a]. . for the initial value problem in (3.1 guarantees the existence of an e n -approximate solution. applying (3. Note that (3.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 . denoted as <£„.

where If f ( t . Since / is uniformly continuous on R and <p n k -»0 as fc-»oo uniformly on [t0-a.9) becomes which verifies that 4>(t] is a solution. note that cf> is continuous because each </>„ is continuous. Also.3) we let and we write the e^-approximate solution as an integral equation of the form Choose a subsequence {</>nJ of (3.1.10 Differential equations. t0+a] we have Therefore. Theorem 3.9). it follows that f(t. by definition of An(t] for t E [ t 0 — a.4>nk(t}}^f(t. in the limit (3. t0+a]. x) is a con- . stability and chaos in dynamic economics denoted by <£.4>(t}} uniformly as k->oo on the same interval. We have proved an existence theorem. Furthermore.) tinuous function on the rectangle R. To show that </> is a solution to (3. (Cauchy-Peano existence theorem.

where / contains properly /. We will see. 1). therefore. theorem 3. then 4>(t}. If there is no such ifr(t). then the sequence of sn-approximate solutions can be used to construct this solution.3). however.3) on an interval /.1 assures us that a solution exists for the initial value problem on some interval /. If ijs(t) is also a solution of (3. Example 4. . the choice of a converging subsequence is necessary to establish existence of a solution. if more than one solution exists. tzl is called a maximally continued solution and / is a maximal interval of existence.1. te I. then we say that ijs(t) is a continuation of (f>(t) and J is called an extension of /.(f>(t) becomes unbounded and. be a solution of the initial value problem in (3. the method of construction in the proof of theorem 3.1 cannot in general give all such solutions of the initial value problem. Note that at t = l. Finally. Second. it is impossible to extend it to (-00. only under the stated assumptions a solution exists. the existence theorem claims that. To illustrate these concepts consider the initial value problem in (2. and we explore the conditions under which such a continuation is possible. 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. 1]. Continuation of solutions Theorem 3. First. see exercise (4) in section 8. Its solution <f>(t) = l / ( l — t) is maximally continued. there may exist polygonal paths {(/>„} which diverge everywhere. 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 /.14) where x = x2 and x(0) = 1. Put differently. therefore. Let </>(0. It is mathematically interesting and in some applications it becomes important to know if solutions can be continued on an extended interval.1 is not helpful in showing how to construct a solution. For an illustration. 4. in section 6 that if we know the solution is unique. with the maximal interval of existence being (—00.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.

x(t0) = x0 on an interval (a. we use Volterra's equation for t0 and t e (a. stability and chaos in dynamic economics Consider the finite interval (a. we write t -> a + 0 to denote that t approaches a from the right. &)• Actually. and similarly if (a. b). x). that is.1) as w and u approach b from the left. t e (a. the continuation can be extended by using (6. then Here M is the bound of f on D. If 0(0 is a solution of the initial value problem x = f(t. Theorem 4. From (4.12 Differential equations. Similarly we write t -» b — 0 to mean that t approaches b from the left. Note that if a<u<v< b. |f| < M <oo. Proof.0 ) ) e D. t e ( fl . then 0 can be continued to the left of a. ' e ( a . Furthermore. 0(a + 0)) e D.0(6 — 0)) as an initial condition.1. then 0 can be continued to the right of b. (Continuation theorem.) Let f(t. then 0 ( w ) — 0(u)-»0 which implies by the Cauchy convergence criterion that A similar argument establishes the existence of 0(a+0). b]> is a continuation of 0(0. x) is bounded on D. 0 ( 6 . Define <f/(t) as follows Then «A(0. we define We are now prepared to state the next theorem. 0(6-0))£ D. For t e (a. For a function </>(0. Next. if (b. b). x) be continuous in a domain D<^R2 and suppose that f(t. . To show that 0(6 — 0) exists. 6). 6). then the limits 0(a + 0) and 0 ( 6 — 0 ) exist. 6) of the real line. suppose that (b.

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

Upon reflection we conclude that the partial derivative df/dx does not exist at x = 0. From the continuity of f ( t . (Uniqueness. We obtain. we conclude that at least one such solution exists. t0+a]. using the mean . To show uniqueness we assume that (f>(t) and^(f) are two solutions.1). x)| and a -min(a. Then the initial value problem has a unique solution for te[t0. Proof. Our purpose is to use the added restriction about df/dx to show that 4>(t) = ij/(t) for te[t0. Theorem 5. b/M). 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. be continuous on the rec- with a and b positive and let M = max|f(t.1 can help us discover what is wrong with the initial value problem in (5. To remove this difficulty and obtain the uniqueness property. x) = 3x2/3 we compute which becomes unbounded as x -> 0.) Let/ and df/dx tangle R.14 Differential equations. For f(t. x) and theorem 3. It is therefore both necessary for applications and interesting mathematically to uncover restrictions that will guarantee uniqueness of solution. Example 5. 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.1.1. we state and prove the next result. stability and chaos in dynamic economics The above example illustrates how a fairly simple initial value problem has infinitely many solutions.t0+a].

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

This holds because the continuity of Bf/Bx on the closed and bounded rectangle R implies that Bf/8x is bounded.2.6) is called the Lipschitz constant.7).1 are sufficient to imply that/( J. x) satisfies a Lipschitz condition. We immediately observe that if f ( t . and k in (5.7). if df/dx exists and is continuous on the rectangle R in (5. x) and (t. This follows immediately because Therefore. We write for some positive k and (t. Therefore.11). Consider the initial value problem and let the rectangle R be We wish to show that/( t. furthermore. then/(f.9) and using (5. x) is continuous on the rectangle R. . x) satisfies a Lipschitz condition in the specified rectangle R with 2 as a Lipschitz constant. by (5. we conclude that the hypotheses of theorem 5. we have which implies by placing absolute values in (5. x) in the rectangle R in (5. x) = tx2 satisfies a Lipschitz condition. From the continuity of Bf/dx on the rectangle R. given by with a and b positive and. y) in the rectangle R of (5. f(t.7). stability and chaos in dynamic economics we then say that / satisfies a Lipschitz condition with respect to x.16 Differential equations. x) satisfies a Lipschitz condition.8) that for all (t. Example 5.10) for the initial value problem in (5.

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

one should remember that uniform_continuity does not imply a Lipschitz condition. b/M).6) by choosing 8-e/k. This follows immediately from the definition of uniform continuity and (5. x) is bounded. Furthermore. as before. 0 < x < 1 is uniformly continuous but does not satisfy a Lipschitz condition. also called Picard iterates. The function f(x) = \/x. where for positive a and b. Note that nothing is implied about the continuity of f(t. if a function f(t. however. x) satisfies a Lipschitz condition with respect to its variable x. Let \ f ( t . x) satisfies a Lipschitz condition. of course. Consider the initial value problem and suppose that / is continuous on the rectangle R. 6. for . x)|<M on the rectangle R and. f(t. x) is continuous and satisfies a Lipschitz condition. stability and chaos in dynamic economics Third. 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). The successive approximations. x) is uniformly continuous with respect to x. set a — min(a. More about the implications of Lipschitz conditions is presented in the sequel. although mathematical historians suggest that this method had been used earlier by Liouville and Cauchy in certain special cases. Then for |x — y\<8.18 Differential equations.6) implies which says that/(f. x) with respect to t. x) is uniformly continuous in x. The continuity of f(t. the result we are about to state also asserts the uniqueness of the solution which is obtained from the added hypothesis that f(t. We know. then for each t. x) is sufficient for the existence of a solution on some interval containing the initial point f0. x) on R implies that f(t. Successive approximations An important existence and uniqueness theorem can be obtained by assuming that f(t. that the continuity of f(t. the Lipschitz condition in (5.

This implies that tf)n+l(t) given by (6. b/ M). If we assume that the same conditions hold for 4>n(t). 1.3) also exists on [t0. . x)\ on the rectangle R and set a = min(a. </> n (0) is defined and continuous on [t0. t0+ a~\.1.) Let f(t. . A similar proof holds for [t0-a. x). from (6.. given recursively as follows for n = 0. f 0 +a]. t0+a] and is continuously differentiable. Since </>o(0 = *o..2). . We first show that every <f>n(t} exists on [t0. We establish the theorem for the interval [ 10. then/(f. t0+a] as continuous functions.1) are defined to be functions <f>0. it follows that Next. . 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. . this establishes that (f>n(t). t0 + a ].. 1. $. 2 . (Picard-Lindelof existence and uniqueness.. exist on [t0. 2 . .Basic properties of differential equations 19 the initial value problem (6.1). ^o+«]. . t0+a]. 1. Then the successive approximations (f>n(t). Proof. The next theorem establishes that the successive approximations converge uniformly to the unique solution of (6. Theorem 6. 2 . we establish that </>„(?) converge uniformly on [f 0 . n =0.To do so we first need to show by induction that . Inductively.3) and the boundedness of f ( t . <£o(0 is a constant and satisfies these conditions. Let M be a bound for \ f ( t . x) be continuous and satisfy a Lipschitz condition on the rectangle R as in (6.'t0]. n = 0.1). . Furthermore. . and is continuously differentiable. and t e [t0 — a..

6) to get This analysis verifies (6. t0+a]. Assume that for n > 1.3) for n>\.20 Differential equations.8) is uniformly convergent on [t. Use both the hypothesis that f(t. x) satisfies a Lipschitz condition with a constant k and the induction assumption in (6. assume For the last step in the induction note that which is obtained from (6. (6.5) holds.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. that is. stability and chaos in dynamic economics For n — 0.5) follows immediately from (6. (6.4). the series . Therefore.

t0+a~\ and n = 0. 0(0) as n-»oo. To show how the process of successive approximations works to produce a solution of the initial value problem. (f>n(t)) converges uniformly to/(r. to prove uniqueness.3) yields Finally. x) on the rectangle R implies that/(f.1. t0+a] and write An induction similar to (6. that is. t0+ a]. 1. we provide two examples. t0+a] and the partial sum <f>n(t).Basic properties of differential equations 21 is absolutely and uniformly convergent on [t0.2. It is easy to verify that the limit function </> (t) is a solution since the uniform continuity of f(t. <f>(t) = $(t).1) on [r 0 . As HH>OO we know that 4>n(f)-»0(0 uniformly and (6.5) shows that for te[t0. let ij/(t) be another solution of (6. This proves the theorem. A term by term integration in (6.11) yields \(f>(t) . Example 6.if/(t)\ < 0. Consider the initial value problem This initial value problem is equivalent to Volterra's equation . where converges uniformly to a continuous function 4>(t) on [t0.

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

Its solution is given by . 7.2) since it incorporates the parameter a. we see that (f>(t) is indeed a function of three variables: t.3). <£ n (f)-»e' / 2 . 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. t0 and x0. We may recall example 2.Basic properties of differential equations 23 In general. 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. Here a is a real number.1 and reconsider the initial value problem whose solution is given by Inspecting (7. which is the required solution for all real t. A simple illustration is provided by the initial value problem which is only slightly more general than (7. we can go a step further and indicate that a solution may also depend on a parameter. Assuming a solution existed. we have As n^oo.

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

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

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

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

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

If we regard the n dependent variables xt as the coordinates of a single vector variable written as x . x) using measure theoretic techniques that originate in Caratheodory (1927).. Given what was said about (9. f n ) .. Finally.. consider the substitution which transforms (9. In conclusion.. see also Simmons (1972).. Hale (1969) and several other standard advanced differential equations books. f2. . . p.(x t ..1) in this case. there is no loss of generality in using (2./2.fn are n real continuous functions defined on some domain DC: Rn+}. x2.1). • • • . It is of some historical significance to mention that the Cauchy-Peano theorem of section 3 can be traced back to Cauchy in the early part of the 19th century and to Peano (1890) who offered a substantial generalization of Cauchy's work.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. To see the appropriateness of (9. can also be expressed by (9. The original ideas on uniqueness may be found in Lipschitz (1876).2).3). then (9.Basic properties of differential equations 29 differential equations written as where n is a positive integer and f1. our claim is verified. Also. note that existence can also be established using modern functional analysis techniques as is done in Coppel (1965). 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. xn) and the n functions f{ as the coordinates of a single vector function / = (/i.2). 23) and his detailed bibliographical references. Detailed historical remarks on various existence theorems are found in Hartman (1964.1) can be used to represent (9. existence theorems have been established under assumptions weaker than the continuity of f ( t .

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

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

1) can be written as where A(t) is an n x n matrix whose elements are the fly(f) functions for i. 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. 2 . b] that solves (2.3).1. where implies that a solution exists on some interval containing t0. because linear systems satisfy the Lipschitz condition. 2 . more can be said than existence on some interval containing t0. . Namely.-(0» i = 1. The system (2. a.2) is called a linear homogeneous system. oo) or (-00. a solution can be extended to [a. if a solution exists it is also unique. . n. Actually. . . Note that h(t) is called the forcing function or the input function. . b]. This result is the consequence of the continuation theorem 4. In applications [a.1 of chapter 1 because a linear system is bounded in the rectangle R. b]. . Let be an initial value problem for the nonhomogeneous linear system. .y(0 and h t ( t ) are continuous real valued functions with i. . . Then. Furthermore. b] is usually taken to be [0. and thus. oo). By theorem 3. if ft(f) = 0. then (2. . n. Therefore we can state Theorem 2. . . a solution exists for all t e [a. stability and chaos in dynamic economics 2. the continuity of A(t) and h ( t ) on the rectangle R. j = 1. b~\. for linear systems. there exists a continuously differentiable unique solution <j>(t) on the entire interval [a. « . x is a column vector with x. elements and h ( t ) is a column vector with elements Ji. . Linear systems Consider the linear system of n first order differential equations where for t&[a.32 Differential equations.2) is called a linear nonhomogeneous system. 2 . j = 1.1 of chapter 1. In matrix notation (2.

1) if each column of <P(t) satisfies (3.1) and such that det <P(t) T* 0. .Linear differential equations 33 Example 2.1) at initial time t0 is a fundamental matrix solution such that 4>(f 0 ) = /. X(t) = [xij(t)'\ denotes an n x n matrix. n. .5) indicates that the 0-solution satisfies (2. 2 . <P(t) = [4>tj(t)] and X(0 = [x«/(0] denote the derivatives of <P(t) and X(t).1). 3.1) is an n x n matrix with each column satisfying (3.1).1 that the 0-solution is the only solution for this initial value problem. These substitutions yield: Thus (2. If a matrix solution <P(t) is also nonsingular. The second order homogeneous initial value problem can be written in matrix form by making the substitutions (9.4) of chapter 1. it follows from theorem 2.5) are continuous for re (-00./(01 denotes the matrix solution or the fundamental matrix solution of (3.1. Since the functions of the matrix in (2.4) can be written in matrix form as Inspection of (2. j = 1. with / being the identity n x n matrix. ^(0 = [</>.1).5). In all above cases i. In other words. A(t) = [aij(t}~\ denotes the n x n matrix in (3. . 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. a fundamental matrix solution of (3.. oo). it is called a fundamental matrix solution. These properties are presented after the notation used is introduced. Matrix solutions satisfy certain properties. . . A principal matrix solution of (3.

34 Differential equations.2) for *€[«.) Suppose that <P is a matrix solution of and let t0E [a. then <£ satisfies (3. Proof. Theorem 3. Then for te[a.1). stability and chaos in dynamic economics Theorem 3. Denote the columns of <P by $. b]. b]. Then for every te [a. Proof. b].2.1. . . < / > „ .1). The generalization is straightforward. (Abel's formula. Consider the matrix differential equation If 0 is a fundamental matrix solution of (3. . Since ^ is a fundamental solution of (3. .1) each of its columns satisfies (3..&]. Note that . We prove the theorem for the special case n = 2.

4.1). furthermore.1) and let C be a nonsingular n x n constant matrix. Suppose that <P(t] and W(t) are two different fundamental matrix solutions for t e [a. This is an immediate consequence of (3. Proof.5. in the second determinant we subtract a2\ times the first row from the second row. either det 0(t)=0 for all re [a. There then exists a constant n x n nonsingular matrix C such that . Proof. Let 0 be a fundamental matrix of the linear homogeneous system in (3. Then <PC is also a fundamental matrix of (3.3) follows. 6] or d e t # ( f ) = 0 for all f e [ a . Then. This completes the proof. 6] of the linear homogeneous system in (3.3. Suppose that <P is a matrix solution. Theorem 3. b] is arbitrary. this calculation shows that and upon integration (3. Theorem 3.1). b]. Theorem 3.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. This operation results in Therefore. which establishes the result.3) since t0e[a. Calculate Thus <PC is a matrix solution.

1. Specifically. b]. stability and chaos in dynamic economics Proof. However (3. . oo). 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. b] and 00 ~J = /. By hypothesis. Example 3. 0"1 exists for all t G [a. oo). On the other hand. Therefore. Taking the time derivative on both sides of 00 ' = / gives from which we conclude that The result in (3. 0 is a fundamental matrix solution which implies that det 0(0 ^ 0 for all t e [a.9) is not a fundamental matrix solution since det 0 = 0 for all t e (-00. where C is an n x n constant nonsingular matrix.8) and therefore is a matrix solution.6) is needed to show that (d/df)(0 ' #") = ().7) conclude that 0 ] V = C or that V = 0C.36 Differential equations. note that From (3.8) and det 0 = e' e~' = 1 ^ 0 for all t G (-00. Consider the linear system which is written in matrix notation as Note that ^ = [S ] and </> 2 -[o ] solve (3.

Theorem 3.11).11). Given (3.7.6. Proof. The next result is very important.4 the general solution of the homogeneous system can be written as . oo). By theorem 3.) 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 (-00.1) then <P~l is a fundamental matrix solution of (3.Linear differential equations 37 This section concludes with a definition and two additional theorems. Theorem 3. (Variation of constants. If 0 is a fundamental matrix solution of x = A(t)x. which shows that 3> } is a solution of (3. It gives the solution of the nonhomogeneous system and it will be used several times throughout the book. the adjoint equation is defined to be where y and y are row vectors of the same dimension n. The next theorem establishes that if <P is a fundamental matrix solution of (3. Differentiate both sides of 3><P l = I to obtain Therefore.1) where x and x are column vectors of dimension n. then the matrix 0"1 is a fundamental matrix solution of the adjoint equation Proof. Let <£ be a fundamental matrix solution of the homogeneous linear system.

it must be the case that <Pc = h. We wish to satisfy the nonhomogeneous equation by the same expression as (3. Linear systems with constant coefficients In this section we discuss the system where A is an n x n constant matrix. if we integrate from t0 to t. as and differentiate. it is instructive to analyze linear systems with constant coefficients because of their importance in economic applications and in stability analysis. Even when n — 2. that is. Rewrite (3.12) but allow c to be a function of t. If. stability and chaos in dynamic economics where c is an arbitrary constant vector. We first consider the homogeneous case when h ( t ) = 0 in (4.13) In (3. 4.15). a matrix with n2 numbers and h ( t ) is a continuous n vector function. this explains the name of the theorem as variation of constants.12) with c now being a variable. using (3.14) to satisfy the nonhomogeneous equation.2). This follows from inspection of (3. the initial condition is <f>(t0) = x0. Thus c= <3>~lh or equivalently.1) is not trivial to solve. instead.14) and (2. then the solution (f>(t) will satisfy the initial condition O(t 0 ) = 0. Although we do not wish to deviate from our methodology which emphasizes basic properties of differential equations. then the solution of the nonhomogeneous equation becomes which establishes the theorem.1). to get In order for (3. . (4.38 Differential equations.

7) of chapter 1 as 0(0 = c e°". Theorem 4.2) is given by and the solution of the initial value problem is given by Remark 4. oo).Linear differential equations 39 To motivate the solution of the homogeneous case in (4. First note that t. 97-107) or Hale (1969. Proof of theorem 4. See Arnold (1973. Second. Let A be an n x n constant matrix.1 in chapter 1. te R = (-00.2). pp. and so a good guess for the solution of x = Ax would be 4>(t) = QA'C.6) converges for every A and t. with c an arbitrary constant n vector. t0 and x0 are finite. and consider the corresponding homogeneous system A fundamental matrix <P for (4. To show that 3>(t) = eA' is a solution we must show that it satisfies (4. This example is the simplest case of (4.1) with h ( t ) = Q and n = 1. .1. so that eA( is well defined for all square matrices. 94). P. the definition exp(A/) is: The infinite series (4. we must define eA' to avoid ambiguity.1. that is. recall example 2. For an n x n constant matrix A.1). Its solution is given in (2.1. otherwise <P and </> are not well defined. The next theorem establishes that this guess is correct.

This concludes the proof. Note that they do commute if A is constant or if A(t) is diagonal. alt. Remark 4.6) is not generally useful in computation. if the elements or entries of A(t) are functions of time.7) use the definition of a derivative and (4. that is.6) Furthermore. p.5) is immediate. First.. Let h > 0 and compute In the last step the limit is A because by (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.5) as the solution of the differential system x = Ax for A being an n x n constant matrix. stability and chaos in dynamic economics To establish (4. for A a constant n x n matrix express where a0.2 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.. using theorem 3.. Theorem 4. See Coddington and Levinson (1955. If A(t) is an n x n nonconstant matrix. 76). . an_i are functions of t which are determined in the next step. The definition of eAf in (4.6).40 Differential equations.2.

9) can be applied to give the final result Example 4. al . as functions of t.] are given by which means that A = 2f is an eigenvalue of multiplicity 2.11) and (4. then use with all derivatives in (4. define If A.2. have been found. . . Compute eAr for A = [20 °2]. a 1 } . From (4.12) to get two equations that will determine a0 and a1. is an eigenvalue of At of multiplicity k. k> 1. an_l.. is an eigenvalue of At of multiplicity 1 then use to solve for a0.Linear differential equations 41 Second. The eigenvalues of At = [20' 2°.12) being evaluated at A. . . The two equations are and solving them for a0 and a1 yields Now that a0 and a1. If A.10) obtain and use (4. to solve for the appropriate a 0 . «„_. Compute eA' for A = [l 4l- . . . (4. Example 4.1.

The two equations are and A2 = —3t and to find a0 and a} use Solving these equations yields Put a0 and a{ in (4. with A being diagonal. stability and chaos in dynamic economics The eigenvalues of At are \l-2t (4.11) to obtain Solving these last two equations obtain Using Euler's relations . The eigenvalues of At = [_° o] are computed from and they are A t = if and A 2 = —if.6) because A" is also diagonal.9) to get the final result In examples 4. Example 4. one may also use directly the definition in (4. Substitute these two eigenvalues into (4.11).2.42 Differential equations.1 and 4. Compute eA( for A = [0 1 £].3.

Linear differential

equations

43

conclude that

Finally,

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

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

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

or, equivalently,

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

44

Differential equations, stability and chaos in dynamic economics

This initial value problem can be written in matrix notation as

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

we determine that

Therefore, after making the necessary simplifications, we conclude that

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

Example 4.5.

Solve the nonhomogeneous initial value problem

This problem can be written in matrix form as

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

Linear differential

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:

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

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

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

54 Differential equations. T] with T a positive real number and let e > 0 be given. to arrive immediately at Solving (1.2) for x ( t ) and using the initial data in (1. 0. x) = x2 guarantees the existence of a solution on some appropriate interval. 1/c) is the maximal interval and the solution cannot be continued to the right because <fr(\f c) does not exist. 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 . Actually. is unique. passing through the point (0.4) suggests that some form of a boundedness property holds for the solution in its domain [0.x2. We ask the question: can a restriction be placed on the initial value x(0) = c> 0 so that Equation (1.4) describes how close <f>(t. 0. Let us go a little further. Therefore it is justified to search for a solution by integrating (1. x(0) = 0.t0. Consider the interval [0. c). 0) = 0. 0>c) m (1-3) is unique and continuous in all arguments in its domain of definition. the interval (—00. 0) = 0 is its solution. x0) is to the 0-solution denoted by cf>(t. the question can be reformulated: can a restriction be placed on the initial value so that . Actually (1. Using the 0-solution as a reference.1). Moreover. indicates that (f>(t) = </>(*. 1/c). this solution. conclude that is a solution on (—00. Finally continuous dependence with respect to initial data x(0) = c > 0 holds since </>('. T]. Inspection of the initial value problem x .1).

uniqueness and continuity with respect to initial data hold on a finite interval [0. x(0) = c>0 shows how the properties of existence. Furthermore. 5 can be chosen such that This estimate of 8 follows from (1. there is a 8 = 8(e. 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 [0.0) to (f>(t. both given. T) > 0. Actually for this initial value problem. 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. This implies that the continuity of the solution (f>(t. oo). and the appropriate domain for this variable is [0. T] increases with T^oo. 1/c).3) with c replaced by 8 and t replaced by T. oo). no solution exists on [0. The above analysis of the initial problem x . In many applications the independent variable t denotes time. c) is due to a change in the initial value at t = 0 from 0 to c.6) we conclude that as the length of the interval [0.6) it follows that if \c\ < 8 then From (1. but that stability fails to hold on [0. oo). Actually.Q.4) holds. 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. This computation illustrates the importance of the continuous dependence of solutions on initial data on a finite interval [0. depending on both T and e. The source of change from (f>(t. oo). For the initial value problem in (1.c) is not uniform with respect to t in the interval [0. 0. the answer to the question asked is: for T> 0 and e > 0. such that if c < 8 then (1. T].Stability methods: An introduction 55 Equation (1. Definitions Consider the differential equation .x2.0. 2. 8 must approach zero.1). for 8 as in (1. where the latter is being used as a reference point. T] which is a subset of (-00.5) is motivated by the researcher's interest in knowing the deviation of a solution from its 0-solution. oo) let alone a stable solution.

x): [0. or do they drift away from one another as f-»oo.Q. x ) satisfies the conditions ensuring existence. Studying the stability properties of (f>(t. ct) is a solution of (2. c2) remain very near to one another as f-»oo. x0) or by </> (/11 0 . The solution of (2. c2) behave as /H»OO? DO 0(f. x0) or x(t.5) is a definition and that if y = 0 then g(t. how do the solutions 4>(t. tQ.56 Differential equations. if not all applications. namely (0.3) and (2. 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. c2) is equivalent to studying the stability of y relative to the 0-solution. it follows that Since $(f. in how close a solution remains to the equilibrium . y denotes the difference between two solutions.2) suggests.4) gives Observe that the last step in (2.2). 0. To once again motivate the intuitive notion of stability.0.Q. which is instability? The mathematical treatment of the problem of stability becomes simpler. ct) and (f)(t. This is so because. but more importantly. Cj) and (f>(t. In most. oo) x R" -» R" and assume that the function f ( t . 0. oo) x R". as (2. uniqueness and continuous dependence of solutions on initial conditions. x0) or x(t\ t0. Consider (2. Cj) relative to (f>(t. the researcher is not primarily interested in how close two arbitrary solutions remain as f-»oo. Cj) and (0. then Combining (2. Therefore to find a certain solution. c2) both in [0. it is necessary to specify its initial conditions.1). from (2. by taking time derivatives and rearranging terms. has an infinite number of solutions.1) and two initial conditions.Q. t0. 0. A system of ordinary differential equations such as (2.1) which at time t0 passes through the initial point x0 is denoted by $ (t. stability and chaos in dynamic economics with f(t. we ask the question: if c. by defining that is. 0) = 0. which is stability. and c2 are close. without loss of generality.1).

1. The 0-solution is uniformly stable if it is stable and if 8 can be chosen independently of t0 > 0. ?0. and also. oo) xR"-> R" satisfies the conditions ensuring existence. . Remark 2. An equilibrium solution or a trivial solution or a rest point is a solution. t0. This consideration also reveals an important property of the stability for differential equations. t0.Stability methods: An introduction 57 solution.5) to conclude that there is no loss of generality in translating the equilibrium solution x to the 0-solution. Therefore. The 0-solution is called stable in the sense of Liapunov if for every e > 0 and f0 > 0. x 0 )^0 as f-»oo. possibly requiring a different value for 8.2)-(2. x0)\<rj if t>t0+T(rj). 26). there is a 8 = 8(e. then it is also stable at every initial time f.t0 and the inequality \(f>(t. x0) | -» 0 as t -* oo. that satisfies the equation One may repeat the analysis in equations (2. the various definitions of stability that follow are made with reference to the 0-equilibrium solution. 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.7) as curves in a (n + 1)dimensional space. Definitions 2. If the equilibrium solution is stable at t0. x0) < e determines a cylinder of radius e about the f-axis. tQ. The inequality |x0| < 8 defines a ball in the hyperplane t . if for every r\ >0 there is a 7(17)>0 such that |jc0|<§0 implies |<£(r. uniqueness and continuous dependence on initial data and parameters. Specifically let and suppose that f(t. See figure 3. there exists a 80 = 80( /0) > 0 such that JCD| < 80 implies | </> (t. x):[0. 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.1 and Hale (1969. In other words. The 0-solution is uniformly asymptotically stable if it is uniformly stable. p. Finally. denoted by x. > f0.1. the 0-solution is asymptotically stable if it is stable and if for every t0>0. The property of the 0-solution being stable can be visualized geometrically by considering the solutions of (2. the 0-solution is unstable if it is not stable. if 5 0 (f 0 ) by the definition of asymptotic stability can be chosen independent of f0 — 0.

Example 2.2. the 0-solution is unstable if A > 0. Furthermore. asymptotically stable and uniformly asymptotically stable if A < 0. Example 2. the 0-solution is also uniformly stable. The equation x = x2. The equation x = x has solutions of the form x ( t ) = x0e' when x0 is an arbitrary constant. Example 2. analyzed in the previous section.58 Differential equations. this is as example 2. since the solutions are independent of time. Consider the equation x = 0. The solutions of this equation are x ( t ) = x0. Finally.3. The 0-solution is stable and uniformly stable if A = 0. Consider the system . The solutions are of the form x(r) = x 0 e At . The 0-solution is unstable because x0 e' does not approach zero uniformly on [0.1. oo) as x0 approaches zero. as example 2. This example generalizes the previous two examples.4. has a 0-solution that is unstable because neighboring solutions are not defined for all t e [0. but it is not asymptotically stable. Consider with \eR. where x0 is an arbitrary constant. Example 2.1. oo). uniformly stable.5.1 Example 2.2. The 0-solution is stable. The 0-solution for t>0 is stable. stability and chaos in dynamic economics Figure 3.

Modify the previous example to consider with solutions x ( t ) = x0e ' and y(t)=y0e '. Example 2. for r a positive real constant. 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. By choosing y0/ x0 small.e. Example 2.1) and therefore all the definitions of stability presented in the preceding section. that is. i. thus the 0-solution is stable. 3.Stability methods: An introduction 59 and let x ( t ) and y ( t ) denote the corresponding solutions. The circles can be made arbitrarily small by choosing r to be small. . the solution paths are circles centered at the origin. apply to the homogeneous linear system. This means that the paths are rays through the origin. Observe that the ratio of the solution paths is constant. y ( t ) / x ( t ) =y0/Xo = constant. The continuity of A(t) implies the existence and uniqueness of a solution satisfying certain initial data. but it is not asymptotically stable. Observe that This means that. 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'.6. with reference to the 0-solution.7. the 0-solution is shown to be uniformly asymptotically stable and therefore also uniformly stable.. and x and x are n column vectors.

Note that we can use Taylor's theorem to write Denote the Jacobian matrix of the first order partials by A(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). but also because nonlinear systems can be approximated by linear ones. using (3. x + z).2) it follows immediately that Observe that the solution z ( t ) = 0 is an equilibrium solution of the system z=f(t. that is. x + z) in (3. x + z). x) . we wish to approximate /(t. we have simply reviewed what was stated in the previous section. where f:R"+l-*R" has at least two continuous partial derivatives with respect to its variable x. x) = 0. x) are equivalent to the stability properties of the 0-solution of the system z=f(t.3) and that the stability properties of the solution x ( f ) of x -f(t. x) we will need to apply Taylor's theorem. not only because of the relative simplicity and usefulness of such a system.3).0. It is instructive at this point to introduce the concept of linearization. we conclude that . This assumption is needed because in linearizing x-f(t. (3.4) and the fact that/(f. and using (3. t £ [0. recalling that f ( t . Let x ( t ) . x).60 Differential equations. Taking the time derivative of z ( t ) . oo) be an equilibrium solution of x =f(t. let df(t. Consider x=f(t. Thus far. which studies the linear approximation of a nonlinear system near the equilibrium. stability and chaos in dynamic economics The stability analysis of the homogeneous linear system is a natural point of departure. Next. x)/dx = A(t) where Thus.

Once again the approximate linearized system z = Az can be used to deduce. If the nonlinear term is small compared to |z|. Using Taylor's theorem as in (3. by using a translation of variables and Taylor's theorem. Therefore. the stability properties of the 0-solution of The next four theorems establish various stability properties of (3.2 in the next section. \h(t.0. and h ( z ) / \ z \ is a continuous function of z which vanishes for z = 0. z)|/|z|-»0 it may be expected that the 0-solution of (3. This system (3. x) with an equilibrium solution x ( t ) . A is the Jacobian of the first order partials evaluated at x.Stability methods: An introduction 61 with h(t. under certain conditions. given a nonlinear system x=f(t. then the stability properties of the 0-solution of (3. the stability properties of x ( t ) can be studied by analyzing the stability properties of the 0-solution of the nonlinear system in (3. Identically the same procedure of linearization can be applied to the autonomous differential equation x =f(x).5). we can write z — f ( t .2) holds. 0)/dz = 0. x + z) as the sum of a linear system and a residual nonlinear system. among other things. 0) = 0 and dh(t. In summary. 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 (3.5) can be deduced from the stability properties of the linear system z = A(t)z. Since for fixed /. that is.5) consists of a linear term and a nonlinear term with higher polynomials of z. In the next section we will study.1) for A(t) being a continuous n x n matrix. This suggests that the study of the linear homogeneous system should receive our primary attention and will lead us to theorem 4. uniformly in t. f ( x ) .5) shows the same stability behavior as the 0-solution of the linear variational system z = A(t)z.4) write In this last equation. 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 .

The system (3.1-3. stability and chaos in dynamic economics of the nonlinear system x = Ax + h ( x ) .1) is stable for any t0e R if and only if there is a positive constant K = K(t0) such that Proof. Let f0e R and suppose that \3>(t)\ < K for t> t0. t0) < e/K\<P I(t0)\.12) of chapter 2 that any solution </>(0 of the linear homogeneous initial value problem x = A(t)x.1) is uniformly stable for f0> (3 if and only if there is a positive constant K = K(fi) such that . Choose c = <P~l(t0)x(t0) and write the solution as Given e > 0 choose 8 = 8(e. Theorem 3. if |x0| < 5 then \3>(t)<P~l(t0)x0\ < e.2. The various applications of subsequent chapters will make use repeatedly of the linearization method. Let 0(0 be a fundamental matrix solution of (3. t0) > 0 such that. The system (3. where 4>(0 is a fundamental matrix solution and c is an arbitrary constant vector. x(t0) = x0 can be written in the form <f>(t) = <P(t)c.1. suppose that stability holds. Theorems 3. This means that From this last step obtain Theorem 3.5 follow Hale (1969. Stability follows because if \XQ\ < 8 then Conversely. that is.1) are bounded. Let <£(0 be a fundamental matrix solution of (3.1). The first theorem below establishes that the 0-solution is stable if and only if the solutions of the linear homogeneous system (3. 84-89). pp.62 Differential equations. there is a 5(e. for any e > 0 and t0. Recall from (3.1) and let )8 e R.

11) and by theorem (3. with the remark that assuming uniform stability means that for a given e > 0. Furthermore. we want to show that there is a T(TJ) > 0 such that l if t0>(3 and t>t0+T(rj). Theorem 3. since </>(0 = <P(t)(P~l(t0)x0 with |4>(f)|-»0 and ^"'(O^ol a constant. 8 is independent of tQ. Suppose that \<P(t)\-*Q as f-»oo.13) deduce that .11) holds.1) is uniformly asymptotically stable for t0> B if and only if it is exponentially asymptotically stable. suppose that the 0-solution is uniformly asymptotically stable for t0>fi.1. Assume (3. it follows that |<£(f)|-»0 and asymptotic stability holds. we deduce stability. This value of T establishes (3.9) follows from (3.3. 8 = <5(e).10). that is.9). Suppose that (3. Let 0(0 be a fundamental matrix solution of (3. The converse is immediate because |</>(f)| = \0(t)^~l(to)x0\^0 implies (3.Stability methods: An introduction 63 Proof. For (3. Then. |x 0 |^5 0 .4. Then (3. The system (3. The converse follows in exactly the same way as the converse of theorem 3. Let x0\ < 1 and note that for any 77 > 0 such that 0 < 17 < K.1).12) to hold. choose T=-a \n(rj/K}.2). From (3. The system (3. Let <P(t) be a fundamental matrix solution of (3. let e > 0 be given and choose 8 = 8(e) < e/K. 0 < T 7 < 5 0 .11) implies uniform asymptotic stability of the 0-solution of the linear system.12) and therefore (3. 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. There is a 5 0 >0 such that for any 77.1) is asymptotically stable for any f0e R if and only if Proof. uniform stability holds.1) and let B e R. that is. there are constants K = K(/3)>0 and a = a((3)>0 such that Proof. Theorem 3. Conversely. there exists a T= T ( T ? ) > O such that by definition of uniform asymptotic stability and all f 0 >/3. Then for any t0 > (3 if |x0| < 8 it follows that and uniform stability holds.1.

2 in section 4.1).Finally. we present a theorem concerning the stability of the perturbed linear system. stability and chaos in dynamic economics for t0>p.2. both because of its intrinsic importance and its use in linear approximations of the form (3. From theorem 3. the stability analysis presented in the last four theorems deals with the homogeneous linear system x = A(t)x of (3. there is a positive integer k such that /cT< r .5. there is a 8 > 0 such that Then. x):R x R"^R" is continuous for (t. Finally. B e R and suppose that h(t.4 there are constants K = K((3) and a = a((3) such that . the 0-solution is uniformly asymptotically stable for t0 > )3. uniform stability implies that there is a positive constant M = M(/3) such that Let a — -In(i7/5 0 )/r and K = M eaT. Note that for any t> t0. x). Also suppose that for any s > 0.f 0 < ( f c + l ) ^ . Theorem 3. t>t0+T.64 Differential equations.5). which is a generalization of theorem 4. Proof.15) to compute This computation completes the proof. Since x = A(t)x is uniformly asymptotically stable for f0> /8 by theorem 3. In particular for t > /3. So far.1) is uniformly asymptotically stable for t0>(B. Suppose that x — A(t)x in (3. use (3.

recall that from the variation of constants theorem. p. Coppel (1965.23) implies |0(0| < 8 for all t> t0 provided \4>(t0)\ < d/K. Example 3. 87) report the following example to illustrate that extreme caution must be exercised in treating perturbed linear systems such as (3.1.24) is a special case of (4.20) as Apply Gronwall's inequality to (3.16) holds.17) is uniformly asymptotically stable. For t > t0 such that 0(f)| < 5 use (3.17) is of the form Choose e so that eK < a and let S be such that (3.eK > 0 by choice of these constants. p.Stability methods: An introduction 65 Furthermore. However.19) to write Make the transformation z(0 = e a '|0(0l and use it to rewrite (3.18) and (3.21) to obtain which implies for all values of t > t0 for which |0(0| < & Since a .21) in chapter 2. Thus the 0-solution of (3. The second-order linear equation has two solutions </>(0 = sin t and 0(0 = cos t and is uniformly stable but not asymptotically stable. Recall that (3.17). (3. the equation . any solution of the nonhomogeneous linear system (3. 71) and Hale (1969.

as section 5 of chapter 2 describes it. assume that the matrix A of (4. To establish stability we need to show that the solutions of (4. Without loss of generality. 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 (3.66 Differential equations. the special nature of A allows us to obtain additional results. (i) The 0-solution of (4.24) has two solutions (f>(t) = t~l sin t and (f>(t) = t~l cos t and is uniformly asymptotically stable.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. Proof. stability and chaos in dynamic economics which can be considered as a perturbation of (3.24) has two solutions (j>(t) — sin t — t cos t and 4>(t) = cos t+t sin t and is unstable.1). Then the solution of (4. On the other hand. .1) is in Jordan canonical form. Note that x — 0 is an equilibrium solution of (4.1 of the previous section. 4.1) are bounded and then use theorem 3. Although the theorems presented in the preceding section can be used to study the stability properties of (4.1. the equation which can also be considered as a perturbation of (3.1) can be written as where J is as (5. Theorem 4.1).1) and that its stability can be given in terms of the eigenvalues of A. (iii) The 0-solution is unstable if at least one eigenvalue of A has positive real part. (ii) The 0-solution is asymptotically stable if all eigenvalues of A have negative real parts.10) of chapter 2.

by hypothesis. where The eigenvalues of A(t) are A1(t) = [-1 +iV?]/4 and A 2 ( f ) = [-1 -i>/7]/4. it is easy to prove that the condition that all eigenvalues of A in (4. Ji. .Stability methods: An introduction 67 Consider separately the Jordan blocks J0 and Jf. . < 0 for i = l. i = 1. if at least one eigenvalue of A has positive real part. . Thus.1) is time independent. i = l. the 0-solution of (4. note that Re Ak+i <0. Therefore |ej°'| is bounded. . ..1) is stable. However.1. in this case. all eigenvalues of A have negative real parts. . Finally. .1. . .1). the condition that all eigenvalues of A in (4. there are positive constants K and a such that \QA('~'O}\< K e~ a( '~' o) . 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. . For the other blocks.4 the 0-solution is asymptotically stable. If the eigenvalues of a nonconstant matrix A(t) satisfy the conditions of theorem 4.1) have nonpositive real parts and every eigenvalue of A that has a zero real part is a simple zero. (f>(t) in (4. s. i = 1. that is. For linear autonomous homogeneous systems such as (4.k. By theorem 3.1. s. is bounded. f > f 0 > 0 . stability implies uniform stability and asymptotic stability implies uniform asymptotic stability. Furthermore. Finally.\k be the diagonal elements of J0 . Actually. and by theorem 3. it appears in block /0. . stability is equivalent to boundedness and asymptotic stability is equivalent to exponential asymptotic stability. . . By construction. It is important to emphasize that theorem 4. Remark 4. Remark 4. the solution . . one cannot deduce stability for x = A(t)x. is not only sufficient but also necessary for stability. there exists a positive constant K such that e j( '~' o) < K for t > t0>0. if an eigenvalue of A is simple. Use (5.17) of chapter 2 to also conclude that |ej/'|.2) is an increasing solution that becomes unbounded and stability does not hold.1 states sufficient conditions for stability and asymptotic stability for linear systems with constant coefficients. . . . these two eigenvalues have negative real parts. .1) have negative real parts is not only sufficient but also necessary for asymptotic stability as well. . s. 5. . . The second part of the theorem follows immediately since. Because (4. i = 1. .2. Let \l . . By hypothesis Re A . that is.

3. is exactly the characteristic polynomial p(\) in (4. it can be shown by induction (see Miller and Michel (1982. p.4) and call the roots of p(\) the characteristic roots or eigenvalues of (4. Therefore. if an equation is given in the form of (4. This means that.68 Differential equations.4). If A is positive definite. Suppose that (4.6). 122)) that the characteristic polynomial of A in (4. in practice.6). are the same as the roots of p(\) — 0 in (4.Ax where Observe that theorem 4.6) which are obtained by solving the characteristic equation det(A — A / ) = 0 . 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. If an n x n matrix A is negative definite.4).1 describes the stability or instability of x = Ax in terms of the eigenvalues of A.4). stability and chaos in dynamic economics is given by which is not asymptotically stable since it grows exponentially. Since (4. the eigenvalues of A in (4. are equivalent. Remark 4.4) is transformed into a system x . Remark 4. one need not transform it into a system x = Ax and compute the eigenvalues .5) which are obtained by solving the characteristic equation of the nth order equation in (4. then its eigenvalues are positive and the 0-solution of x — Ax is unstable.4) and x = Ax. then its eigenvalues are negative and the 0-solution of x = Ax is asymptotically stable. that is det(A-A/).4. with A as in (4.5).

9) given by A2 + 4 A + 4 = 0 are AI = A2 = -2. with /?(A) as in (4. = -l and A2 = 2.8) in order to compute the eigenvalues of [2 }]. one can directly compute the roots of the characteristic equation p(\) = 0. because Aj =2i and A 2 = —2i.7) into (4. Example 4.2. Determine the stability or instability of the 0-solution of The roots of the characteristic equation of (4. The 0-solution of is asymptotically stable because the roots are At = -2+ i and \2Example 4. the 0-solution is asymptotically stable. Rather.2 = 0. One can compute the eigenvalues directly from the characteristic equation of (4. then (4. Consider the system . the 0-solution is unstable. = x and x2 = Xj. Consider the equation Let x.Stability methods: An introduction 69 of A in order to determine stability or instability.5.5). Example 4.4. but not asymptotically stable. and apply theorem 4.7) can be written as and the eigenvalues of the matrix are A. Example 4. Therefore. is stable.1.7) given by A 2 . The 0-solution of -2-i.4. Therefore.3. Example 4.1 to the characteristic roots. In view of remark 4. note that you need not transform (4.A .

x and x are n column vectors and h(x) is an n column vector with each element being a function of x. we only have one linearly independent eigenvector associated with A = 0.10) and suppose that h(x)/\x\ is a continuous function of x which vanishes for x — 0. If /i(0) = 0 then 4>(t) = 0 is an equilibrium solution of (4.10). Solve the equation for A = 0 to find that p} = 3p2/2 and p3 = -3p2. A is an n x n constant matrix. then the 0-equilibrium solution of (4. is it possible to deduce stability or instability for the 0-solution of (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.Ax. 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. Then (i) if the 0-solution of the linearized system x = Ax is asymptotically stable.10). Thus. To do this we need to determine whether there are 2 linearly independent eigenvectors for the eigenvalue 0.70 Differential equations. not much could be said about the stability or instability of the 0-solution of (4. This means that. Having analyzed in some detail the system x = Ax in (4.16) of theorem 3. stability and chaos in dynamic economics and compute the eigenvalues to find that A! = -7.10). Since zero is an eigenvalue of multiplicity 2. This eigenvector is of the form for c an arbitrary constant. Note that this latter assumption is motivated by (3. for which we would like to know its stability properties.2.10) is also asymptotically stable. Theorem 4. Theorem 4. A2 = A3 = 0. Consider h ( x ) of (4. the eigenvalue zero is not a simple zero and the 0-solution is unstable.1 states conditions for the stability or instability properties of the 0-solution of x .5.10). although A = 0 is of multiplicity 2.. Unless we put some restrictions on h(x).5 in the previous section. Therefore. Therefore assume that h(0) = 0 and also that h(x) is very small compared to x. we must determine whether or not it is a simple zero.1). .

Remark 4. Consider the system which can be expressed as in (4. the stability of the 0-solution of (4. the 0-solution of x = Ax is stable.10) have a real part that is nonpositive with at least one eigenvalue of A having a zero real part.6. .2. Example 4.5 of the previous section. Note that this theorem does not tell us what happens when all the eigenvalues of A in (4. The first part of this theorem can be proved in a way similar to theorem 3. Recall that if the condition just stated holds. the 0-solution of this system is unstable.5.2. should all the eigenvalues of A have a nonpositive real part with at least one eigenvalue having a simple zero real part. This cannot be claimed for the 0-solution of (4. Example 4. Proof.Stability methods: An introduction 71 (ii) if the 0-solution of x = Ax is unstable.10) is unstable. The eigenvalues of the matrix are ±1. by theorem 4. system Determine the stability of the 0-solution of the nonlinear Write this system as and note that the nonlinear term satisfies the hypotheses of theorem 4.10).2 is called the Stability Theorem in the First Approximation or the Principle of Small Oscillations. Theorem 4.10) cannot be determined from the stability of the 0-solution of the linearized system.1(i). the 0-equilibrium solution is asymptotically stable. Since the eigenvalues of the linear part are -2 and -3. then the 0-equilibrium solution of (4.10) by writing Observe that the 0-solution is an equilibrium solution and that the nonlinear term [ j^] satisfies the conditions of theorem 4. therefore. We will present a proof after we have developed the Liapunov method in the next chapter. Thus.7.

72 Differential equations. From (4. the system can become unstable. p. Therefore. Consider Note that (4. the 0-solution of (4. 77). On the other hand.12). This illustrates that the nonlinear part of the system can influence the stability of the entire system.12) is stable. Therefore by part (i) of theorem 4. p. 364) and Hahn (1967.14) has the same linearized system as (4. by slightly modifying the nonlinear part.13) observe that x\(t} + x\(t)->0 as f-»oo and x2l(t) + xl(t) < c. system The standard example to illustrate remark 4.1.12) is only stable. but with solution . although the linearized part in (4.11) given by (4. the system in (4.8. stability and chaos in dynamic economics Example 4.5 is the following presented in Braun (1978.11) is given by and the eigenvalues are ±i. The linearized system of (4. To study the behavior of the nonlinear part of (4.11) is asymptotically stable.11) observe that Integrate this last equation to conclude that where c = c\+c\.

16) are determined by the properties of the 0-solution of z — Az as presented in theorem 4.1. rewrite (4. approaches infinity in finite time. We close this section by connecting the stability results of x = Ax and x = Ax + h ( x ) .2. These ideas are illustrated in the next two examples. the 0-solution of (4. In turn. 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 4.14) is unstable.Stability methods: An introduction 73 where c — c]+cl is as before. x2) = (1.17) as The last system can be put in matrix form as . set and using (4.18) yields x = ( x 1 .2 respectively. with an equilibrium solution x.19). Therefore. Consider the two dimensional nonlinear system and note that its equilibrium solution is found by solving the system Solving (4.15) conclude that every solution *i(0.14). despite the fact that the linearized system in (4. Example 4.9. xi(t) of (4. From (4. such that x^(t) + x l ( t ) ^0. To study the stability properties of x^t) — 1 and x2(t) = 1. presented in theorems 4. the equilibrium properties of the 0-solution of (4. Recall from section 3 that given a system x =/(x).1 and 4. 1) as a unique equilibrium solution.12) is stable. to the stability analysis of an arbitrary nonlinear system x = f ( x ) .

A2 = (-3 -iV3)/2.21) as or equivalently. the 0-solution is asymptotically stable and the equilibrium solution Xi(t) = 1 and x2(t) = 1. as The eigenvalues of the matrix A = [2 Q] are ±2 and therefore the 0-equilibrium solution of z = Az is unstable.17) evaluated at the equilibrium solution.74 Differential equations. 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. in matrix form. Note that A is the Jacobian of partials evaluated at the equilibrium point. observe that the Jacobian is .24) is unstable and finally the solution x1(t) = 0 and x 2 ( t ) — 1 is unstable. Again.20) satisfies the hypotheses of theorem 4. Note also that the 0-solution is an equilibrium solution for (4. More specifically for (4.20) is the Jacobian of partials of (4. by theorem 4. Set and using (4.2. This example is slightly more complicated than the previous one.20).10.21). is also asymptotically stable. x 2 ( t ) .2 the 0-solution of (4.20) and that the nonlinear term of (4. stability and chaos in dynamic economics Observe that the 2 x 2 constant matrix in (4. Thus.1. Example 4.23) rewrite (4. obtain that Aj = (-3 + iV5)/2. Computing the eigenvalues of the linear part of (4. There are four equilibrium solutions: We first study the equilibrium solution x1(f) = 0.

Using the substitution (9. (5.1). (4. 5.4) of chapter 1.1) is equivalent to the system x = Ax where A is given by The foregoing analysis.2) or by finding the roots of the characteristic polynomial of (5. putting the four equilibrium solutions of (4. More specifically we can state: Theorem 5.25) we can determine the stability properties of the respective equilibria. = A2 = 2 and A. the first three equilibrium solutions in (4.2) or the roots of the characteristic polynomial of (5. The Routh-Hurwitz criterion describes a method for determining the stability of the nth order equation (5. = A2 = -2. For cases (b).1). We have already completed case (a) and concluded that it is unstable.Stability methods: An introduction 75 Thus. 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 ^0.1) without computing the eigenvalues of A in (5.25) becomes respectively with corresponding eigenvalues A = ±2. (Routh-Hurwitz criterion. can be used to determine the stability or instability of the 0-solution of the nth-order equation (5. and particularly remark 4.22) in (4.4 in the previous section. Therefore.22) are unstable and the fourth equilibrium solution is stable.) Consider the nth-order polynomial p(\) with real coefficients given by . A. (c) and (d).1 to jc = Ax with A as in (5.1.1) by applying theorem 4.

A unified theory of this classical problem and its variants is found in Coppel (1965. Remark 5. 16-22). The autonomous nth-order linear equation or the autonomous linear system . It is of some historical interest to note that the problem of determining how many roots of the polynomial p ( A ) in (5. stability and chaos in dynamic economics Assume without loss of generality that a0>0. Thus the real parts of the roots of 2A2 + 3 A +2 = 0 are negative and the 0-solution of (5. pp. or Gantmacher (1959).1.5) is asymptotically stable. pp.(2 • 0) = 6>0. Some results of the preceding analysis can be conveniently summarized as follows.3) have negative real parts was initially solved by Sturm in 1836. 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. 142-158). 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 (1967.1.76 Differential equations. Example 5. 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) . Solving 2A2 + 3 A + 2 = 0 directly we verify the result since Aj = (-3 + iV7)/4 and A 2 = (-3-iV7)/4. In 1877.

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

as t runs from 0 to 2n. or. The nonlinear case can also be studied using the insights obtained from the linear case..1. This state is. 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. the solution (</>i(0. if both eigenvalues of A are different from zero. cos t) traces out the unit circle x\ + x\=\. For two dimensional systems of the form of (6. This means that the origin x = 0 is the only equilibrium point of (6. X1. we now proceed to study the phase portraits of two dimensional linear systems.1. x = x2.5) with the assumption that det A ^ 0. The apparently more general case where h is a constant two dimensional vector. x2) phase space. 2 and x is a 2-dimensional column vector with elements x1 and x2. use the linearization method of sections 3 and 4 and recall that .5). It is no loss of generality to study the phase portraits of the homogeneous system (6.1 of this chapter is equivalent to the system obtained by making the substitutions x = x1. The solution 4>\(t} = sin t. </> 2 (0 = cos t is easily verified to satisfy (6.5). assume that det A ^ 0. equivalently. j = 1.78 Differential equations. unique if and only if the determinant of A is different from zero. stability and chaos in dynamic economics Example 6. the solution (sin /.5). furthermore. the solution describes a helix. can be reduced to (6. </>2(0) = (sin t. Throughout this section.-. as t runs from 0 to oo. Having made the above preliminary remarks. x 2 ). More precisely.5) by translating the coordinates. Dynamic economic analysis relies heavily on such a phase analysis. The second-order linear equation studied in example 3. Remark 6. Furthermore. Note that x — 0 is always a state of equilibrium of the system (6.4). while in the (xl. In the three-dimensional space (t. cos t) traces out this circle infinitely many times.with i. More specifically consider the linear system where A is a 2 x 2 matrix with constant coefficients a.

2.7). Phase analysis is an additional tool in the study of stability of differential equations that supplements the theorems already stated. suppose that we wish to study the stability or instability properties of the system x = Ax of (6. Remark 6. Having made the above three remarks. It can be shown mathematically that the transformation P amounts to. or compression toward. Remark 6. for two dimensional systems. However.1 of this chapter. as is the case with many economic models. we can also obtain important qualitative information by computing the eigenvalues of A and applying theorem 4. as a third possibility. 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. we assume that the system has already been transformed into canonical form.7) in the neighborhood of an equilibrium solution are very similar to the phase portraits of linear systems. where A is a 2 x 2 constant matrix such that det A ^ 0. For systems that cannot be solved explicitly.3. Thus. a rotation about the origin. then by letting y = x — 4>(t}. which nevertheless preserves the essential properties of the phase diagrams. In particular. Without solving x = Ax explicitly.7) as where A is a constant matrix and h(y) is very small compared to y. as was done in chapter 2. and to study the stability properties of its solution. we can write (6. phase analysis can be used to evaluate the qualitative properties of the model. some line through the origin. the effect of the transformation P is a distortion resulting from two mutually perpendicular expansions or contractions. Or. One way would be to solve explicitly this system by computing the exponential of the 2x2 matrix A. the transformation P does not change the character and essential properties of these portraits. we can compute the eigenvalues of A and refer to the phase portraits presented below.5). This reflection is followed by a stretching of the plane away from. and possibly another such stretching in a direction perpendicular to the first line. the phase portraits of nonlinear systems such as (6. This third method is the subject of the remainder of this section. Under these assumptions. . phase analysis supplements the methods described previously for solving such systems explicitly.Stability methods: An introduction 79 if (f>(t) is an equilibrium solution of (6. In discussing the possible shape of the paths of the system x = Ax. at most. or a reflection in a line through the origin.

The matrix A has a repeated real eigenvalue A. < A2: the origin is an unstable tangent node. which means that A does not have a zero eigenvalue and that the origin is the unique equilibrium point. 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. From remark 7. (i) Suppose A 2 < A ) < 0 : the origin is a stable tangent node.10). If cl — 0 and c2 ^ 0 we obtain the y2 axis with the origin deleted and observe that . The solution of this canonical form is Within this case we can further distinguish three subcases. This case can be divided into two subcases. If cl — c2 = 0 then (6. (iii) Suppose At < 0 < A2: the origin is a saddle point. (ii) Suppose 0 < A.80 Differential equations. See figure 3. then the trajectories would be tangent to the y2 axis. stability and chaos in dynamic economics Consider x = Ax of (6. < A 2 < 0 .2(a). if cl ^ 0 and c2 = 0 we obtain the _y. the motion along an arbitrary trajectory consists of an asymptotic approach of the point toward the origin. then we obtain the y2 axis with the origin deleted and note that y2-* ±00 as t^> oo.5) has two real and distinct eigenvalues A. . the trajectory in this case becoming tangent to the y^ axis at the origin. In this case A is similar to the matrix (a) in (6. When c^O and c2 ^ 0 then for any point in the first quadrant. Case 1. If cl = 0 and c2 7= 0 in (6.y^O as f-»oo. axis with the origin deleted and conclude that y} -» 0 as t -> oo. The matrix A of (6. we distinguish the following cases.9) as was indicated in section 7 of chapter 2.2(b) would be reversed. and A2.5) and recall the assumption that det A ^ 0. Case 2.1 of chapter 2.2(b). If A. Similarly. If A 2 < 0 < A 1 ? then the orientation of the trajectories in 3.10) yields the origin. This subcase is similar to subcase l(i) with the orientation of the trajectories being reversed. See figure 3. recall that A is similar to one of the four matrices Therefore.

2 .Stability methods: An introduction 81 Figure 3.

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. that y2 = (c2/c^yi. In this case its canonical form is matrix (d) in (6. if A < 0 the origin is called a stable improper (or degenerate or one-tangent) node and the phase portrait looks like 3.2(c). See figure 3.13) y1 and y2 tend to zero as t H> oo. see figure 3. provided c^O.12) given by In this subcase. in this subcase. since from (6. 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. then the origin is an unstable improper node.2(d) with the arrows reversed. stability and chaos in dynamic economics (i) Suppose the matrix A is diagonal. the phase portrait consists of straight lines y2 = (c2f c. then the motion moves away from the origin and the origin is called an unstable node or unstable focus.2(d). If A > 0. Then A is similar to matrix (b) in (6. If A > 0 .9) and the system can be written as .11) obtain immediately that y2/yi = ( c 2 / c } ) . or equivalently. Case 3. (ii) If the matrix A is not diagonal. The final case occurs when the matrix A has complex eigenvalues.82 Differential equations. then the motion moves towards the origin and the origin is called a stable (stellar or isotropic) node or stable focus. If A < 0. This means that. )yl passing through the origin generated as C1 and c2 take arbitrary values. then its canonical form is like (c) of (6.

the origin is called a center or a focal point. to get Substitute (6. Observe that in 3. Suppose that a < 0.2(f). then from (6. Differentiate (6.2(e).Stability methods: An introduction 83 To study system (6. Furthermore. if w > 0 the arrows point in the clockwise direction and if w < 0 . here r is the rate of change of the distance from the origin. then r is a constant.14) in (6. the origin is called a stable focus or a spiral sink since the trajectories are spirals which approach the origin asymptotically as t -» oo. The trajectories are circles centered at the origin. When a < 0. (ii) If a = 0.17). The solution of (6. r-> 0 and the phase portrait looks like 3.14) is now given in polar coordinates by the solution of (6.15) with respect to time to obtain Solve this system of equations for r and 0. 0) in terms of r and 0. 6 is the angular velocity about the origin.18) as t -> oo.2(f) with the arrows reversed. We can summarize the above results and connect them with previous analysis in two remarks.14). In this subcase. it is convenient to introduce polar coordinates. then either a < 0 or a > 0. If a > 0 then the origin is called an unstable focus or a source and the phase diagram is like 3.2(f) we assumed that a > 0 and w < 0. the phase diagram looks like 3. Let where r>0 and r-Vy2+y2.15) to conclude The last system expresses the velocity of a representative point in the polar coordinates system (r. (i) If a = 0.16) using (6. The latter is Two subcases arise immediately. .

There are systems that have no equilibrium solutions. stellar and improper) and foci are unstable. See Hale (1969. 0) = 0 for t e [0. but also the insights of phase portraits developed in this section. p. Show that the concepts stable and attractive are independent of each other. The 0-solution is asymptotically stable if it is stable and attractive. (2) Consider x=f(t. An example of such a system is (4) . The 0-solution is called attractive if there exists a number 60 = 6o(t 0 ) > 0 such that |x0|< 60 implies |o (t.5. See Hahn (1967.x) such that f(t. then the linearized part can be analyzed using not only theorem 4.> R n and consider x=f(t. Stable nodes (tangent. x0) | -> 0 as t -> oo. Saddle points and unstable nodes (tangent. 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.84 Differential equations.2. stellar and improper) and foci are asymptotically stable. oo). oo). x) such that f:[0. Remark 6. 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). 27).2.4. 7. suppose that the 0-solution is stable at t0. centers are stable but not asymptotically stable. 0) = 0 for t e [0. oo) x Rn -> Rn and f(t. Furthermore. If the nonlinear part satisfies the conditions of theorem 4. stability and chaos in dynamic economics Remark 6. t1 E [0. t0. oo). Miscellaneous applications and exercises Suppose f:[0. pp. Finally. Show that the 0-solution is also stable at t1 = t0. o o ) x R n .

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

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

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

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

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

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

To supplement this geometric meaning for n = 2. let y1. y2. x2) > 0 for x1. suppose that V(0) = 0.92 Differential equations. . The surface y = V(xl. V(x1. . x2) < 0 for xl. . a positive definite function V(x). How can this help us with issues of the stability of the 0-equilibrium of x = f ( x ) ? To answer this question. of a cup on a table. We have already given an intuitive geometric meaning of a positive definite V(x).1 . x e D with a negative semidefinite V(x) is usually called a Liapunov function. x2 in a neighborhood D of the origin and furthermore that V(x1. stability and chaos in dynamic economics The functions V(x) and V(x) play an important role in Liapunov theory. x2 in D. Actually. put in plain English. 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.

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

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

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

since V is continuous and S is compact. 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. Since D 0 nU is compact and V is continuous. Since X0 is chosen arbitrarily close to the origin.1. See figure 4. Thus x ( t l ) is on the boundary of D0 inside U. Some independent possibilities include: . V cannot become unbounded for x e 5. there is a ft such that x ( t ) leaves D0n U at time t1.96 Differential equations. Let X(t1) E d(D 0 nU).2. stability and chaos in dynamic economics Figure 4. Consider the system with f(0. Therefore. However. Example 2.2 This last equation says that as t increases V(x(t)) eventually becomes unbounded. we conclude that the 0-solution is unstable because no matter how close to the origin we start. solutions escape a bounded set D0 in finite time. 0) = 0. y). x ( t ) must eventually leave D0n U. But x(t1) cannot be on the part of the boundary of U inside D because by hypothesis V = 0 there.

assume that f(x. 6) observe that V(x) is positive definite and V(x) is negative definite and conclude from theorem 2.5 of chapter 3. V is negative semidefinite on D and by theorem 2. the 0-solution is stable. assume that f(x. assume that g'(0)<0. then this example reduces to example 2. y) is positive definite on D. More specifically. Third. Second.1. Example 2. First. This example illustrates the generality of the Liapunov method in deciding stability or instability.8 it is shown that the 0-solution is asymptotically stable using a specialized analysis.2 that the 0-solution is asymptotically stable. y ) plays a critical role. 6) of zero. Second. the eigenvalues of the linearization of (2. For example. The nonlinear system in (2. Let g(x) be a continuously differentiable real valued function on a neighborhood D = ( — 6. y) is positive semidefinite. Note that if f ( x .3 that the 0-solution is unstable. the 0-solution need not be asymptotically stable. For x E (-6. conclude by theorem 2. In example 4. that the 0-solution is stable but it is not asymptotically stable. in general.10) that the nonlinear part f ( x . suppose that f(x.8) cannot be studied conclusively by computing the eigenvalues of its linearization. Consider the autonomous system and make appropriate assumptions to study the stability properties of (2. Then. V is positive definite. It is clear from (2. if f(x. y) = 0 on D.11). . The analysis of this chapter illustrates the generality of the Liapunov approach. 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. y) = x2 + y2 is positive definite. y) = 0 on D.2 the 0-solution is asymptotically stable. assume that g'(0)>0. stability cannot be decided by examining only the linear system because the nonlinearities of the system may play a critical role in determining the stability of the whole system.8) can be computed to be ±i from which we can only conclude the stability of the 0-solution of the linear system.Advanced stability methods 97 First. Then V is positive definite on D. 6) and g ( x ) > 0 for x E (-6. It is shown there that with f(x. V is negative definite and by theorem 2. the three cases discussed here illustrate that. A special case is reported in example 4.0).2. y) is positive semidefinite on an open neighborhood D c R2 of the origin.8 of chapter 3 where f(x.3 let U = R2 and conclude that the 0-solution is unstable. However.12) and the assumption that g'(0)>0. Using (2. y) is negative definite in a neighborhood D of the origin. To apply theorem 2.

denoted by K.14) is multiplied by a positive constant A. Example 2. stability and chaos in dynamic economics Example 2. Consider the second-order equation which can be rewritten in system form as Assume that xf(x) > 0 for x = 0 and f(0) = 0.14) is called homogeneous of degree 1.L(t)). Investment is defined to be the time derivative of K(t). with 0 < s < l .f"(k) < 0. It is assumed that (2. In a later chapter. (2. the 0-solution of (2. lim k->0 + f'(k) = oo. stability issues of economic growth are presented in greater detail. In this example we establish the stability of the equilibrium solution of the neoclassical economic growth model.1. lim k->oo f'(k) = 0. From the homogeneity assumption obtain (note that the variable t is dropped) where k = K/L is the capital-labor ratio. If this property is satisfied.4. all at time t. K ( t ) denotes units of capital stock and L(t) denotes units of labor force. . L). then the dependent variable is also multiplied by the same constant.14) where Y(t) denotes units of output.3. (2. Equilibrium requires that investment must equal saving.14) satisfies the property: if each of the independent variables in (2. that is. Consider a production function Y(t) = F(K(t).f'(k)> 0. and saving is defined to be sF(K.98 Differential equations. Assume that f(0) = 0. Let Then Therefore by theorem 2.13) is stable.

Compute: In (2.2 the k*-equilibrium solution is asymptotically stable for k in a neighborhood of k*. By theorem 2.4.20) note that the inequality follows from the strict concavity property of f(k). A useful reference on this subject is the book of Burmeister and Dobell (1970).18) to obtain a unique positive equilibrium solution. Assume that and set k = 0 in (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.17) to derive the one-sector neoclassical differential equation of economic growth for the certainty case: Equation (2. Consider the system .15) through (2. V(x) is negative definite because k * f ' ( k * ) < f ( k * ) .Advanced stability methods 99 Assume that labor grows exponentially given by Under the above differentiability and concavity assumptions about (2. Denote the equilibrium solution by k* and use the Liapunov function where x = k .14).18) has been the subject of much research in economics. The importance of this system has already been emphasized in the previous two chapters. This concludes example 2. Actually k* is asymptotically stable for k>0. Solow (1956) used equations (2. Also. The next logical step in the study of the Liapunov method is the analysis of the linear autonomous system with constant coefficients.k*.

1. Proof. the 0-solution of x = Ax is asymptotically stable and from remark 4. 2. . by theorem 2.3 we need a Liapunov function. Also. Lemma 2.25) converges and thus B is well defined.2.23) is negative definite. 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.24). A has negative real parts there are positive constants K and a such that |e At | < K e-at. Let C be a positive definite matrix and suppose that B is a positive definite solution of (2. by hypothesis. Therefore.1 of chapter 3 we conclude that the eigenvalues of the matrix A have negative real parts. t > 0. Suppose A in (2. Then V(x) in (2.1.22) is positive definite and V(x) in (2. Recall that AT denotes the transpose of A and define Since.2 and 2. 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. stability and chaos in dynamic economics with A being an n x n constant matrix.21) is a real n x n constant matrix such that det A = 0. B is positive definite because by hypothesis C is positive definite. Thus the integral in (2. so that for any vector y € Rn. Conversely.100 Differential equations.25). suppose that the eigenvalues of A have negative real parts and let C be a given positive definite matrix. To apply theorems 2. y = 0. from its definition in (2.

B in (2. To apply the Liapunov approach let C = I. by theorem 4. = (2 • 1)-(1 • 0) = 2>0 we also conclude that the 0-solution is asymptotically stable.27) is also symmetric.5. Since a1 = 2>0 and a 1 a 2 -a 0 a 3 . The solution is Therefore. the eigenvalues of the matrix in (2. consider the Routh-Hurwitz criterion of theorem 5. In this example we reviewed two methods exposited in chapter 3 and the Liapunov method.26). Example 2. that is.2 the 0-solution is asymptotically stable. for instance. 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. Next.1 of chapter 3.Advanced stability methods 101 Finally. 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 . let C be the identity matrix and use (2. 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.24) since This completes the proof. Therefore. They are At = A2 = —1.1 of chapter 3. Note that since I is symmetric. B satisfies (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. Consider.

the following analysis is more than an illustration.10) of the previous chapter.3) of the previous section To determine that V(x) in (2.102 Differential equations. recall that a proof of theorem 4. Proof. From the hypothesis about W(x) for any given e > 0. Then is positive definite in a neighborhood of the origin. Put V(x) = xTBx and compute V(x) for (2.2 is pending. Let k = min |x|=1 Vp(x). Suppose that h(x) in (2. stability and chaos in dynamic economics Routh-Hurwitz criterion. Actually. it is a proof for theorem 4.28). Note that W(x) = o(|x| p ) as |x|->0 means that ( W ( x ) / \ x \ p ) . there is a positive. 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. we apply the Liapunov method of lemma 2.2 of the previous chapter. Lemma 2.21).29) is negative definite we need the following lemma. Let Vp(x) be a homogeneous positive definite polynomial of degree p.28) is the same as (4.2. . symmetric. and also let W(x) = o(|x| p ) as |x|-»0 be continuous. for any x = 0. Furthermore. Let I be the identity matrix which is positive definite and suppose that the eigenvalues of A have negative real parts. Then.1 to the equation Recall that (2. there is a 6 ( e ) > 0 such that if |x|< 6(e) we have | W ( x ) | < e|x| p .28) has continuous first derivatives in Rn with h(0)=0 and 6k(0)/dx = 0. using the definition in (1. The advantage of the Liapunov method becomes evident when.28). instead of considering a linear system as (2. Since Vp(x) is positive definite k > 0 and since Vp(x) is homogeneous of degree p. definite matrix B such that ATB + BA = — I.> 0 as |x|->0. 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.

28) obtain that By lemma 2. as follows. then we conclude.29) is positive definite in a neighborhood of the 0-solution of (2.28) arises from the linearization of the nonlinear autonomous system x = f ( x ) . the analysis beginning after (2.28). no eigenvalue of A has a zero real part and an eigenvalue of A has positive real part.31) for x as in (2.28) and by theorem 2. 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. Since (2.28) is unstable. Then (i) if all the real parts of the eigenvalues of the Jacobian f x (0) are negative. the 0-solution is asymptotically stable. Thus.2 the 0-solution is asymptotically stable. Theorem 2. we can restate theorem 4. x2) with x1 and x2 having the same dimensions as B1 and B2 respectively.2 part (ii) of the previous chapter. Example 2. V(x) is positive definite in a neighborhood of the 0-solution of (2.28) establishes theorem 4. which has just been proved.1 twice in the following manner. Consider the nonlinear system . 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. the 0-solution is unstable. on the other hand. assume that the matrix A is in Jordan canonical form. Computing V(x) of V(x) as in (2.2.Advanced stability methods 103 With the help of lemma 2. (ii) if some eigenvalue of the Jacobian fx(0) has positive real part. The first block A.3 the 0-solution is unstable. as in theorem 4. with two blocks. Therefore for the 0-solution of (2. If.29) is negative definite and by theorem 2.2.28). consists of all the eigenvalues having negative real part and the second block A2 consists of all the eigenvalues having positive real part. V(x) = xTBx is positive definite and V(x) in (2.2 of the previous chapter. as in section 5 of chapter 2.4. This way we can apply lemma 2. we conclude that —V(x) in (2.2. To establish this result without loss of generality. Define the Liapunov function where x = (x1.6. that the 0-solution of (2.

Using this terminology.5 we conclude that we can apply the Liapunov approach with C = I to solve for B given by (2.4(i).1. The same conclusion is also obtained from theorem 2.1. Although it is usually easier to compute the eigenvalues of A and use theorem 4.32) is asymptotically stable by theorem 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. the 0-solution of (2. stability and chaos in dynamic economics and study its stability properties. Therefore. Of course. p. we can rephrase theorem 4. both the eigenvalue method and the Liapunov method for systems such as (2. The same example can be worked out using theorem 4.29) to obtain From lemma 2.21) or (2.104 Differential equations.3. 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) = 0.32) choose as V(x) the following: To compute V(x) use (2.32) can be put immediately in the form of (2.34) is V(x)>0 for x = O and V(0) = 0. Also from lemma 2.2 of the previous chapter or theorem 2.2 is proved.2 of the previous chapter to obtain the eigenvalues of A and to check the properties of h(x).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. Note that (2.1 observe that B in (2.27) is positive definite so that (2. Hahn (1963.4 by saying that if the stability behavior of x = Ax is significant then for h(x) = o(|x|) the stability behavior .28) are connected by lemma 2. This example illustrates the usefulness of the Liapunov method in determining the stability properties of a nonlinear system.2. Remark 2.27). Therefore. for system (2.28) From the analysis in example 2.

Thus. l/c 22 ) apply the translation y 2 = x 2 (l/c 22 ).0) and ([c 22 -c 12 ]/[c n c 22 -c 12 c 21 ]. l/c 22 ) is unstable.c22> c12. therefore. . 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. y2) are positive on U n D . y2) = 0 on the boundary of U inside D. the equilibrium (0. y2) and V(x1. V and V are positive definite and therefore (0. 0). When the behavior of A is not significant. As was pointed out earlier. Before we can determine the stability properties of this system we need to find the equilibrium states. (l/c 1 1 . Let V(x1. 0) is unstable. when A has a critical behavior we cannot automatically deduce the stability properties of x = Ax + h(x). Then the closure of U contains the origin. x2. 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.7. 0) consider Note that for small values of xl.Advanced stability methods 105 of x = Ax + h(x) is also significant. 0). y2) = xl. V(x1. V(x1. Second. often times. cn > c 21 . for all (x. That is. [c11 .1 in this section where the nonlinear part plays a critical role in determining the stability properties of the entire system. By assumption x1 >0. (0. for the equilibrium (0. l/c 22 ). x2) = (0. Set x1 = x2 = 0 in (2.C 12 C 21 ])- First.{0}. for (0.c21]/ [C11C22 . (x1.. Recall example 2.36) to obtain four equilibria: (0. 0< c12< c22. it is called critical.y 2 ) sufficiently close to the origin we get that X1 > 0.X1> 0 and also that x2 > 0. Example 2.

Local stability for nonautonomous systems Theorems 2.0) = 0 for all f>0 and there is a positive definite function .2 and 2. 0). Also.3 of the previous section can be extended easily to nonautonomous systems. Therefore the equilibrium (z1.36) as with equilibrium (y1. This section collects the appropriate definitions and states theorems on the stability properties of nonautonomous systems.y2)->(0. For the fourth equilibrium point denote and apply the translation Using (2. A function V(t.1.37). oo) x D -> R is positive definite if V(t. solving det(AI-A). y2) = (0. x) is continuous in ( t . 2. z2) is stable. 3. The proofs are similar to the ones presented earlier. the only difference being that some attention is required to see that things happen uniformly in the time variable t. 0). are unique and also depend continuously upon initial data. rewrite (2. Several useful definitions are collected below.0) is unstable using an analysis similar to the second case. Definitions 3.38) in matrix form as in (2. Consider the nonautonomous system where f:[0. stability and chaos in dynamic economics Third.1.28) by writing Note that in this last equation the nonlinear term approaches zero as (y1.106 Differential equations. V(t. x):[0. Put (2. with A being the linear part of this last equation we obtain that the eigenvalues of A have negative real parts. Let D be an open subset of Rn that contains the origin. the equilibrium (l/c 11 . oo) x Rn -» Rn is continuously differentiable so that solutions exist. x ) .

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

) Suppose that there is a continuously differentiable. x):[0. (Uniform asymptotic stability. 198-204). x(t. This completes the proof. x):[0. x): [0. The interested reader can find these proofs in Hahn (1967. x ) < 0 so that V(f. x) < 0.1.1) is uniformly asymptotically stable. r] -»[0.2. The proof is similar to the proof of theorem 2.108 Differential equations.1.) Suppose that there is a continuously differentiable positive definite function V(t. 0) = 0 for all t > 0 we can choose 6 to be so small that if |x0| < 8 then V(t0. x(t. x) in (3. stability and chaos in dynamic economics Next we state theorem 3. x) > g(|x|) for 0 < | x | < r and t >0. To illustrate these theorems we present three examples. Theorem 3. Example 3.1. t0. Proof. decrescent function V(t. x 0 )) is nonincreasing with V(t. positive definite. t0. Theorem 3. For 8 thus chosen we conclude that | x ( t . t 0 .x) in (3. let g(x):[0. Theorem 3. Then the 0-solution of x = /(r. Then the 0-solution is unstable. x) is continuous with V(t. decrescent function V(t.) Suppose that there is a continuously differentiable. oo) x D -> R such that V(t.1 in the preceding section with additional attention paid to the variable t. Then the 0-solution of x =f(t. x ) > 0 with V(t. x):[0. oo) x D -» R such that in every neighborhood of the origin there are points x such that V(t. (Instability for nonautonomous systems. oo) x D -» R with V(t.x 0 )|< e because V(t. Proofs are similar to the ones presented in the previous section and are omitted.1) is stable.2. x ) > 0 . x) < 0. x0))<g(e) for t > t0. t0) such that if |x0|< d then | x ( t .3. Theorem 3. pp. (Liapunov stability for nonautonomous systems.x) positive definite. x0) < g ( e ) . We need to show that there is a 8 = 8 ( e . Then the 0-solution of x = f(t. The following three theorems summarize the stability and instability properties of the nonautonomous systems. positive definite. For the nonautonomous system . t 0 . x 0 )| < e for all t > t0. Using remark 3. oo) be a continuous function that is strictly increasing with g(0) = 0. Since V(t. (Uniform stability.1) is uniformly stable. oo) x D-> R with -V(t.4.) Suppose that there is a continuously differentiable decrescent function V(f. Let £ > 0 and t0 > 0 be given with e < r. such that V(t. x) in (3.

3) is with eigenvalues A1 = 0 and A2 = —1. We want to show that the 0-solution of the second order nonlinear equation is stable. x2) < 0. . Furthermore since the nonlinear part of (3.5) is stable.1. Suppose that a ( f ) > 0 and d ( f ) > 0 for t E [0. The linear part of (3.x2) in (3. It is given by Since V(f.4) is not decrescent. the 0-solution is stable for x in a small neighborhood of the origin.2).2 to conclude the uniform stability of the 0-solution because V in (3.3) can also be established using exercise 10 of the previous chapter.4) using (3. Example 3. oo). we conclude by theorem 3. observe that although V>0 and V<0 we cannot use theorem 3. xl.3) is bounded and foo e-t dt = 1 we conclude by exercise 10 that the 0-solution of (3. Furthermore.Advanced stability methods 109 consider the Liapunov function and compute the time derivative of (3.1 that the 0-solution of (3. It may be instructive to note that the stability of the 0-solution of (3.3) is stable.4) is positive definite and V(t. Let and compute Therefore by theorem 3. X1.3) is stable.3. Therefore (3.

it is relevant for the economic theorist to reflect on the relative importance of the various stability concepts. Actually. Actually. If b ( t ) > 0 then the 0-equilibrium is unstable. Use and compute If b(t)< 0 then the 0-equilibrium is uniformly stable. p. 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.110 Differential equations. The exposition of these theorems has been mathematical in scope and no emphasis has been given to an evaluation of the various stability properties. If b(t)<0 then the 0-equilibrium is uniformly asymptotically stable.8) of the previous chapter and is related to example 2. Consider the system reported in Hahn (1967. In economic applications it is not difficult to find reasons to argue that asymptotic stability is more important than stability. For example. Our goal is to illustrate that the analysis of dynamic economic models benefits from the methods of stability theory.4. how could such models be helpful in guiding the theorist's deductions and the policy maker's recommendations? Therefore. 204) Note that (3. 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. 4. suppose . As is mentioned elsewhere in this book. stability and chaos in dynamic economics Example 3. our study of stability is motivated by reasons that go beyond its intrinsic mathematical interest. uniqueness and stability properties of the equilibrium solution.1 of the previous section. unless dynamic economic models are analyzed for the existence.7) generalizes example (4.

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

For example imagine. However. This behavior implies that the 0-solution is globally asymptotically stable but not stable. 0. x 0 )|> e for values of t in some subinterval of [0.0 and x(0) = x0 From (4. To proceed with various results on global asymptotic stability we need some topological definitions and a lemma about the limit properties of orbits. . Therefore. if we choose x0= 1 then it is not true that x(t) in (4. to obtain which yields the solution for t . x0) grows rapidly before it decays approaching zero as t -» oo.4) that x ( t ) = 1 as t -> oo. for example. Here we give an example of an ordinary differential equation in which the 0-solution is locally asymptotically stable but not globally asymptotically stable. Consider which upon integration becomes Use the method of partial fractions from the theory of integration in elementary calculus to rewrite the last equation as Integrate this last equation from 0 to t. the 0-solution is not globally asymptotically stable.4) observe that as x0 is chosen close to the 0-solution. For x0 = 1 obtain from (4. no matter how small an x0 we choose. 0. then x(t)-> 0 as t-> oo and thus conclude that the 0-solution is asymptotically stable.3) conclude that x = 0'and x = 1 are the two equilibrium solutions of that equation. because for any given e>0.4) will approach zero as f-» oo. oo). the solution | o ( t . stability and chaos in dynamic economics Example 4.112 Differential equations. x). 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. local stability does not imply global stability. It is also true that global stability need not imply local stability.2. From (4. in the simple two dimensional space (t.

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

is a Liapunov function if V(x) is positive definite and its trajectory derivative V(x) is negative semidefinite for x e D. p). Recall from section 1.12) denotes scalar multiplication. The theorems that follow the Liapunov methodology rely on the concept of the Liapunov function. Observe from the definitions given that any orbit is an invariant set.5) if for any p e M. . reduce to conditions involving one of the two inequalities or where a dot in (4. n. that is. j = 1. . Recall that if x = [x1. . p) e M for all t e (-00. . In other words. Also. y n ] E Rn are n-vectors then the dot . Having introduced the concept of global asymptotic stability and made several essential definitions we are now ready to state and prove a few theorems.1. . Lemma 4.5) is denoted by and defined as w(y + ) Similarly.5). The properties of the w-limit set are summarized in the following lemma. stability and chaos in dynamic economics The positive limiting or w-limit set of an orbit of (4. a set M c Rn is called an invariant set for (4. The w-limit set of an orbit y of an autonomous system (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.10) with the only exception that t is replaced by -t. J ( x ) = [df(x)/dx] = [ d f i ( x ) / d x j ] . . x n ]e Rn and y = [y1. and w ( y + ) approaches 0 as f-»oo. the negative limiting or a-limit set is defined in the same way as (4.5) is closed and invariant. p. that a scalar function V(x):D<= Rn -> R. then o(t. where i. . . compact. 47). Finally. . 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. . if the positive semiorbit. oo). . The criteria for global asymptotic stability that make use of the Jacobian. connected and the distance between o(t.11) and (4. is bounded. y+.114 Differential equations. 2. These theorems follow either the Liapunov methodology or state conditions involving the Jacobian matrix J ( x ) of x=f(x) in (4. 0 E D. . then the w-limit set is nonempty. For a proof see Hale (1969.

Since x 0 is an w-limit point there exists a sequence { t k } . From the continuity of the Liapunov function we get that uniformly for t e [0. Theorem 4.13).Advanced stability methods 115 product or inner product or scalar multiplication is given by Most of the results that follow are relatively recent and have appeared in Hartman (1961). x 0 )|->0 uniformly for t e [0. From the assumption that V(x0) < 0 conclude that The continuity of solutions on initial data theorem 7.5) 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. Let f(x) of (4.1. 296-299) and LaSalle and Lefschetz (1961. e] as k-»oo. 56-71). We need to show that if x0 E w ( y + ) then x0 E{x: V(x) = 0}. However. Suppose that o(t) is a solution of (4. Then V(x 0 ) = 0.o(t. Thus it is proved that x 0 e{x: V(x) = 0}. and Markus and Yamabe (1960). Without loss of generality suppose that tk < t k+1 .15) yield for tk>0.x 0 |->0 as k->oo.1 of chapter 1 implies that if | ( o ( t k ) . In particular as o ( t k ) .* x0 for k->oo. where e > 0 is small. pp.14) and (4. with o(t k )->x 0 as k -» oo. 537-555). Hale (1969. suppose that V(x 0 ) < 0 and consider the solution o ( t . e].> V(xo) as k-»oo and from the fact that V<0 conclude that To show that V(x0) = 0. Hartman and Olech (1962). pp. tk->oo.5) for all t > 0 and suppose that x0 is a point of the w-limit set of o ( t ) that lies in D. this last equation is a contradiction to (4. Proof. then | o ( t . . From the continuity of the Liapunov function obtain that V ( o ( t k ) ) . o ( t k ) ) . x0) for 0 < t < e. This section draws heavily from Hartman (1964. (4. pp.

and if there exists a unique point x0 such that V(x 0 ) = 0. and strengthen the hypotheses by assuming that V(x) is a Liapunov function. this x0 is globally asymptotically stable. The hypothesis that V(x)-> oo as |x|-» oo implies that V [ o ( t . Remark 4.3.) Let f(x) of (4. p ) ] exists and because V(x)<0 we conclude that V [ o ( t . p ) ] < V[o(0. Remark 4. (Global asymptotic stability. f and V are continuously differentiable on the whole R" space and let V ( x ) > 0 . Then all solutions of x =/(x) exist on [0. under this added assumption. and the other assumptions about f and V imply that these bounded solutions approach the singleton {x0} as t-»oo. This is true because as in the proof of theorem 4. if M = {x0} then x0 is globally asymptotically stable. p) be a solution of x = f(x) for p e R". Thus. by hypothesis there exists only one unique point x0 such that V(x 0 ) = 0.2. all solutions exist on [0. p)= o (t. oo) and are bounded. The boundedness of solutions means that there exists an to-limit set in Rn which by the preceding theorem 4. Therefore. 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}. assume that {x0} = {0}. p)-» x0 which proves that x0 is globally asymptotically stable. Then we could conclude that the 0-solution is not only globally asymptotically stable but also locally stable from theorem 2. that is. However.2. V(x) < 0 for x e Rn and V(x) -» oo as |x| -> oo.p)]. Proof.1 of this chapter. 0. we conclude that independent of the initial point p e Rn all solutions o(t. 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 4.2.2. assume that {x0} = {0}.1. Again with reference to theorem 4. 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.2) imply local asymptotic stability. oo) and are bounded. by requiring that V is positive definite instead of positive semi-definite. Remark 4. {x: V(x) = 0} = {x0}. that is.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)>0.1 is a subset of {x: V(x) = 0}. Under the stated assumptions about f. In the preceding theorem without loss of generality. stability and chaos in dynamic economics Theorem 4.116 Differential equations. that is.2. Furthermore. Let o(t. V and V in theorem 4.

all together these hypotheses imply that. Then the 0-solution of x =/(x) is globally asymptotically stable. 298) let the Liapunov function V(x. Thus. These three assumptions imply that (1) V(x. 67-68) or Hale (1969.4. Consider the Lienard equation which can be written equivalently in system form as Following LaSalle and Lefschetz (1961.» oo as |x|->oo implies boundedness of solutions. V(x) < 0 for x = 0 and V(x) -» oo as |x| -» oo. We can also reason in the language of remark 4. y) be given by and its trajectory derivative is obtained immediately by Assume that (1) xg(x)>0 for all x = 0. and (3) Jo g ( s ) ds -> oo as |x|->oo. pp. Example 4. Remark 4.Advanced stability methods 117 for x = 0. the 0-solution is globally asymptotically stable. imply that all solutions are bounded and converge to the largest invariant singleton set M = {0}. independent of the initial condition x0e Rn at t = 0. therefore the 0-solution is globally asymptotically stable.3. y ) . x = 0. . V(0) = 0. p.> oo as |x|->oo. (2) f ( x ) > 0 for all x = 0.1 as follows: assuming V to be a Liapunov function such that V(x)->oo as |x|-»oo with V(x) < 0. the solution o ( t . x 0 )-»0. 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. this implies local asymptotic stability and the assumption V ( X ) .

2. positive definite matrix. Then the 0-solution is globally asymptotically stable. y) = (0. Proof.5) is continuously differentiable on the whole Rn space and f(0) = 0. Put and observe that such V is positive definite and V ( X ) .2 to conclude the global asymptotic stability of the 0-solution of x =/(x). symmetric positive definite matrix and let the Jacobian matrix J(x) satisfy for all points x = 0 and for all vectors y = 0. Observe that for V as in (4. symmetric.3 that the 0-solution is globally asymptotically stable.2 we also conclude that the 0solution is locally asymptotically stable. Theorem 4.11) and (4.1 we conclude that the 0-solution (x. or remark 4. from theorem 4. assume that A is a n x n constant. (Global asymptotic stability. 0) is locally stable. real.118 Differential equations.11) and (4. real.) Suppose that f(x) of (4.12). .22).20) in the calculation of V(x) and afterwards appeal to theorem 4.19) and (4.12) can be replaced by or by The theorems below make use of (4. stability and chaos in dynamic economics Therefore.2 we conclude that the 0-solution is globally asymptotically stable and from remark 4. Specifically.21) we can conclude from theorem 4. from theorem 2.3. Let A be an n x n constant. The next two theorems make use of the Jacobian of f(x) and involve trivial generalizations of conditions (4.> OO as |x|-»oo. Conditions (4. If it can be shown that V is negative definite using (4.

Actually.) Suppose that f(x) of (4.2 the 0-solution is globally asymptotically stable. Proof. Put (4.21) and the properties of the matrix A to conclude that if x = 0 and V(0) = 0. real.> OO. .24) into (4.23) to the desired result that V(x) < 0 for x = 0 and V(0) = 0. Theorem 4. Thus the 0-solution is globally asymptotically stable. observe the following: for 0 < s < 1 use the chain rule to write which by integration yields because f(0) = 0. (Global asymptotic stability. From (4. and from theorem 4. Since V vanishes at zero then f(0) = 0.Advanced stability methods 119 To go 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.4.26) conclude that V is positive definite and V-»oo as |x|->oo because |/(x)|-»oo as | x | . the 0-solution is also locally asymptotically stable. Let A be an n x n constant.5) is continuously differentiable on the whole R" space and furthermore suppose that |f(x)| -> oo as |x|-> oo.23) and use the hypothesis (4. Use as a Liapunov function and compute for x = 0 and V(0) = 0.

b) with the property that there exists a positive number a such that the distance between o(t) and the boundary of E denoted dE. 0. 548-554). d E ] > a. pp. x0) -> 0 as t -»oo. Suppose that f(x) of (4. Lemma 4. stability and chaos in dynamic economics To state the next global asymptotic stability theorems we need a definition and a lemma from Hartman (1964. The domain of attraction of the 0-solution of x =/(x). 0.o(0)| < 5 there is an increasing function s ( t ) . let Du ={x: | X | > u } and assume that holds for x e Du and all y e Rn. Theorem 4. 550-554). The next lemma and the theorem are due to Hartman and Olech (1962) and are reported in Hartman (1964). Suppose also that the 0-solution of x = f ( x ) is locally asymptotically stable. s(0) = 0 and for the right maximal interval of existence of w(t). .120 Differential equations. 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. pp. where / is continuously differentiable on a domain D.5 have found many applications in capital theory and several results are presented in chapter 9. Then there are positive constants 8 and K such that for any solution w ( t ) of x = f ( x ) with |w(0) .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. t e [0. t E [0. means the set of points x0 e D such that the solutions 0(f. s ( b ) ) the following holds For a proof see Hartman (1964. satisfies d [ o ( t ) . Then the 0-solution is globally asymptotically stable.5) is continuously differentiable on the whole Rn space with f(0) = 0 and f(x) = 0 if x = 0. Both lemma 4. b). 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.5.2. x0) exist for t > 0 and o(t. Also.

X E E* and (4. To compute (4. p. Suppose that /(x) of (4. 0. Markus and Yamabe (1960.27).32) start with . In particular w ( t ) E E* on its right maximal interval of existence.4. Let E* denote the open set obtained by deleting B ( u ) from the set E in lemma 4. is bounded in Rn and it approaches See Markus and Yamabe (1960. Then there exists a point XO E E* on the boundary of the domain of attraction of the 0-solution. Proof. 310) use the following example to illustrate theorem 4.29) for (4. Theorem 4.2 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 (4.28) holds for xeE*. Since the domain of attraction of the locally asymptotically stable 0-solution is open.2.6.5) is continuously differentiable in the whole R" space.B ( u ) . 0. b). Using lemma 4. y) E R2. This is a contradiction of the fact that x0 is on the boundary of the domain of attraction of the 0-solution. c2 such that Then each solution o ( t ) of x=f(x) the critical point as t->oo. The proof makes use of lemma 4. From hypothesis. 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). Let o(f. pp. that is E* = E .6. f ( x ) = 0. 309-310).Advanced stability methods 121 Proof. Example 4. dE*]> a on the right maximal interval [0. Consider the system for (x.2. x 0 ). Assume that each eigenvalue of is negative and also that there are positive constants cl. x0) of x =f(x) be such that d [ o ( t . Suppose that the 0-solution is not globally asymptotically stable.

6 every solution approaches the unique critical point as t -> oo.2 and remark 4. Therefore. Economists have used these results as subsequent chapters illustrate.6. y) observe that Use the computations of (4. Remark 4. Here we present one typical result that is the direct analogue of theorem 4. symmetric matrix B so that (4. Remarks 4. Chetaev (1961) and Zubov (1964) summarize these theorems which follow the Liapunov methodology and appeared in Russian journals during the 1950s.33) in (4. For detailed bibliographical references see Hahn (1963).34) Therefore.29) which considers a constant. (4. Numerous theorems exist that establish the global asymptotic stability of nonautonomous systems. |det M| > 4. positive definite.33) conclude that |trace M| = 6. Russian mathematicians such as Krasovskii (1963). From (4. Furthermore.5. Barbashin (1970).122 Differential equations. Markus and Yamabe (1960) state and prove a theorem that is more general than theorem 4.3. They use a condition more general than (4. All the results in this section refer to global asymptotic stability of an autonomous system. computing the characteristic polynomial of M(x. by theorem 4. Actually.6. . Hartman (1961) further generalizes JTB + BJ by considering a nonconstant matrix B.29) is generalized to M = JTB + BJ.35) and apply the Routh-Hurwitz criterion to conclude that the eigenvalues of M are negative.31) are satisfied. stability and chaos in dynamic economics and obtain where as before JT denotes transpose of J. The interested reader is referred to these two papers for further details. there exist constants c1 and c2 so that (4.30) and (4.

Finally. x):[0. we also need the equivalent of V(x)-»oo as |x|-»oo used in this section.Advanced stability methods 123 In addition to the definition given in the previous section about V(t.3 of the previous section we conclude that the 0-solution is locally uniformly asymptotically stable. So it remains to be shown that the domain of attraction of the 0-solution is the whole Rn space. Theorem 4. use the property that V(t.8. x) is negative definite. 0) = 0 for all t > 0 and there exists a continuous function U(x): Rn-> Rn with U(0) = 0. x) in (3. Suppose that the 0-solution is the only equilibrium of the nonautonomous system x = f(t. oo) x Rn -> R to be radially unbounded if V(t. x) =» U(x) for all t > 0 and all x E Rn. y) e R2.f21. U(x) -> oo as |x| -» oo such that V(t. x) is radially unbounded to show the boundedness of solutions. oo) x Rn -> R such that V(t. x) being positive definite and decrescent. The first one is due to Markus and Yamabe (1960) and the second is due to Olech (1963).f22 vanishes identically in R2. We close this section with two theorems about the global asymptotic stability in the plane. 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. Also suppose that there exists a continuously differentiable.f 2 are continuously differentiable for all (x. decrescent. Proof. positive definite. assume that one of the four partials f11. x) given in (3. and radially unbounded function V(t.7. x):[0. Theorem 4. Then the 0-solution is globally asymptotically stable. U(x) > 0 for x = 0. We define a continuous function V(t. and use the fact that V is negative definite to conclude that bounded solutions converge to the 0-solution. .2). and V(t. Then the 0-solution is globally asymptotically stable. To do this. Consider the two dimensional system and assume that f1. From theorem 3.1) and suppose that f: [0. oo) x Rn -> Rn is continuously differentiable.f12.

f 2 are continuously differentiable for all (x. then this assumption with (4. Indeed. 311-314). stability and chaos in dynamic economics Proof. characteristic roots with negative real parts (as assumed in theorem 4.124 Differential equations. pp. Olech's theorem 4.40) or (4. Example 4.5.f21. if any of the four partials f11.40) or (4. at each point in R2. (4. Thus.39) to obtain that the Jacobian of (4.37) satisfies Furthermore. y ) in (4.38) and (4. tion of To determine the global asymptotic stability of the 0-solu- compute (4.0) = 0 and also suppose that the Jacobian matrix J ( x .8 and 4.36) and assume that f1. Proof.41): Thus.41) to establish that the 0-equilibrium solution is unique. See Olech (1963.39) implies (4. Theorem 4.y)e R2 as assumed by Markus and Yamabe.f vanishes for all (x. the 0-solution is globally asymptotically stable.9 are closely related..8 by Markus and Yamabe. (4. Together these facts imply global asymptotic stability.39). pp. assume that either or Then. Suppose that f1(0. y) e R 2 .38). See Markus and Yamabe (1960.8) and then employs (4.38) and (4.9.0) =f 2 (0. Observe also that theorems 4. .f12.41).40) or (4.36) has. the 0-solution is globally asymptotically stable.9 contains theorem 4. Olech uses conditions (4. Consider the two dimensional system in (4. For an extension of Olech's theorem see Meisters and Olech (1988). 390-394).

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

More specifically the following holds. .1) satisfy the assumptions stated above and let k eigenvalues of A have negative real parts and n — k have positive real parts. See Brauer and Nohel (1969. The analysis is local.> 0 as t -> oo. (ii) there exists an n > 0.x) of (5. 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. sufficiently small such that any solution x ( t ) near the origin but not on S at t . To repeat. See Coddington and Levinson (1955. Proof. (Stable manifold. 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. x) space.t0 cannot satisfy | x ( t ) | < n for t > t0.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. and Irwin (1980) discuss in detail the stable manifold theory.) Suppose that the n x n matrix A and the function h(t.1. in a sufficiently small neighborhood of the 0-solution. stability and chaos in dynamic economics there exists a 6 >0 and T>0 such that Although the system described by (5. p. 6.1 to be an n x n noncritical. The books by Carr (1981). real matrix we distinguish between k eigenvalues with negative real parts and n . pp. The special cases k = n or k = 0 refer to asymptotic stability and instability.1) with the assumptions just stated seems more general than the two dimensional phase portrait 3. 330-333).1) starting on S at t = t0 for t0 sufficiently large. around a small neighborhood of the 0-solution. Guckenheimer and Holmes (1983). Theorem 5.2(b).x).126 Differential equations. 205). Having assumed A in 5. in the (t. Miscellaneous applications and exercises (1) For the system use the Liapunov function V(x) = x2 to determine the stability properties of the 0-solution. the intuition is similar. satisfies x ( t ) .

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

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

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

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

p. Without further ado. 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. consider the following optimal control problem subject to measurable. This raises the question of stability: under a slight perturbation will the system remain near the equilibrium state or not? LaSalle and Lefschetz (1961. this chapter presents results obtained primarily by mathematical economists since the early 1970s.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. . Introduction This chapter surveys various stability results of optimal control and indicates some possible areas of their application. Unlike previous chapters where most of the results reported have been obtained by mathematicians several decades ago.

The choice of T to denote the terminal time.1) is chosen as the vehicle of explanation of the results in this chapter because it is described in Arrow and Kurz (1970. the problem becomes: subject to Note that sup in (1. Problem (1. 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. and x0 is the initial position of the state vector at time 0. The objective is to maximize subject to equations (1.5) denotes supremum which is taken over all instrument functions V ( .p>Q is the discount in future utility. x ( t ) is the state vector at time t. stability and chaos in dynamic economics where U is the instantaneous utility. which is usually taken to be the set of all measurable v ( • ) or the set of all piece wise continuous v( •). T is the planning horizon. v(t) is the instrument vector at time t. there is a function h(x) such that . that is.2) and (1.132 Differential equations. denoted by v * ( t ) . under strict concavity assumptions on U(. let Then. chapter 2). To specialize problem (1. is of the time stationary feedback form. the optimal v ( t ) . the technology function and transpose should not cause any difficulty because it is rather standard in the literature. t is time.). As pointed out by Arrow and Kurz.1) somewhat. W is independent of t0.) and T(.3) over some set 0 of instrument functions. ) E 0. and.

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

These assumptions are placed on problem (1. i = 1. n). 2. The next few pages summarize the fundamental work of Magill (1977a) on the stability of the linear quadratic approximation around a steady state solution of (1. The linear quadratic approximation at a steady state (x*. the local results of Magill lead naturally to the global results of Cass-Shell. These results go far beyond the simple checking of eigenvalues that most people associate with a local analysis. respectively. . and Brock-Scheinkman. . The linear quadratic approximation of equation (1. . v*) = (x*. . . where The symbols all evaluated at (x*. Furthermore. stability and chaos in dynamic economics exists and is unique for each x0 » 0 (note that for x e R". v*) for the general problem (1.134 Differential equations.8) at a steady state x* is subject to measurable. . Furthermore.5).5) to avoid many tangential technicalities and are maintained throughout this chapter. Rockafellar. 0). . n) and is interior to any natural boundaries (this means that x f ( t ) > 0 for all t > 0. . 2. x » 0 means that xi > 0 for i = l.5) is presented in the next section. it is assumed that / is twice continuously differentiable and that the optimal plan is one with piecewise continuous time derivatives. which are discussed below. .

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

viz.5) if the engineers had focused on the case p>0 instead of the case p < 0. let us use the OLRP to explore the determinants of L. p.1). allows results for the case p = 0 (the bulk of results on the OLRP) to be carried over directly to the case p > 0. Fortunately.1) to economic problems. Before plunging into statements of formal theorems. stability and chaos in dynamic economics becomes the same problem as equation (2. The importance of observing that equations (2. 41)).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.S. Assume that the matrix is positive definite in order to reflect the concavity of U(x. the paper by Magill (1977a) fills this gap. Results on the OLRP are applicable. First. p. used by Magill (1977a) and Anderson and Moore (1971. Such an approach would virtually resolve the local asymptotic stability question for problem (1.A. n(t) may be replaced by in equation (2.136 Differential equations. provided that the question of sufficient conditions for the validity of the linear quadratic approximation is resolved for problem (1. The following is based upon Magill (1977a).1) and (2. but brevity demands that many of his results be passed over. problem for economic problems with p > 0 for two reasons. The constraint in equation (2. Second. v).A. the OLRP suggests an important class of Liapunov functions upon which several theorems below will be based.2).5) to the L. the minimum from £0 itself (Anderson and Moore (1971. This transformation of variables. 53). .2) becomes where / denotes the n x n identity matrix.S. e(t). leading to the negative definiteness of the matrix in economic problems. The minimum is a positive definite quadratic form £oP£0 under general assumptions (see Anderson and Moore (1971)).

equation (2. If n(0) is administered today. and Magill (1977a). Then in the one dimensional case. If |G|.5) is unstable if and only if equation (2. and stability will not be affected. p.5) to explore when instability may be likely. Following Anderson and Moore (1971. Defining the OLRP (2. Without loss of generality we may assume G > 0.Stability of optimal control 137 When is the OLRP equation (2.2) unstable? First. Let us use equation (2. However. The intuition behind this is quite compelling for. inputs n(t) cost n T ( t ) R n ( t ) to administer. the absolute value of G. Change units to reduce the problem to the case 5 = 0. and the larger p is.2) with S = 0 becomes subject to Clearly. and Q-SR . Note that since the left hand side of (2. the system is unstable. . To sum up in words: why stabilize a highly unstable system (large F) when control input is ineffective (small |G|).2) is unstable. 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. put S = 0. if F is positive. the larger R is. put n2= -n1. the smaller |G| is. the smaller Q is.4) is positive definite.1 S T are all positive definite. we see that instability is more likely the larger F is. Consider the one dimensional case. R. For if G < 0. then £ ( t ) Q e ( t ) will be smaller in the next instant. But the future is discounted by p. 47). Q. is small then a lot of input n(t) must be administered in order to have much impact on g(t).

Hence. a theorem to be proved below will show that G. The paper by Magill (1977a) develops a rather complete set of results for all p. provided that A>0. Let us apply our intuitive understanding of the determinants of G.A. Sufficient conditions for G. For S > 0. of the OLRP are covered in detail in Anderson and Moore (1971. ambiguity is obtained in this case.A.A.1 ST larger and makes smaller. and -f*xx+f*xvf*-1~f*xv is small (it is positive by concavity of f). because a decrease in S makes F — GR . G. or else the integral will blow up. instability of A which is related to its lack of symmetry makes instability of the optimal path more likely. instability at x* is likely when p is large. still holds.S. an increase in S makes the underlying system matrix. however. Note that when F = 0 and S = 0.138 Differential equations. smaller (a stabilizing force). stability and chaos in dynamic economics It is clear from equation (2. chapter 4) for the case p < 0.S. .5).A. in the one dimensional case. If S — 0. gained from the OLRP to the linear quadratic approximation (1. is intuitive from the existence of a finite value to the integral and the positive definiteness of the matrix Roughly speaking. (x*(t). In the multidimensional case when p<0. roughly speaking. v*(t)) must converge to 0 as t-»oo.5) that when S < 0 a decrease in S is destabilizing.9) to the neoclassical model of investment (1.S. v)). This is so because.-f*vvis large (it is positive by concavity of f in (x. but R--1STbecomes smaller (a destabilizing force). since 0 is not a stable matrix.8). the underlying system matrix is not stable. Here By the reasoning above from equation (2.S. It is known that instability in the multidimensional case is related to the amount of asymmetry in the underlying system matrix.

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

given by equation (2. and asking that V1 > 0 is simply asking that the increases when the minimal cost is calculated Anderson and Moore (1971). Roughly speaking. Here we are concerned only with their stability analysis.2) and (3. they take the time derivative of V1 along solutions of equations (3. since the state-costate equations (3.S. Such a Liapunov function was used earlier by Samuelson (1972a) to eliminate limit cycles in the case p = 0. Cass and Shell formulate a general class of economic dynamics in price-quantity space which includes both descriptive growth theory and optimal growth theory. n). Thus.A. the costate q*(t) in equations (3. Stability results based on V. Here. The second Liapunov function is given by minimal cost fall as time at £*(t) for each t. P is positive semi-definite when the integrand is convex in (£.3) for the OLRP is given by Thus. analysis in economics.3) are linear. More specifically. The minimum cost.3) that satisfy . and Magill V1 is the basic Liapunov The next two sections report stability results based on these two Liapunov functions. stability and chaos in dynamic economics It is important to interpret the meaning of V1 for the OLRP. Furthermore. See Sivan (1972). x* = q* = 0.140 Differential equations. Cass and Shell (1976a) and Rockafellar (1976) were the first to recognize that V1 is of basic importance for G. there is a matrix P such that Also. is quadratic in £0 and is 0 when £0 = 0.2) and (3. Kwakernaak and (1977a) for a more complete discussion of why function in the OLRP literature. 4. C(£0) = -W(£0).2).2) and (3.

oo) allow them to prove that the steady state solution x* is G. More precisely: Theorem 4.3) and if equation (4. x * ( t ) ) for some t >0. x) is concave in x Convexity in q follows from the very definition of H°.3). v).1). then Proof.x) = ( q * ( t ) . Note that if U.2) implies Thus. Also (S) is the same as Cass and Shell (1976a) also prove the following useful theorem. x ( t ) ) of equations (3.A.2. x) is convex in q and concave in x. in the set of all solutions of equations (3. there is a 8 > 0 such that \x — x*\ > e implies Then if (q*(t). x * ( t ) ) solves equations (3.) For the case p>0 assume that for every e > 0.S.Stability of optimal control 141 and interpret the economic meaning of the assumption They show that equation (4. only a slight strengthening of equation (4. T are concave in (x. Assume that H°(q. It should be noted that (S) is only required to hold on the set of (q. x) such that (q.2) and (3. .2) and assumptions sufficient to guarantee that x*(t) is uniformly continuous of [0.1.2) and (3. See Cass and Shell (1976a). That is. Then for any solution ( q ( t ) .3) that satisfy equation (4. See Cass and Shell (1976a). then it is trivial to show that H°(q. Proof.2) and (3.1) holds. Theorem 4. (Cass and Shell (1976a).

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

These results are developed rapidly with primary emphasis on contrasting them with the other theorems reported in this chapter. x ( t ) ) .2) and (3. A more precise statement of theorem 4. 1977a).Stability of optimal control 143 Proof. Theorem 5.3 is given in Rockafellar (1976) who works with a more general system. 1977a) based on the Liapunov function V2. Stability results based on V2 In this section we summarize the stability results of Brock and Scheinkman (1976. Then Let (q*(0).2) and (3.q ( t ) T x ( t ) along solutions of equations (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. 5. Differentiate the Liapunov function V2 = . See Rockafellar (1976).1.3) to yield where and where / denotes the n x n identity matrix and the matrices of partial derivatives H°gg _ H°xx.3).3) that correspond to optimal paths.2) and (3. provided that . The basic idea of the proof is just to show that (R) implies along solutions of equations (3. We will return to some of the Brock and Scheinkman results in the next chapter where their applicability to capital theory is demonstrated. The following sequence of theorems summarize the results in Brock and Scheinkman (1976.

oo) -> R.1). Put V1(q. x*). if (q*( •). Note that theorem 5.5) holds automatically. x) = (q*.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. The rest is a standard Liapunov function stability exercise. The second part of the theorem is just a standard application of results on G. x) = -(q -q*)T(x-x*) and use (b) and (c) to show that V1(q. Remark. Proof. x*( •)) is bounded independently of t or if then there is a stationary solution (q*.3) such that Proof. x*) as t-»oo. implies (c) For all w = 0.2.144 Differential equations. x*) is the unique stationary solution of equations (3. Inequality (5.2 gives a set of sufficient conditions for the Cass and Shell hypothesis. x) < 0 for (q. (b) For all (q. Then all solutions of (3.2) and (3. x*) of (3. and equation (5. If (a) (q*. wTB(q*. given a function y( •): [0.3). .A.3) is obvious from equation (5. Here. Theorem 5. x*).3) that are bounded for t >0 converge to (q*.2) and (3.2) and (3. by means of Liapunov functions. Assumption (5. lim sup y ( t ) denotes the largest cluster point of the function values y ( t ) as t -»oo. x) = (q*.S. x*)w>0. Thus. stability and chaos in dynamic economics where Furthermore.

x*) is the unique stationary solution of (3.x*). to be locally B-quasi-concave at XO E Rn if for all w e Rn.A. w = 0.3).Wxx( •).7) holds for optimal paths. For if W( •) is concave and W x ( . in some sense.x)-pqx is B-quasi-concave along ( q * ( t ) .2) and (3.) in the last line exposes why the Liapunov function.q * ) T ( x .x) is locally a-convex-B-concave at (q*. Benveniste and Scheinkman (1979) provide a set of very general conditions on equation (1. We define a twice continuously differentiable function f: Rn-> R. Then (g*.( q . Also note that boundedness of ( q * ( t ) . 548) to the system equation (5. x * ( t ) ) may be dispensed with provided that one assumes and refines the Liapunov analysis or one assumes that W x ( .2 are. . . p. x * ( t ) ) where 4aB > p2.3. ) exists. Theorem 5. Let (q*(t). ) exists. This is an adaptation of Hartman-Olech's theorem in Hartman (1964.1 and 5. (b) (q*. x*) is G. 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. Assume (a) H° is twice continuously differentiable.Stability of optimal control 145 to hold. Assume that W x x ( . complementary since each asks that Q be positive definite in directions which are transversal to each other.x) is locally a-quasi-convex and H°(q.3) that corresponds to an optimal path.x * ) is natural. and (e) H°(q.S. (c) x* is a locally asymptotically stable solution of the reduced form system (d) H°(q.8) with their G( •) = . then The use of W x ( .5) that imply that Wx exists and that (5.2) and (3. ) exists and is negative definite on Rn+. Proof. Theorems 5. x*(f)) be a solution of equations (3.

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

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

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

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

the G.Also assume that W x ( .3) that correspond to optimal paths. Theorem 7.2 may be sharpened in this way. See Brock and Scheinkman (1977a) for details and some extensions of theorem 7.) exists. equation (7. and especially for problems where H°qq is independent of (q. See Brock and Scheinkman (1977a) for a wide class of investment models where equation (7. 4.2) and (3. but the production function is not necessarily quadratic. for quadratic problems.7) is applicable. 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. However. Obviously. We may now state the following theorem. Recall from chapter 4 that M is future invariant under x = f(x) if for each x0e M the solution x(t. so that qTx < 0 along solutions of equations (3.1. Let q( •).150 Differential equations. This term is hard to grasp. Problems where H°qq is independent of (q.1. test (7.S.1 would be very nice if the term H°qq did not appear. ) . x( •) be a solution of equations (3. x) arise in neoclassical investment models in which the adjustment cost function is quadratic.2.3) suggests choosing Thus.1 and 5.1. x0) starting from x0 stays in M for t > 0.3. stability and chaos in dynamic economics Assuming Wxx( •) exists and is negative semi-definite. theorems 4. Here . 4.7) is useful.7) to the OLRP. Theorem 7. 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.2) and (3. 5.A. x). Let us apply equation (7.3) such that Assume along x ( .

S. (Magill (1977a). assume that is nonpositive definite.A.S. independently of p.A.S. by theorem 7. Theorem 7. since under Magill's hypotheses.) Assume that are negative definite.A.2.1. . then the OLRP should be G. The Liapunov function V4 Consider the Liapunov function. This is in accord with our intuition that.A. Put Then. This brings us to one of Magill's (1977a) nice results for the OLRP. if F is a stable matrix. tests mentioned above make use of H°xx in a way that parallels H°qq in theorem 7. 8. Magill (1977a) shows that implies the following The rest is standard. None of the G.8) put G = I. Furthermore. then since R > 0 by convexity of the objective. Proof. Then If R and F are one dimensional. We state it for the case of certainty only.1 regardless of the size of p and Q.Stability of optimal control 151 To get some understanding for negative quasi-definiteness of equation (7. S = 0. we see that F<0 implies G. Then G. holds for the OLRP.S.

The right hand side of (8. Then since qTx< 0. a<0 to get V4< 0 for all t > 0. therefore.1) is derived by differentiating V4 along solutions to equations (3. stability and chaos in dynamic economics which leads to the following: find sufficient conditions on H°(q. One useful sufficient condition for V4 < 0 that emerges from this approach is holds along the solution ( q ( t ) . x ( t ) ) to equations (3. Relationship (8. which is equation (8.2) and (3. b > 0 such that 2b + ap > 0.1).3). just put 6 = 0. Suppose that A ( A ) > 0 . x ( t ) ) . Here A(A) denotes the largest eigenvalue of (A + A T )/2 and A the smallest. t E [0. is when B is not positive semi-definite and A is not negative quasi semi-definite for all t > 0. we then get V4 < 0 for all t > 0 by putting a = 0. Grouping the terms common to qTx in V4. x ( t ) ) . Note that the first line of V4 is just so if B is positive semi-definite along ( q ( t ) . if A = H 0 . . for particular choices of a. x ( t ) ) and if we assume that q T x<0 along optimal paths. The only case where we can get a new theorem. oo). b E R. choose a < 0.3).152 Differential equations.1 H 0 q x + (H 0-1 qq H 0 qx ) T +(H 0-1 qq ) is negative definite along ( q ( t ) .2) is nonpositive provided that However.2) and (3. for t > 0. Therefore.x) such that V 4 <0 holds along ( q ( t ) . Similarly. b > 0.

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

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

A. the matrix equation See Magill (1977a) for this easy derivation and a discussion of the properties of the Riccati quadratic matrix equation (9. given any differential equation system (9.2) that generates optimum paths that lie arbitrarily close to the solution trajectories of equation (9. assume that S = 0 in equation (2. even when the rest point is L. Still. to get G. Without loss of generality.A.5) for all concave U. Thus we must go to the two dimensional case in order to construct a counter-example. Thus. where g(t. n = q to ease the notation.2).2) starting from £0.S. G. It should be pointed out that there is a close relationship between uniqueness of the rest point and G.3) can be generated by optimum paths to problems of the form (9. The uniqueness of rest points is comprehensively studied in Brock (1973) and Brock and Burmeister (1976).S: Obviously.3). and unique. In economic applications more information on F is available.S.S. In other words. The heuristic argument given above suggests that anything generated by equation (9.S. For the one dimensional case.A.A.3) we should be able to construct a problem (9. t -> oo for all E0. We may assume F(x) is concave in x. rest point but are not G.A.Stability of optimal control 155 (7) Here |A| denotes a norm of the matrix A. a lot of phenomena may be generated by systems of the form x = F ( x ) with F concave.2). £0) denotes the optimum solution of equation (2.S. cannot hold when there is more than one rest point.3) for F concave is possible. £o) -> 0. for example. Now the system . An obvious example in the plane is concentric limit cycles surrounding a unique L. it appears that strong additional hypotheses must be placed on the Hamiltonian. An important research project would be to classify the class of optimal paths generated by problem (1.A.S.5).A. T. Put £ = x. rest point. The Hamilton-Jacobi equation generates. This suggests that any behavior that can be generated by systems of the form (9. it is fairly easy to show that F < 0 implies e(t. letting W(x 0 ) = xTWx 0 be the state valuation function of equation (2. There are many systems x = F ( x ) that possess a unique L. above and beyond convexo-concavity.2).

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

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

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

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

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

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

increasing returns prevail in the power industry. it does not generate the correct mechanism for choosing between them. economic actors must engage in some type of joint centralized approach to the control of investment in order to achieve a Pareto optimum. it is jointly concave. stability and chaos in dynamic economics The central finding that the decentralized regulatory institutions fail to generate Pareto optimal competitive equilibria. First best regulatory modes in a two sector model This section proceeds rapidly because we reinterpret existing literature. g(0) = 0. g'(0) = 0. They must coordinate their planned paths of investment. g'(x) > 0 for x> 0.162 Differential equations.O. The optimum planning problem is Here. that is. It is the assumption that commissions and their firms face interest rates parametrically. g'(oo) < 0. increasing in both arguments and satisfying right and left hand Inada conditions. and g is twice differentiable.C. The economy's freely shiftable capital stock x is allocated between power production and capital goods-consumption goods production. g(x) is convexo-concave. overlapping generations. Power production is convex increasing. But this requires a degree of centralized planning that does not prevail in mixed economies.1. satisfied by the same two trajectories and rest points as the optimum planning problem. 2. is likely to remain in more complicated setups with heterogeneous consumers. Put We assume A2. The function g1 is neoclassical. Even though the equilibrium interaction between interest rates and increasing returns generates F. multiproducts and uncertainty since these complications require even more markets to achieve the same degree of coordination. We analyze a two sector abstraction that is analytically tractable and generates a Skiba-like phase diagram under plausible assumptions. that is. Hence. .N. g1 is output of capital and consumables. The central cause of the failure of decentralized institutions is easy to explain. Function g2 produces power which is needed as input into gt.

1) may be restated thus: put The Euler equation and material balance equation are given by Figure 6.1 . Obviously the planning problem is a Skiba problem.3) the optimal planning problem (2. 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(. We digress to describe Skiba's results.1. Digression on optimal growth under convexo-concave technology Using the definition of g(x) given in (2.1. 2.) is graphed in figure 6.

Then g' is given by where subscripts denote partial derivatives. (2.7) are given by the two points x.7) is phase diagrammed as in Skiba (1978. Steady states of (2.3 . stability and chaos in dynamic economics Let x0 denote the value of x1 that solves (2.3). The phase diagram is depicted in figure 6. AP(x).164 Differential equations. p. (2. and marginal product MP(x) by The convexo-concavity of g implies the relationship between AP and MP which is depicted in figure 6. The system (2.2.6). Figure 6.6).3. x. 536).2 Figure 6. Define average product.

537). VII denote the discounted sum of utility along two trajectories I. (Skiba (1978).2.) Let VI. II satisfy the transversality condition at infinity (TVCoo).10a). p.Microeconomic dynamics 165 Skiba's result is: Theorem 2. as well as the Euler equation. . A useful tool in comparing values along different trajectories is Lemma 2. II starting at x0 that satisfy the Euler equation and Then VII> VI provided that or.) Assume p < max AP(x).2. See Skiba (1978) and Dechert and Nishimura (1983) for continuous time. Then there is a cutoff point xs such that x < xs < x.1 and suppose that trajectory II cuts x = 0 at x*. x are the only trajectories that satisfy the Euler equation and the TVCoo (2.1.) The Skiba trajectories I. and Dechert and Nishimura (1983) prove this result also for discrete time. II and the steady states x. In order to avoid concern with technical tangentialities we will assume A2. Notice that both trajectories I. Majumdar and Mitra (1982). and such that II is optimal for x0 < xs and I is optimal for x0> xs. Proof. (Skiba (1978. (Nondegeneracy. Assume A2.

along I starting at x0. Proof. respectively. and along II starting at x0.10c) to write. VII(x0) denote values computed at the steady state x. VI(x0). Apply lemma 2. One can show that x s < x by using a lemma of Dechert and Nishimura (1983).) is an optimal trajec- .3. tory then (Dechert and Nishimura (1983).) If x ( . Let x be the smallest positive solution of the equation g(x) = px. Corollary 2. Lemma 2. by putting Ci(0)= c. Let V. This ends the proof.4. II are defined.166 Differential equations.2. Then x* < xs < x* and If there is no point x* where II cuts x = 0 then for all x0 where both I. The inequality follows from concavity of u and application of (i) or (ii). Skiba shows that (2.10b) implies Apply (2. stability and chaos in dynamic economics Proof.

By Jensen's inequality Suppose by way of contradiction that Hence.) If x0 > x. t >0 generates more utility.p t d t . Theorem 2. we know that . x*] is the common domain of definition of Vi. Therefore along II since x0<x*<x..i = I. Notice that x <0 along II. The interval [x*. (Dechert and Nishimura (1983). In view of corollary 2.5. The slope of Vi is given by the corresponding value of ph i = I. where x is the smallest positive solution of g(x) = px. To understand the Skiba-Dechert-Nishimura results look at figure 6.Microeconomic dynamics 167 Proof. This contradiction to the optimality of x(. then I is optimal. II.p t d t = f o o ( g ( x ) .x ) e . We find a contradiction to (DN) if II is optimal.x 0 . > This contradicts (DN) and the proof is finished. Look at Skiba's phase diagram to see that Furthermore. Hence.4. Proof.3 we need only to examine the case x0<x*. we have Multiply both sides of (a) by e -pt and integrate to get (g(x0)-px0)/p foo (g(x) . II. the constant path defined by x ( t ) = x 0 .px) e .) completes the proof.

Turn now to the concave case. The cases where g is convex increasing and concave increasing are easy to analyze given the above background. Notice that if x0 < xs it is still optimal to stagnate and run the capital stock down to the origin. The phase diagram for this case is obtained from figure 6. x*] follows. 2.168 Differential equations.4 The conclusion that there is a unique cutoff point XSE [ x * . Figure 6. First best decentralization in a regulated economy Let there be a large finite number of identical price taking consumers that act as if they are infinitely long-lived and let there be a large number of .2.4 still describes the qualitative features of the solution. Doing this we obtain the standard phase diagram of the neoclassical growth model. stability and chaos in dynamic economics Figure 6.3 by pushing the large steady state x off to +00. Take the convex case first.3 by pushing x to zero. The phase diagram is qualitatively the same as that obtained from figure 6.

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

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

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

where

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

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

where

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

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

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

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

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

But profits are

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

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

(ii) The solution of:

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

parametrically and initial conditions

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

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

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

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

This ends the proof of part (i).

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

Equilibrium requires

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

Therefore (2.32) implies

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

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

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

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

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

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

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

Compare this with first best marginal cost pricing

The solutions are graphed below.

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

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.x 1 ) ] that will enable us to compare steady states.1.25). A3. the dynamics are given by Here X1(P. This becomes. for mode v. x1) satisfies the natural condition Inequality (3. . Let us phase diagram the second best dynamics and compare them with the first best (see figure 6.16) and bypass the routine job of locating sufficient conditions for (3.178 Differential equations. Inequality (3.16) captures the idea that the marginal product of capital in the consumer-capital goods sector falls as the wedge between the second and first best allocations of capital across sectors widens. stability and chaos in dynamic economics Next. Therefore.6).16) to hold. it follows that Sufficient conditions on gt and g2 are needed so that the relationship between MP1(x. The only thing that is changed from the decentralization in section 2 is equation (2. we analyze the dynamics for each mode of regulation v. We assume (3. g 2 ( x . x) denotes the solution of It is straightforward to locate assumptions on g1[x1.16) is assumed to hold. X 1 v ) ) and MP1(x.

6 Figure 6.Microeconomic dynamics 179 Figure 6.7 .

There are three trajectories that satisfy the F. the problem of multiple equilibrium paths of development is surely worse in multiproduct. p ( i > ) ) . draw three conclusions.N. and (iii) the trajectory II. x0). multi-input. 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.O. p. x)) falling below the horizontal line p — p in figure 6. Third. . with respect to the steady state (x( v).C. too little power is produced in second best. Analysis of the second best dynamics is not easy. (ii) the trajectory I.2 that is so useful in comparing values along I. 533) that there is no limit cycle around the steady state ( x ( v ) . his lemma 2. Furthermore. The vertical lines p — 0 are pushed closer together as v increases. however. p( v)). the Klevorick problem (1971) of the optimal choice of v may be posed for each x0 as maximize W(v.180 Differential equations. x 1 (v. the fundamental problem of steering the economy onto the welfare maximizing path still remains. heterogeneous consumer extensions of our model. Second. Under A3. No apparent mechanism other than central coordination will suffice to get the economy onto the welfare maximizing equilibrium. Since output of consumables drops. First. We may still. 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. at any level of total capital stock. Since marginal cost lies below average cost then. This problem is much more difficult to solve and operationalize than the original partial equilibrium Klevorick problem. II and steady states is no longer valid. Furthermore. of regulatory equilibria: (i) the steady state ( x ( v ) .6. p(v)) is no longer valid. then the curve x = 0 rises. They may pass in which case only II remains. This corresponds to MP 1 (x. Skiba's argument (1978.1 a smaller input of power causes a drop in MP1 at each level of total capital stock x. the steady states move toward each other with x ( v ) rising and x ( v ) falling as v rises. v>0 where Another choice appears when X0 = X(v).7).

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

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

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

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

Examples It is useful to have some worked examples to illustrate the phenomena presented. Under assumption 3. In order to have a solution to the optimum planning problem we assume concavity of g. Let Then Notice that g(x) may be convex or concave. that is. For the decentralization case.N.1 the planning problem (2.21). r) by solving the F. of (2.1) is a standard textbook Ramsey optimal growth problem with concave production function. find the inverse demand curve P2= D2(yi.Microeconomic dynamics 185 5.C.O. Doing so we obtain where Put .

7) social benefits B falls in r and rises in x2. From facing r(t) parametrically it follows that x 2 ( t ) is the unique solution of (2. The conclusion is that the global social optimum may be realized by regulated utilities and atomistic firms solving (2. let x2 denote the positive rate base that solves (5. recalling that B denotes a 2 B l / ( l . If B>1. .27). Let X i ( t ) .20).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.21) facing r ( t ) parametrically provided that B<1. 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. regulated utilities will expand their rate bases x 2 to infinity facing any interest rate r ( t ) parametrically. stability and chaos in dynamic economics From (5.1).3) is equivalent to 13 < 1. Notice that (5. therefore.24) when B>1.1) becomes.24) when B < 1 and x2(t) = +oo is the solution of (2.13) with equality. in the case /3 > 1 the Ramsey problem is unbounded and x2 = +00 is the solution. The reader is encouraged to reflect on this problem and to read Dechert (1984) which shows that the Averch. To explain.Johnson effect has not been theoretically justified under the assumptions that are relevant in regulation. (2. Define r(t) by as in (2. In the case B < 1. In this case there is no equilibrium. Since ft > 1 the marginal incentive rises with the rate base for Ramsey and first best. For the Ramsey regulation problem (3.24) and (2.186 Differential equations. For the AJ(v) regulation problem (3. The marginal incentive to expand x2 is v. AJ(v) regulation induces choice of x2 nearer to the social optimum than private profit maximizing monopoly. Let us look at decentralization. y i ( t ) solve the optimum planning problem (2.X 1 ) Since l — al>ftl.

Microeconomic dynamics 187 Next. are ql + p C ( I ) . it can be read before section 6. C'(I)>0 as I>0. 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. . Let (K. Miscellaneous application and exercises (1) Following Gaudet (1977). since the last section continues the discussion on what has been said so far. K denotes capital units. Investment expenditures. I) denote an arbitrary equilibrium of (6. The firm maximizes the sum of discounted future net cash flows subject to where 5>0 denotes rate of depreciation. L denotes labor units. That is. C ' ( I ) < 0 as 7<0. B<1.2). we turn to several microeconomic applications before we conclude the chapter with further remarks. 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. at the rate of gross investment I. C"(I)>0. Actually. Let E = a + B take on any positive value. and a — aw/p((3 — 1). suppose that a competitive firm's production function is of the Cobb-Douglas form where 0<x. p is the output price and w is the real wage. 6.

e = 1. (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.3) does not hold. e < 1.3) imposes no restriction on the sign of (1 . Denote by W(r) B(t) E(t) kj(B/E) — the value of the firm to its equity holders at r. -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. 6(0 = the net change in debt financing. we find that its characteristic roots are where 6 = [2(l-B)-a]/(B-l). e > 1. I) is locally unstable. Furthermore. If then both roots are real and of opposite signs and (K. = the stock of debt capital.3) is satisfied and as already noted saddle point stability holds and the optimal investment path is the stable manifold of the saddle equilibrium. Assume that capital markets are purely competitive. To study the role of returns to scale on the stability of the equilibrium (K. or constant returns. For a stability analysis under increasing returns see Brock and Dechert (1985).2) around (K. Gaudet (1977) concludes that although an unstable equilibrium can occur only with increasing returns to scale. hold then inequality (6.1)-(6. notice that (6. investors prefer more wealth to less and the investment decision process leaves the firm's business risk-class unchanged. stability and chaos in dynamic economics Linearizing system (6.e) and therefore we may have a saddle point stable equilibrium even with increasing returns to scale. and the subsequent decision concerning the firm's growth and divident policy. If (6. I) is a saddle point equilibrium.188 Differential equations. X ( f ) = t h e level of expected net earnings available to all equity owners. I) note that if decreasing returns. . =the stock of equity capital. the existence of increasing returns does not rule out the possibility of a saddle point stability.'I). then the roots are either real and both positive or complex with positive real parts and (K.

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

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

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

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

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. (10) In two papers. roughly. 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. provided the substitute-complement relationship of commodities. both present and future. They show that in a continuous time general competitive economic equilibrium model if all commodities. fits into the Morishima (1952) matrix pattern. Hirota (1981) shows that most assignment patterns are stable. Keenan (1982) and Hirota (1985). See also Scarf (1981) who points out the significance of Hirota's example.1975). both present and future are gross substitutes. See also Balasko (1975). That is. 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. then stability with static expectations is equivalent to stability with adaptive expectations.1974. See also Burmeister and Graham (1973. that demand is determined by constancy of the marginal utility of money. while the globally unstable case emerges only in an extreme limited situation. Such a modification of demand function eliminates the income effects which can cause the tatonnement price adjustment process to be unstable. (9) Arrow and Nerlove (1958) study the role of expectations on stability.Microeconomic dynamics 193 of initial stocks.1973). 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. for a class of economies which includes Scarf's instability example as a limiting case. 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. The results of Sonnenschein (1972. Bewley defines the permanent income hypothesis to be. 1980b) studies the role of the permanent income hypothesis on short run and long run stability. Hirota (1985) gives an estimate of the fraction of initial endowment distributions which result in global stability of a tatonnement process. 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. By perturbing the assignment of initial holdings. Debreu (1974) and Mantel (1974. More specifically. Bewley (1980a. Since the permanent income hypothesis makes sense only in the short run Bewley (1980b) shows that short run global stability .

Bewley (1980a) shows that an analogue of the results of Sonnenschein (1972. perverse income effects reappear as a source of instability. Hotelling showed that the competitive resource owner would deplete at the socially optimal rate. 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. the undiscounted value must be growing at precisely the rate of interest.194 Differential equations. In fact. the price of an exhaustible resource must grow at a rate equal to the rate of interest. For the present value of price. However. is expected by producers to be rising too slowly. Put differently. suppose that price. 1976) applies to the long run adjustment process assuming the permanent income hypothesis. Then resource deposit is not a good way to hold wealth. the current price must decrease along the demand curve. 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. or price net of extraction cost. 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. both along an efficient extraction path and in a competitive resource industry equilibrium. stability and chaos in dynamic economics holds for the tatonnement process. (12) Urban economics is a fertile field for the application of the methods of dynamic analysis and stability. Thus. Debreu (1974) and Mantel (1974. Producers will try to liquidate their resource deposits by increasing current production and by investing their revenues at the higher r%. But as production increases. Similar reasoning suggests that if prices are expected to grow faster than the interest rate r. The intuition behind the Hotelling rule is simple. 1973). For an introductory survey of the . or price net of extraction cost. (11) According to the now famous Hotelling rule established in Hotelling (1931). If we assume that this interest rate r is equal to society's optimal discount rate between future and present. 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. say below the interest rate r. to be the same in all periods. For an introduction to the economics of exhaustible resources see DasGupta and Heal (1979) and their references. initial pessimistic price expectations lead to current price decreases. 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.

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

x 1 ) ) = g(x) is concave increasing in x If. Malliaris (1988a) presents three approaches to this problem and surveys numerous references. stability and chaos in dynamic economics (15) The cash balances problem of the firm concerns the management of the timing of cash receipts and payments. There would be less cause for concern if we had to go to a heterogeneous consumer multigoods general equilibrium model to generate the difficulty. It seems that only control of rate bases will correct the problem. The piece meal recommendations to commissions made by devotees of Ramsey pricing are stimulated by partial equilibrium analysis. 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. To the extent our abstraction captures aspects of reality we have shown there is serious danger that the system will follow the wrong path. How might such a situation reveal itself in practice? Take the case of g(x) everywhere convex which is worked out in the examples. Let us attempt to explain what we think the relevance of this exercise is to practical problems of regulatory policy. We found that no problem emerges when the aggregate production function maximum g1(x1. 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. Such recommendations may be counterproductive if the economy follows a suboptimal path of development. . 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. 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. g 2 ( x . The paucity of structure of such models naturally leads to few restrictions on the set of equilibria. 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. however. It is disturbing that the difficulty emerges in a model with so much plausible structure. 7.196 Differential equations.

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

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

then there is at most one optimal path x(t. then there exists a function h: R" x Rm -» Rn. H.x0.x0. x ( t ) e R n . Observe that x(t)ER". the maximum in (1. As before superscript T denotes the transpose of a vector or a matrix. and a vector of parameters a. (1962). where x(t. 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. a)->x(a) as f-»oo. called the optimal policy function.4) we write down the necessary conditions for an optimal solution In section 2 the system of differential equations (1.200 Differential equations. stability and chaos in dynamic economics Here i i ( x ( t ) . dx/dt = x(t). a).5) and (1. x ( t ) . the rate of change of the state.a) is the optimal path corresponding to x0 and a. a) is strictly concave in (x.) is absolutely continuous if dx/dt exists almost everywhere. aeRm and p>0 with p being the discount rate. If TT( •. as where q is an auxiliary variable. a ) is instantaneous payoff at time t which is assumed to be a function of the state of the system at time t. such that Furthermore. that is. Using (1. also called a costate variable.2) is evaluated at the optimum we use the notation H°. x).1) is taken over the set of absolutely continuous functions x ( t ) such that x(0) = x 0 . When the Hamiltonian of (1. denoted by x(a). Define the Hamiltonian function. Chapter 5 surveys various sufficient conditions on the instantaneous payoff function TT and the discount rate p of (1. If an optimum exists for each (XQ. whose existence is claimed by the maximum principle in Hestenes (1966) and Pontryagin et al. a) for each x0 and a. Recall that a function x ( .1) such that there exists a steady state solution.6) is used to obtain an important abstract result in comparing optimal steady states. x(t). As in Rockafellar (1976).1) is time independent. •. x0. x(t. which is locally asymptotically stable . h does not depend upon x0 or on t because (1.

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

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

In view of the Sonnenschein-Mantel-Debreu result.3) if this system is either one dimensional or if dE/dp has a lot of zeroes in it. the epitaph of the Correspondence Principle was written by Arrow and Hahn (1971. Phelps and Winter (1970) develop the beginnings of an alternative disequilibrium dynamics.2) came under attack as a description of an adjustment process. After Phelps et al. This was discouraging enough but while this type of research was going on the very mechanism (2.2) but no consensus seems in sight. 321) in their chapter on comparing equilibria. and also. Shortly after Arrow and Hahn (1971) was published. 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. "Whose maximizing behavior does such a mechanism describe?" They remark that it is mechanical and not based on rational behavior. Turn now to a closely related idea.2). These findings led to a lot of research on the Correspondence Principle.Stability in investment theory 203 contains n restrictions. this principle in some form lurks in the underworld of economists of a more practical bent. Nevertheless. there were several attempts in the literature to rationalize mechanisms of type (2. p. they also ask. reported in Quirk and Saposnik (1968). 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. a priori sign restrictions on dE/da contain n more restrictions. the Sonnenschein (1972)-Mantel (1974)-Debreu (1974) theorem appeared. 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. Gordon and Hynes (1970) argue that speculative activity would destroy any such mechanism as (2. But there are n2 elements in BE /dp. 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. BE /dp is a stable matrix and dE/da has a priori sign restrictions. Yet. Arrow and Hahn (1971) in their chapter on comparing equilibria gave little credence to the hope that the . 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. in such examples. Hence. The papers by Gordon and Hynes (1970) and Phelps and Winter (1970) come to mind. (1970) was published.

3.1). They did show.S. how sufficient conditions for L. x.3).204 Differential equations. We have a Revised Correspondence Principle.4) with respect to (1.2) in the Correspondence Principle.A. and Lucas and Prescott (1971) and Brock (1972) on perfect foresight models.1) together with the dynamics of the solution (1. whose solution generates the equilibrium-disequilibrium adjustment process (1.3) play the role of (2. the hypotheses of stability of the solution x(a) of (2. Let play the role of (2.1) and let (1.2) alone would yield useful restrictions on dp/da. however. of equilibria of (2. . Observe that the Revised Correspondence Principle is stated as a methodological notion unlike Burmeister and Long's (1977) Correspondence Principle which is a theorem. can be fit into (1. A version of the Correspondence Principle is offered below which is somewhat immune to the cirticisms listed above. Lucas (1967). stability and chaos in dynamic economics hypothesis of L. to name a few. 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. For problems of type (1.A.2) such as all goods are gross substitutes yield useful restrictions on dp/da.1).3) together with a priori structural assumptions which are economically meaningful on TT(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. a) lead to useful comparative statics information on dx/da.1). or G. of (2. Treadway (1971) and Mortensen (1973) on adjustment cost models in the neoclassical theory of investment. Abstract results on comparing optimal steady states Here we develop some mathematical results which are used in economic applications in later sections. Consider the system mentioned in the introduction.3). such as Cass and Shell (1976a) on optimal economic growth.S. that is.S. Many intertemporal equilibrium systems studied in the literature.

3) is automatically satisfied at a steady state. Add to both sides of (3.Stability in investment theory 205 with initial condition x(0) = x0.4) and (3. Hence equations (3. and Brock and Scheinkman (1976) as reported .8) pxlqa to get for a e Rm. Rockafellar (1976).8) by a vector a e Rm. we obtain The right hand side of (3. The transversality condition has been shown by Benveniste and Scheinkman (1982) to be necessary as well as sufficient for a general class of problems.2) are necessary for optimality in a large class of problems. The differential equations (3. A steady state x(a) with its associated costate q ( a ) must solve the equations below The transversality condition (3. This can be seen immediately by premultiplying and postmultiplying the right hand side of (3.5) with respect to a and drop upper bars to ease the notation.1) and (3. for notational convenience. Totally differentiate both sides of (3. and the cross product terms cancel.8) is nonnegative quasi-definite because H° is convex in q and concave in x. where. we define The matrix Q(a) plays a central role in the stability hypotheses of Magill (1977a).4) and (3.5) characterize optimal steady states. Recall that a e Rm.

9). The proof follows immediately from (3.A. stability and chaos in dynamic economics in chapter 5.6) to obtain Equation (3. This theorem will be useful when we turn to a problem where a enters the Hamiltonian with a specific structure.1. x).206 Differential equations. Next we present another abstract result.0. Proof. In the spirit of the Correspondence Principle we have an abstract comparative statics result: Theorem 3.12) into (3. q(a0)). In chapter 5 the function V = qTx is differentiated with respect to / along solutions of (1. Insert (3. that is.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.13) become . then x(a0) is locally asymptotically stable. when H°xq . for example.7) for qa in terms of xa. then for all ytRm.H°qx . shows that if Q(a) is positive definite at the steady state (x(a 0 ). so that the positive definiteness of Q(a) implies that V acts like a Liapunov function. equations (3.2) to obtain V = (q. Magill (1977a). x)TQ(a)(q. Solve (3. This will be presented in the next section. Also. If Q(a) is positive semidefinite at x(a 0 ). g(«o). Hence the global positive definiteness of Q implies G. note that except for hairline cases Q(a) is always positive definite when p = 0.12) and (3.1) and (1. Note that for the interesting special case when the Hamiltonian is separable in q and x.S.

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

and calculate .14) by *«.15) is an n x n matrix equation. Consider the quantity and assume that R is negative quasi-definite.and postmultiply (4.H°xq. Pre.208 Differential equations. We must show that for all vectors y. then xai is negative quasi-semidefinite.15) by the n x 1 vector y to get Notice that we used (H°qx)T . hypothesis. It was noted in the introduction that this is a sufficient condition for G.16).A. But which completes the proof.1.1 H°qx is negative quasi-semidefinite at the steady state x(a). But (x a 1 y) T (H° q q r l H° q x (x a i y)<0 by hypothesis. By (4.S. The other two terms of (4.16) are nonnegative by convexity of H° in q and concavity of H° in x Hence yTxlly<Q. The signs in parentheses are the signs of each term in equation (4.13) for a = al. Proof. and manipulate to get Since xai is an n x n matrix equation (4.12) we get Premultiply both sides of (4. y T x a1 y<0.S. stability and chaos in dynamic economics Examine (4.A. We digress in order to sketch how R negative quasi-definite implies L. with G=(H°qq)~l. Brock and Scheinkman (1977a) use as a Liapunov function V-xTGx.A. We now arrive at Theorem 4.S. If p > 0 and ( H ° q q } .8) and (4.1 is a typical example of a comparative statics result derived from a G. Theorem 4. as shown in Brock and Scheinkman (1977a) and Magill (1977a). To verify this claim.

Since ar is the vector of wage rates for x. Thus V <0 and. x). the negative quasi-definiteness of R plays a central role as a sufficient condition for L.18) simplifies down to . We conclude that (4. It turns out to be very powerful in analyzing a large class of adjustment cost models reported in Brock and Scheinkman (1977a). Hence if it exists. for all yeR". Thus. Replace a by a2 in (4.13) and use (4.8) and (4. therefore. Hence by (4.A.20). V is a Liapunov function. We return to discuss xa. by (4.19) and (4.17) says that the long run factor demand curve x(a) is downward sloping in a generalized sense.S.12) to obtain But by (4. The latter follows from the fact that where such that x(0) = x0 is concave in x0 because we assumed that TT is concave in (x. (/C)'1 = -/„„ so that Also.Stability in investment theory 209 Note that V<0 because G = 0 at steady states and qrx<0.11). (4.10). Turn now for similar results on xa2. that is. 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.

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.8) and (4.. Replace a by a. If p > 0 and (H°qq) lH°qx is negative quasi-semidefinite then xa2 is negative quasi-semidefinite. It is worthwhile and instructive to verify theorem 4. hypothesis for the Lucas-Treadway-Mortensen model as well as playing a central role in determining the sign of xaj and xa2.pa2+a\ and differentiate totally with respect to B to get Now obviously. x). stability and chaos in dynamic economics Follow the same argument which leads from equation (4.14) to theorem 4.12) to obtain Hence we have Theorem 4. then so is xa2 which gives another verification of theorem 4. If p > 0 and H°xq = 0 for all x. in (3. Look at the steady state equations. then xai. are all negative quasi-semidefinite and symmetric. Hence if xaj is negative quasi-semidefinite and p > 0. 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. a. Xp. From these last three equations we obtain that the steady state x must satisfy Put ft .1 to obtain Theorem 4.210 Differential equations. . q. Notice how equations (4. It is fascinating to note that the negative quasi-definiteness of (H°qq]~l H°qx is a very expeditious G.15).S. x) and a. xa.2.2.2 in a different manner.14)-(4. Separability of H° occurs when H0xq = 0=H°qx for all (q. Turn now to the comparative statics implications of the separability of the Hamiltonian in (q.A. use (4.3.

we use the abstract results of section 3. Part (ii) follows from (4. (i) The matrix xlj + p T x . The theorem follows because xai is negative quasi-semidefinite and symmetric from (4.35) and the hypothesis that Q(a) is positive semidefinite.10). x q 1^ (ii) if Q(a) is positive semidefinite.and postmultiply both sides of (4. xB and jca. are negative quasi-semidefinite follows from (4. Use equations (3.12) for the Lucas-Mortensen-Treadway model to obtain Pre.32). Again we see a close connection between a G. then xai.S. are all negative quasi-semidefinite. hypothesis and strong comparative statics results. . That Xp and xa. hypothesis. .4.7) to write them in matrix form Premultiply (4. The separability of the Hamiltonian is Scheinkman's (1978) G.S.33) by y e R" to obtain Notice that the cross product terms cancel to give the right-hand side of (4.34).A.29).6) and (3. //J a .34) because H° is convex in q and concave in x. Part (i) follows from (4.8) and (4.29) we get the other results. q^] and rearrange terms to get Replace a by a.Stability in investment theory 211 Proof. use H°xai = -In.30). From (4.34) where Q(a) is defined in (3.A. Proof. = 0 from (4. With xa} negative quasi-semidefinite and (4. We can now state Theorem 4. in (4. Before we complete the analysis in this section. is negative quasi-semidefinite.31) by [x^.

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Differential equations, stability and chaos in dynamic economics

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

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

Premultiply (5.3) by xj to get

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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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215

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

Stability in investment theory

219

(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

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

8) will hold.A.S. Despite this extension.7) we compute From (7. we conclude that d x / d ( a 1 + pa2) is symmetric and negative definite. we obtain the necessary conditions andfxx(x) is negative quasi-definite. it differs in one significant aspect. Suppose thatj^x =fxx. Assume that the optimal path of the extended integrand problem is L. Furthermore. The above result illustrates. Thus we have sketched a proof of Theorem 7. p ( t ) here is a rational expectations equilibrium instead of a constant vector as Lucas.9) and (7. . Although this application is similar to the one in the preceding section. theorem 7. let x be the optimal path of the extended integrand problem in (7. comparative statics results hold as theorem 7. The reader. and that the matrix C is symmetric.10) we conclude that if fxx=fxx.1 shows and are obtained easily because of the powerful technique of consumer surplus. It might be informative to compare the results in theorem 7.A. or equivalently. Then both dx/d(al + pa2) and d x / d ( a l + pa2) are symmetric and negative definite. suppose that the matrix C of section 6 is symmetric. Note that in the static case. Following Hicks (1946. that is. fx = Q with no meaningful information available about d x / d ( a l +pa2). 320-323).S.1 is a generalization of the early literature on the subject as presented by Hicks (1946). the usefulness of the Correspondence Principle in obtaining comparative statics results in the cost of adjustment theory with rational expectations. (2) Static vs dynamic theory. once again.6) and suppose that x is L. Samuelson (1947) and later made popular by Henderson and Quandt (1971). Treadway and Mortensen assume. pp.1 to the results of static theory. Therefore.1.1) to the static case we want to maximize Carrying out the maximization.Stability in investment theory 221 From (7. then (7. Then by Mortensen's theorem we conclude that both d x / d ( a l + pa2) and d x / d ( a l + pa2) are symmetric and negative definite. Reducing (4.

13)? The negative definiteness of dx/da. for an increase in the input price i. When C is not symmetric as we have assumed. then What is the economic content of (7. Substitution between inputs is possible but it could not prevail. Therefore.13) we get From (7. 98) points out.13). yields While carrying out the multiplication in (7.14) and (7. if Aa1 = Aa2 > 0.15) we conclude that complementarity is likely to be dominant in the production process. denoted by Aat>Q. must be cautioned that the dynamic theory is not just a straightforward generalization of the static theory of the firm. Consider the simple case with x = (x1. which in our special case is the 2x2 matrix in (7. our comparative statics results of the dynamic theory of the firm are consistent with the results of the Hicksian static analysis. Treadway (1971) and Mortensen (1973) show that the dynamic theory yields results that are dissimilar to those of the static theory. x2) as the output vector and a . stability and chaos in dynamic economics however. (3) We close this section with an illustration of the usefulness of our comparative statics results in theorem 7. "there is a tendency for products jointly produced in the same firm to be complementary. where i = 1 or 2. More generally. p.222 Differential equations. Then.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.(a 1? a2) as the parameter vector denoting input prices. Hicks (1946. and for factors jointly employed in the same firm to be complementary". .1. theorem 7.

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

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

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

Under these conditions. The earlier Brock analysis essentially abstracted from the government and corporate sectors and it is these aspects (particularly the latter) which . are distinct entities. (b) and (c) has been termed a perfect foresight equilibrium. More recently. Yet this typically is not how real world stock markets operate. Physical capital on the one hand. (c) all markets are continually cleared. 1975) and follows Brock and Turnovsky (1981). Indeed. the purpose of this chapter is to introduce a more complete corporate sector into a contemporary dynamic macro model. the effects of alternative government policies depend critically upon the capital structure employed by firms. Moreover. stability and chaos in dynamic economics The first is its simplistic treatment of the corporate sector. in practice in many cases they don't and thus the underlying behavioral relationships remain arbitrarily specified. The second major shortcoming is that these analyses are all based on arbitrary behavioral relationships. To incorporate this aspect adequately requires an explicit model of optimizing behavior. and the paper claims to these physical assets on the other. The traditional textbook macro model typically assumes that all private investment is financed through borrowing. (b) expectations are determined simultaneously with perfect foresight continually holding. It includes the following key features: (a) all demand and supply functions of households and firms are derived from maximizing behavior. Despite the increasing awareness by economists of the need to ground macroeconomic theory on the firm microeconomic foundations. 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. the policy implications derived from models based on ad hoc behavioral relationships may be misleading. all expectations will be self-fulfilling and for this reason an equilibrium characterized by (a). Accordingly. embedding it in an explicit optimizing framework. 1978). as will become clear below. thereby invalidating the one-to-one relationship assumed by these authors and others. which in turn is a function of the tax structure and the differential tax treatments of different securities. the relative prices of which are continually changing. The deficiencies of following this procedure become particularly severe when one wishes to augment the model to include a corporate sector embodying rational behavior. although his analysis is based on the extreme case of all-equity financing. The approach we shall adopt is an extension of the general equilibrium framework developed by Brock (1974. Recent attempts to differentiate explicitly between physical capital and the corresponding paper claims in a macroeconomic context are contained in Turnovsky (1977.226 Differential equations.

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

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

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

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

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

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

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

say. etc.2e) and (2. etc. we do not incorporate them.6b) yields a set of demand functions for capital and labor. and the various securities in the economy all equal their corresponding real supplies. and in addition all anticipated variables are correctly forecast. etc. labor. 6a). rg.6a). equilibrium may not exist under all tax structures especially when borrowing. which firms also treat as parametrically given. Nothing will be done regarding the question of existence of equilibrium. which are also functions of w. Carrying out this maximization yields a set of demand functions for consumption and various securities together with a labor supply function. 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.1c) with Th defined by (2. and subject to the initial conditions (2. and other parameters which consumers take as given. First consider the household sector's maximization problem defined by (2. Determination of optimality conditions for households As indicated above.2a)(2. w. 3. 4.5) generate supplies of money and government bonds and a demand for goods. Henceforth. will denote the real money supply in a perfect foresight equilibrium. In fact.la). la). E to maximize its utility function (2. m.4). rh. Thus. In this case md = ras. bg. The perfect foresight equilibrium is defined as a situation in which the planned demands for output. rh. and new security creation is allowed. Since such taxes do not generally characterize real world tax structures. the household sector's optimization problem is to choose c. the quantity m. in terms of p*. bp. the corporate sector's optimization problem defined by (2.1c).1b).1b) subject to (2. we shall focus our attention on these equilibrium quantities. with Th defined by (2. the government policy decisions constrained by (2. and a set of supply functions for various securities together with output.234 Differential equations. with 7} defined by (2. although it would be straightforward to do so. Perfect foresight equilibrium The perfect foresight equilibrium (PFE) we shall consider is defined as follows. lending. Likewise. Substituting for Th enables us to define the Hamiltonian . (2. and where no confusion can arise we shall simply drop the superscript. subject to the budget constraint (2. Thirdly.

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

2d) to yield . m. 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.12). I. the optimality conditions (4.1)-(4. (4.10). and (4.5).2c). (4. then the corresponding decision variable is set equal to zero. (4. (4. Determination of optimality conditions for firms To derive the objective function for firms. (4. (4. stability and chaos in dynamic economics Inequalities (4. we shall assume in equilibrium c > 0.4). if any of the decision variables are strictly positive in equilibrium. 5. we begin by eliminating RE from the firm's financial constraints (2.7) all hold with equality. the corresponding constraint is satisfied with equality. (4. (4. m>0.7). Throughout the analysis. (4.8).4). (4. If any of these inequalities are met strictly. The Lagrange multiplier is simply the discounted marginal utility of consumption. so that (4. These dualistic type relationships are reflected in the equations (4.9). so that represents the rate of return on consumption.3).2).6).2). / > 0. Conversely. bp and bg (which are identical) and E respectively. 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.236 Differential equations.11) are the Euler inequalities with respect to c. (2. Introducing the above equality conditions.12) can be simplified and interpreted more readily.

Now using the definition of 7} together with (5.Macroeconomic policies 237 where. we obtain We now define the firm's real net cash flow y ( t ) to be That is. but is independent of V. because we are dealing with PFE. Suppose for the moment that 0*>0 (an assumption which will be justified below and certainly holds in steady state) and assume that lim. Adding qE to both sides of this equation and noting the definition of V given in (2. Then. less the cost of the additional capital purchased.3) (and hence V).3) in the form Next.S0 0* df = 00.6) can now be readily integrated to yield a general solution where A is an arbitrary constant. and recalling the definitional relation D/qE = i.1) becomes We now define the firm's debt-to-equity ratio enabling us to write (5. the superscripts have been dropped. in order for V(s) to remain .5) can be written more conveniently as where 6* is in general a function of t. equation (5. letting (5.. y(0 equals the gross profit after tax.2). Equation (5.

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

Given that the capital gains in the model really reflect accruals.Macroeconomic policies 239 These preferences. we invoke the optimality conditions (4.19) for consumers to eliminate rp and qE Substituting these expressions into (5. (4.11). 6* is independent of i. being expressed in terms of the firm's financial decision variables.17).12). the relevant cost of capital is equal to the consumer's rate of return on consumption 6. But (5. embodied in the optimality conditions (4.19). together with other variables parametric to the firm is now suitable for determining the firm's optimal financial policies. the adjustments themselves being weighted by the share of bonds and equities in the firm's financial structure. i The optimal dividend policy and the optimal capital structure will therefore involve corner solutions. As written in (5. To obtain an appropriate expression for 0*. confirming the well known Miller and Modigliani (1961) proposition for this case.11) may also be written in the form The expression (5. whereas tax rates in reality .11) or (5. adjusted by the various corporate and personal income tax rates.17) and (4. This is done by calculating the partial derivatives with respect to A. Note that in the absence of taxes. impose constraints on the components of the financial rates of return.8). 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. Dividend policy is therefore irrelevant.

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

17) and (5. in terms of the underlying optimality conditions for consumers. we feel that the derivation we have given for the cost of capital. has merit in making explicit the role played by consumers in determining the optimality conditions for value maximizing firms. The reason for the .Macroeconomic policies 241 requires ry to exceed TP by an amount which suffices to take account of the double taxation of income from stock. This result follows immediately from the equality (1 — r y ) = (l —T P )(!-T S ).10). and furthermore is less than (5.21). Thus using (5.21). he finds that with all equity financing. although there is one difference. He shows that the value of any firm in equilibrium will be independent of the amount of debt in its capital structure. again in the case of a single agent. provided that the marginal rate of tax payable by stockholders on income from shares is sufficiently far below the marginal rate of tax on personal income. If (1 -T V . 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. Instead of (5. These expressions are generally similar to those given by Auerbach (1979).) = (1 -T p )(l -r s ).16) simply reduce to a statement of the familiar Modigliani and Miller (1958) no-tax case. then the optimal debt to equity ratio is indeterminate.15)-(5.9) and (5. Thus while our conclusions for the firm's financial policy turn out 10 be familiar. One special case of this arises when all tax rates are zero. 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. when the conditions (5. Our results are also consistent with Miller's (1977) extension of this proposition. use has been made of (5.18).

25). substituting (5.7) we may write Using the linear homogeneity of the production function and the optimality conditions (5. all equity comes from retentions means that it comes from before tax funds. this expression may be simplified to yield . thereby making it cheaper. The fact that in the Auerbach analysis. which in effect rules out the possibility of the values of the claims becoming divorced from the underlying sources of earnings. The proof of the assertion just made is as follows. A. to minimize the cost of capital and determined 0* in . The optimality conditions to this problem are simply That is. From (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.7). stability and chaos in dynamic economics difference in this respect again stems from the difference in assumptions made with respect to dividend policy.24).25) back into (5. to maximize subject to the initial condition fc(0) = k0. For notational ease denote #min by 6*. Having chosen i. Moreover. We are finally in a position to state and solve the real part of the firm's optimization problem. I. it must next choose k. (5.24) and (5. the after tax marginal physical product of capital should be equated to the minimized cost of capital while the marginal physical product of labor should be equated to the real wage.242 Differential equations.

see Weitzman (1973) for the discrete time case and Benveniste and Scheinkman (1982) for the continuous time version.17) holds bp = k. (5. by the necessity of the transversality condition at infinity for infinite horizon concave programming problems of this type. Equilibrium structure and dynamics of system The optimality conditions for the households and firms.2) equates the marginal rate of substitution . 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. This completes the formal optimization of the firm.1) simply defines a short hand notation for the marginal utility of consumption.Macroeconomic policies 243 Now integrating by parts and cancelling. while in the knife edge case where (5.18) applies qE = k. bp and qE are indeterminate.14)-(4. we obtain But the limit of the second term is zero. 6. Combining the optimality conditions in (4. if (5. Equation (6.18) holds with equality.17)-(5.25) we may write Equation (6.24) and (5. Hence we deduce V(f) = k ( t ) . Thus we may conclude by noting that if (5.19).

a full dynamic analysis of the system turns out to be rather complex and not very enlightening.5). They included pegging the real money supply. p. (2. The first of these is a restatement of (4. 6.8). bp(0). which arises when labor is supplied exogenously. Then in section 9 below. we shall analyze a simplified version of the dynamics. As part of the specification of the dynamics of the system. bg.244 Differential equations. In the case of money and bonds.26). stability and chaos in dynamic economics between consumption and leisure to the after-tax real wage. given the dimensionality of the system. 6 g (0).13). the dynamics is fully determined. This simplification suffices to give a good indication of the nature of the transitional dynamics for the general case. The dynamics governing these latter variables are expressed in equations (6. m. The first two of these are exogenously determined. 6 P (0). m(0). together with the linear homogeneity of the production function and the balance sheet constraint (5. fc(0). . we shall proceed directly to a discussion of the steady state. while (6. Equations (6.6a). pegging the rate of nominal monetary growth.8) is the government budget constraint.6b) into (2. The size of this initial jump. These five equations may be used to solve for the short-run solutions for the five variables /. E(Q) = E0. with the initial real stocks being endogenously determined by an initial jump in the price level. and therefore the initial values m(0). and the minimum cost of capital respectively. to simplify the resulting expression for the real deficit. etc. To complete the description of the system we must consider the initial conditions. The final equation (6. Rather than pursue it further with the model specified at the present level of generality.4) and (6. in terms of the dynamically evolving variables a.5) restate the marginal productivity condition for capital. 0* in. in terms of the new notation. then using the optimality conditions for consumers and the optimality conditions for firms. pegging the real stock of government bonds. c.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. k. Unfortunately.8). There are various policies which are traditionally chosen in dynamic macro models of this kind.7) describes the rate of capital accumulation required to maintain product market equilibrium. Essentially it is obtained by first substituting the tax functions (2. the initial nominal stocks are assumed to be given. The derivation of this form of the equation involves several steps. while (6. Once such a policy is chosen.6)-(6. something must be said about government financial policy. one obtains (6. E(0). being given by /c(0) = /c0. bg(Q) are obtained from the transversality conditions at infinity for households and firms.

-> U c ( t ) b g ( t ) exp(—Bt) = 0. since bg is determined residually by (6. we should also explain how the equilibrium stocks of bonds and equities and their respective rates of return are determined.8). The requirement that bK = 0 is less immediate. The argument may be sketched as follows. rp = rg. the price of equities can be obtained by substituting known values into (4.Macroeconomic policies 245 But before concluding the present discussion. the quantity of shares outstanding can be immediately inferred. With both the value of equities and their price determined. Obviously this implies that the rates of interest on private and public bonds must be equal. so that /c0 = bp (0) = B PO /P(0). In the case where firms find it optimal to engage in all bond financing. which is now qE = k.26) implies bp = k. First integrate (4. in order to satisfy the balance sheet constraint (5.18) and integrating. the balance sheet constraint (5.13) to yield Next. 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. However. The nominal rate of interest can then be determined by inserting the known values into the consumers' optimality condition (4. Steady state The steady state of the system is attained when The fact that steady state requires k = m = d=0 is readily apparent. integrate the government budget constraint (6.26).8). lim. a jump may occur at time zero. to obtain . but now exceeding that on private bonds. 7.16). which holds as an equality. with all equity financing. Similarly. with their after tax real rate of return now equaling that on equities. Note that with the nominal stocks of bonds given. In this case the rate of interest on government bonds will again be given by (4. Again an initial jump may be required in q. that is. through the price level.16).

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

16) and the corresponding minimized cost of capital. On the other hand.17) and (4. 8. the equilibrium rates of return on the financial securities can be obtained by substituting the solutions from (7. the system dichotomizes into two recursive subsystems. I. It is also in part a consequence of the interdependence between real money balances m on the one hand.Macroeconomic policies 247 real stock of government bonds to maintain the budget in balance.5) is interdependent. and capital and labor on the other. 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. Characterizations of alternative steady states In order to discuss the steady state of the system in further detail. Finally.19). the following steady states may be characterized. This is determined by the inequality conditions (5. .15)-(5.2)-(7. for the government monetary policy specified by (8. m.2)-(7. The first determines the real decisions k and / while the second determines the financial variables m and p. p.5) into the appropriate arbitrage condition for consumers (4. in the consumers' utility function. it is necessary to introduce some government financial policy. Under certain conditions. We shall restrict most of our attention to the case in which the monetary authorities maintain a constant rate of the nominal money supply. conditional on these initially chosen real variables. It is of interest to note that. in general. the system summarized by (7. Thus. however. then for given g and rates. if the policy is specified in terms of the real stock of government bonds. the four equations determine the equilibrium values of k.1). 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. real production decisions and financial decisions are jointly determined.

Being a perfect foresight equilibrium. to the extent that public and private goods are viewed as imperfect substitutes by households. With the linear homogeneity of the production function.1. so that c and g enter as separate arguments in the utility function. given the parameters B.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. anticipated government policies are indeed able to have real effects. For example. /. the real stock of capital k is known. k. u TJL. 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.248 Differential equations. an expansion in real government expenditure will have real effects on output and employment. With k/l and now / fixed. if public and private goods are perfect substitutes. First.2). while the level of output y immediately follows from the production function.2)-(8. stability and chaos in dynamic economics 8. TP. equations (8. this establishes the capital-labor ratio. the two marginal rate of substitution conditions (8. The government budget then determines the real stock of government bonds necessary to balance the budget.5) have important implications for the debate concerning the effectiveness of fully anticipated government policies under rational expectations. TV. which in turn determines the real wage/J(/c. so that c . and the real stock of money balances ra. On the other hand. This confirms the argument advanced by Fair (1978) that in a fully rational expectations model generated from underlying optimizing behavior. Also. as well as upon both the corporate and personal income tax rates. Having determined k/l. All bond financing by firms In this case inequality (5. together determine the employment of labor /. (8.3). the range of effective government policies may be restricted. /).4) yields the marginal physical product of capital. (8.

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

TC. again confirming the proposition of Fair. thereby inducing them to lower their capital-labor ratio. the marginal rate of substitution conditions (8. TP. (5. The exogenous government policy parameters u. stability and chaos in dynamic economics to be optimal.15) imposes a lower bound on this quantity.6)-(8.11) and have the .1. The effects of changes in the rate of monetary growth and the various tax'rates on the capital-labor ratio are obtained from (8. then TP > ry and k/l will rise. inducing them to increase their capital-labor ratio. (8. All equity financing by firms With all equity financing. an increase in the corporate tax rate TP has no effect on the nominal interest rate.8).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. Ty. It therefore leads to a reduction in the after-tax real interest rate for firms. In this case neutrality with respect to the monetary rate will pertain if and only if rc = 0 and the utility function is separable in m. m and hence k. With k/l so given. if the rate of taxation on capital gains and the required minimum rate of dividend payments are both zero. (5. with the government budget constraint determining bg. 8. all have real effects. An increase in the personal income tax rate raises the nominal interest rate 5 and hence the after-tax interest rate to firms. the implications for the other endogenous variables can be easily obtained by taking appropriate differentials of (8. the previous comments made with respect to the crowding out effects of increases in government expenditure continue to hold. Finally. though the relevant cost of capital determining the capital-labor ratio is now given by (8.2.11).5). Thus for example.10) determine /.250 Differential equations.9). But the reverse cannot be ruled out. On the other hand. Given the effects summarized in (8.2)-(8.

The after-tax marginal physical product of capital must remain fixed. In our analysis. on the other hand. On the other hand. these two rates of return equal (3 in steady state and therefore are independent of the inflation rate. k/l must fall. inducing firms to reduce their capital-labor ratio. so that as rp increases. the effect of an increase in the capital gains tax on the rate of capital gains is ambiguous. it follows from (6.10) 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).5) that under bond financing d6/dp = (TP — r v )/(l — r p ). then the effect of an increase in the inflation rate upon the steady state net yield on bonds equals (rp . we find that under both modes of corporate financing. more general analysis. exactly as in the FGS analysis. are opposite to those obtained under bond financing. which from (5. In fact. it corresponds to our short-run value of 6. . an increase in the corporate profit tax rate TP leaves equity costs unchanged. With the capital-labor ratio and therefore 0*min fixed in the short run. Finally. The reason for these results can be understood by considering the expressions for the equilibrium rate of capital gains.16). (1978). 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.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. depending upon the expression in (8. 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. while with equity financing dd/dp = — rc.ry)/(l Tp) while that on equities is — rc. In the latter. 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).

9. k. With labor supplied exogenously. stability and chaos in dynamic economics 8. in which case A will be indeterminate. The monetary authorities maintain a fixed rate of growth of the nominal money supply. financing its deficit with an endogenous lump sum tax. p. the marginal rate of substitution condition determining the labor supply is no longer applicable.6).16) is satisfied with equality.1). Dynamics in a simplified case Finally. 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. .3. it can henceforth be ignored. we assume that the government maintains the real stock of government bonds fixed. in order to simplify the dynamics as much as possible. in which case firms find it optimal to engage in all bond financing. This will arise only in the knife edge case where (5. the dynamics of the system (6. Thus omitting I from the relevant functions. To keep things simple we shall assume that rv = TP( = T).4)-(9. the final equation determines the endogenous lump sum tax JJL required to meet the government deficit. 6. in terms of a. Also.8). Since this equation is a residual. Given the tax rates. and g.15)-(5. monetary growth rate.252 Differential equations. corresponding to the present set of assumptions becomes The first three equations determine c. we turn to a brief analysis of the dynamics of the system where labor is assumed to remain fixed at an exogenously set level T say. m the dynamics of which are then determined by equations (9. as specified by (8.1)-(6.

we find that its local stability depends upon the eigenvalues of the matrix where all derivatives are evaluated at steady state . Thus for . (9. By invoking the transversality conditions. p may be written in the form while 6 is given explicitly by (9. In addition.13) by A. that is.Macroeconomic policies 253 The solutions for c. we may argue that in response to any disturbance. the system will jump so as to be always on the stable locus associated with the stable eigenvalue. From (9.3). and just one stable root. the sign restrictions we have imposed suffice to ensure that Thus we may deduce that there are two unstable roots.8) we have c° =1/L/ C C <0.8). (9. possibly complex. and using properties of cubic equations. introducing the mild restriction that consumption and money balances are complementary in utility. we also have c°m = -Ucm/Ucc>0.9). Now substituting (9. the dynamics of the system becomes Linearizing the system about its steady state equilibrium.7).4)-(9..and Denoting the roots of (9.3) into (9. Ucm > 0.

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

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

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

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

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

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

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

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

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

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

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

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

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

Therefore. If the initial value of x is at the old steady state value then p will plummet but eventually rise to a higher level.oo).e. Then the analyst pieces together the comparative dynamics by working backwards. This is so because capital stock will still be increasing but not as urgently as before. a 2 on (Tj. The same thing will happen to the stock market value. Draw the stable manifold. on (0. but prices. the set of (x. 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.. the burden of the entire adjustment must fall on price at first. Unanticipated event analysis To get into the spirit of unanticipated event analysis consider the following parable. It is announced that parameter a has now changed from its old value a to a new value a^ that will reign forever.Macroeconomic policies 267 (0. The state variable x cannot change much in a short unit of time. oo). But the only variable that can adjust in the short run is price. Apply this type of analysis to the tax model (11. Now let the corporate tax rate increase from T. There is now a new stable manifold lying below the old one. The equilibrium solution solves (11.)) is in E M ( a 1 ) . p0) at date zero. This is called overshooting. The economy is at (x0. a.. p) such that starting at (x.3.2). in order to make this latter kind of problem analytically tractable assume that a has the value an on (T n . to T2 at date zero. 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. p). p(x. 11. What happens? The economy was on the old equilibrium manifold EM ( a ) . 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. The new equilibrium manifold is now EM(a\}. Therefore. Therefore.1) with a set equal to a.. jump variables can. V.. What is going on here is that prices must give the signal to decrease capital stock to a lower level in the long run.2) above.e. Hence the price of x. 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..e. oo). i.2) you will converge to the unique steady state (x. a. Tj]. We refer the reader to Judd (1985) for the details. in the beginning of the adjustment period price sinks below its ultimate value. . of the firm. i. p) and following the dynamics (11. But if initial capital stock is so small that it is still smaller than the new steady state value overshooting will not occur. a) changes abruptly to p(x. i. on (0.) so that (x0.. p(x0. T2]. Draw the phase diagram for (11.

Conditions for unique solutions in stochastic macroeconomic models with rational expectations are given in Taylor (1977). 11. that is to take place T periods from now and to be permanent over [T. Taylor (1986) reviews rational expectations models in macroeconomics. stability and chaos in dynamic economics This is all easy to see by drawing the phase diagram. Learning and disequilibrium is an important research area in economics despite the fact that this book focuses almost entirely upon rational expectations models. Also. For details see Judd (1985). Attfield et al. the papers of Bray (1982).) at exactly date T.1) at value « 0 over [0. instead. p) and following the dynamics (11. the stability techniques exposited here will help researchers in this area. while McCallum (1983) argues that the nonuniqueness of many macroeconomic models involving rational expectations is not properly attributable to the rationality hypothesis but. a0) to a new value p so that starting from (x0. For example. Marcet and Sargent (1988) draw heavily upon recent work in optimal control theory in their paper on learning. Although it is beyond our scope to study learning and disequilibrium. 1980). p(x0. Blume et al. Anticipated event analysis Consider a change in the parameter a from a0 to a. is a general feature of dynamic models involving expectations. 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. See Judd (1985) and his references. We close with a comment about disequilibrium behavior and learning. . See also Malliaris (1988b. 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. T). It must start at x0 at date zero and follow the dynamics (11. oo). An earlier standard reference is Shiller (1978).268 Differential equations. T) we arrive at EM(a.4. oo). (1982) and Lucas (1986) contain references on learning where stability analysis is stressed. We conclude this section with some additional references. (1985) provide an introduction to the theory and evidence of rational expectations in macroeconomics. 1988c) for learning illustrations related to the quantity theory of money. see also McCallum (1977.1) where the RHS is evaluated at «0 over [0. 1978. Hence p must change from the old value. Working backwards as in dynamic programming we know that to be in equilibrium the system must be on £M(a 1 ) on [T.

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

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

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

The solution x(t) = x of x=f(x) is globally asymptotically stable (G.1) if there exists a compact set K ^ Rn X Rn+ such that <j>. Definition 1.A. For this reason we concentrate on the convergence of bounded solutions. We start by discussing the three basic types of results presented and their relation to the literature.1). Let x satisfy f ( x ) = 0. Thus. In this chapter we present results that build on the work of Cass and Shell (1976a). Under what conditions is the solution x ( / ) = x globally asymptotically stable for all x0? We recall two definitions. In fact. little was known about sufficient conditions for the uniqueness of steady states of (1.1) were available. However. but also requires that there exists e >0 such that In many optimal growth problems. . Papers of Brock (1973) and Brock and Burmeister (1976) gave a fairly general set of sufficient conditions for uniqueness of the steady state.S. Definition 1. The following problem has been analysed extensively in the differential equations literature and has been reviewed in chapter 3.2. Inada-type conditions guarantee that in fact optimal solutions will satisfy our boundedness condition. new problems arise. The solution x ( t ) = x of x=f(x) is locally asymptotically stable (L. However.S. 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.) if there is e > 0 such that |x 0 -x|<£ implies (Ot (x 0 )-» x as t->oc.A. In this case. ko) will be called a bounded solution of (1. Rockafellar (1976). if / is a modified Hamiltonian. See Kurz (1968a). Ot(g 0 . k) space.Stability in capital theory 273 of (1. k0)<=• K for all t. a natural question to pose is our problem 1 for MHDS. Let be a differential equation system. Definition 1. and Hartman and Olech (1962). Magill (1977a).) if for all x0 the solution O1 (x 0 )-»-x as t-*oo. there was nothing done in the Brock (1973) paper on convergence.1. Note that our definition of bounded solutions requires not only boundedness on the (q.(q0.3.

and /„ is the n x n identity matrix.1) is said to be locally asymptotically stable for bounded solutions of (1. In section 2 we show that if F ( z ) Q ( z ) F ( z ) > 0 for all z such that F ( z ) * 0.1) if there is e > 0 such that provided that </>. then every bounded trajectory converges to a rest point.1).A.1) is said to be globally asymptotically stable for bounded solutions of (1. and L. those who satisfy definition 1. The steady state solution (q.274 Differential equations. if for all (q0.::A<^ R2" -» Rn where A is open and convex. by letting Here again a bounded solution means a solution which is contained in a compact set K c A.3.1) and rewrite (1.S. The result is obtained by using the Liapunov function F[(z)F 2 (z). . The steady state solution (q.1) as where F. k ) ) . We will sometimes call MHDS saddle-point systems when we want to emphasize their saddle-point structure. H22(z) = (BH2/dz2)(z + ( q .(<7o. For MHDS the words G. k) of (1.A. k) of (1. will always apply to bounded solutions alone in this chapter. we have Definition 1.5.4. ^o) is bounded. ^o) is bounded. Denote by (q. k ) ) . 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). fc0) such that 0. k) = (q. for all x with f (x) = 0. k) = (q. stability and chaos in dynamic economics Definition 1. then f T (X)/(X)/(x) < 0. Most of the assumptions in this chapter refer to the curvature matrix where H^(z) = ( d H 1 / d z l ) ( z + (q.(q0. that is.S. k) some rest point of (1. implies that all solutions of x = f ( x ) converge to a rest point.

As a by-product of the proof. we show that for the case p = 0. then every solution to x =f(x) converges to the origin provided that 0 is L. holds. It is easy to show that ( R ) . 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). 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.2) converge to the origin. In particular.A. 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. The method of proof of section 3 does not. which is the Cass and Shell hypothesis. Geometric Content of Q. definite provided that For the one-dimensional case.S. and placing conditions on the Jacobian matrix of F so that all trajectories of the original field come together monotonically as f-»oo. then all bounded trajectories of (1. then G. The proof is inspired by the elegant proof of a Hartman-Olech type of result obtained by Mas-Colell (1974).A. The curvature matrix Q is a natural economic and geometric quantity. if the Hamiltonian is quasi-concave in the state variable.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. Furthermore.S. For this reason. — H22 are positive semidefinite matrices. generalize to prove results analogous to Hartman and Olech's (1962) most general results. Note that the assumptions of sections 2 and 3 are somewhat complementary. A notion of a-quasi-convexity is introduced to provide a geometric interpretation for the case where p > 0. the Hamiltonian is convex in q and concave in k for optimal control problems with a concave objective function. which is Rockafellar's . in section 4 we outline the method of proof of a more general theorem. the results in section 4 have a nice geometrical interpretation in terms of quasi-convexity and quasi-concavity. in the metric induced by the arc length measure along the orthogonal field of trajectories. Hence H11. 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. unfortunately. As Cass and Shell (1976a) point out.

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

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

Optimal growth paths will have this boundedness property under reasonable conditions. Magill (1977a) used V to obtain G. . We will make use of the result in Hartman (1964.1) and let Then (2. natural to ask what may be obtained by differentiating the closely related Liapunov function F[F2. thereby. Lemma 2. Here XT denotes x transposed. therefore. and such that solutions of are uniquely determined by initial conditions. Arrow and Hurwicz and Markus and Yamabe prove. that x(t)->0 as f ^ o o along trajectories.A.S. We present an analog of this type of result for Hamiltonian systems. ko) of (2.1) where q0 is chosen so that Ot (qo. Rockafellar (1973) and Samuelson (1972a) have used the same function to investigate stability for the case p = 0. (b) 0 < W(z). stability and chaos in dynamic economics Let (q. k) be a rest point of (2.1) by use of the Liapunov function V = zTz2 for the discounted case. results for (2. Let J ( x ) = df/dx. k0) is bounded.278 Differential equations. Let F(z) be continuous on an open set E c Rm.S. Consider a trajectory z ( t ) = Ot(q0. It is. Cass and Shell (1976a) prove global stability of such a trajectory by differentiating the Liapunov function V = zTz-2 with respect to t. that the negative definiteness of JT + J is sufficient for global stability of x =f(x). results for a discounted linear quadratic problem.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). Their methods provided inspiration for many of the Brock and Scheinkman (1976) results. by differentiating (x) T x = W with respect to t and showing. roughly speaking.A. rephrased for our current need.1 of chapter 4. p. Cass and Shell are the first to obtain G.1. where W(z) is the trajectory derivative of W(z) for any z e E. Let W(z) be a real-valued function on E with the following properties: (a) W is continuously differentiate on E. 539) which is also theorem 4.

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

and. R is the value of the objective function along the optimal path (the value function). that is. Let k*(t. p. stability and chaos in dynamic economics Since y+ has compact closure on the domain of F. See Hartman (1964. W= ktq is bounded above on optimal paths. F(z) = 0. 145).(z0) is optimal. k) solve the MHDS corresponding to (2. Since the rest points are isolated and w(y + ) is connected. Here u: R2n -»R is usually assumed concave and twice continuously differentiable. If we assume that R is twice continuously differentiable. compact and connected. then k T q = k ^ R " ( k ) k < 0 along any optimal path provided k = 0. In fact. Thus. it would be useful to replace the condition that O. Benveniste and Scheinkman (1979) provide a general set of conditions on u that imply that R' exists. z is a rest point. By the previous lemma. then one can show that R ' ( k ) = q where (q. If one assumes that in fact R"(k) is negative definite. For MHDS derived from optimal growth problems. since it is possible to find models in which optimal paths are not bounded. Hence. . w(y + ) = {z}. and so.(z 0 ) is bounded with the condition 0. The concavity of u implies that R is concave. lim Ot (Z O )H» z as f-»oo. bound the Liapunov function W by assuming regularity and concavity conditions on the so-called value function. if E w(y + ). w(y + ) is nonempty. consider an optimal growth problem given fc(0) = fc0. Thus. k0) be the optimal solution and that is. then F T (z)Q(z)F(z) = 0.1.280 Differential equations. q = ( d / d t ) R ' ( k ) = R"(k)k.5). R"(k) is seminegative definite. Remark 2. hence. however. One can.

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

Finally. a contradiction to g'(A)>0.(x 0 )-»0 as t-»oo. Now g(A) = 0 implies [V V(Ax)] T /(Ax) = 0. g"(0)<0. g'(A) > 0.(x0) is bounded. and put We shall show that g(l) <0 in order to obtain (a). Furthermore. and so. in turn.(x0) must have a limit point. x = 0 is the only candidate. This completes the proof. and (b) imply But this is negative by (a). so g(0) = 0. stability and chaos in dynamic economics Proof. Thus g'(A)<0. implies that AxTV2 V(Ax)/(Ax) = 0 by (c). we get Now A=0 implies /(Ax) = 0. We do this by showing that g(0) = 0. all the rest points of 0. Hartman and Olech . and g(y) = 0 implies g ' ( A ) < 0 for A > 0 . Note that to get global asymptotic stability results for bounded trajectories. Hence $. 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}. and get an immediate contradiction. From (3a. (At this point. 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. g'(0) = 0. Let us calculate g'(A). and (b).3). But this.Suppose now that there is A >0 such that g ( A ) = 0. By continuity of g" in A. (d) implies that [V V(Ax)] T x J(Ax) x (Ax)<0. Therefore.1. Then there must be a smallest A>0 such that g(A) = 0. This result is important for global asymptotic stability analysis of optimal paths generated by control problems arising in capital theory. Let x ^ 0. Also. show that g'(A) < 0. Also g'(0) = 0 from/(0) = 0.(x0) satisfy [VV(x)] T /(*) = 0. f(O) = 0. Also. it must be true that there is e 0 >0 such that g ( A ) < 0 for A e [0. But if <£. e0]. By lemma 2.282 Differential equations. 0.) Calculating.

The condition . Then VV(x) = 2xV2V(x) = 2Ia where /„ is the nxn identity matrix. Assumption (c) amounts to 2x/(x) = 0 implies x T (2/ n )/(x) = 0 which obviously holds.1.oo. Thus all bounded trajectories converge to 0 as t . Remark 3. Assumption (a) becomes But this follows because Assumption (b) trivially holds since W(x) = 2x. dV/dt <. Then 0 is globally asymptotically stable. Corollary 3.1. Put V = xTx. Assumptions (a)-(d) of the theorem are trivially verified. and the rest of the proof proceeds as in corollary 3. This ends the proof. We demonstrate the power of the theorem by extracting few corollaries. The following corollary is a stronger result than Hartman and Olech (1962) in one way and weaker in another. Assumption (d) obviously holds because 2x T J(x)x < 0 for all x ^ 0./(0) = 0. It is easy to use V = XTX decreasing in t in order to show that all trajectories are bounded. some already mentioned in chapter 4. Proof. If J ( x ) + JT(x) is negative definite for each x.1. Therefore. Let f: Rm -» Rm. We explain the difference in more detail below. then 0 is globally asymptotically stable.Stability in capital theory 283 (1962) type results emerge as simple corollaries. Consider the ordinary differential equations x=/(x).

but he requires the strong inequality.3. and note that (3a. On the one hand. MasColell puts the stronger assumption: x[/(0) +J T (0)]x<0 for x 7=0 on the rest point. Hartman and Olech (1962) make the assumption: for all x=0. that is.ll) is just Thus.R such that for all x. stability and chaos in dynamic economics has a natural geometric interpretation when x =f(x) is a gradient flow. condition (3a. Assume that and Then x = 0 is globally asymptotically stable for bounded trajectories. It is possible to obtain general results of the Hartman and Olech type from the theorem. the proof of the Mas-Colell result is much simpler than that of Hartman and Olech. . For example. assume that F is maximum at x0 = 0. but negative definiteness of J(0) + JT(0) does imply negative real parts for /(0). there is a potential F: R" . A function F: Rn -> R is said to be pseudoconcave at x0 if Put x0 = 0. It is well-known that negative real parts of the eigenvalues of J(0) do not imply negative definiteness of J(0) + JT(0).lO) amounts to pseudoconcavity of the potential F. w T f (x) = 0 implies w T [/(x) + / T (x)]w<0 for all vectors w. Let G be a positive definite symmetric matrix. Furthermore. and let 0 be the unique rest point of x =/(x). A result similar to corollary 3. So he places the restriction on a much smaller set of w. But on the other hand.284 Differential equations.2 is reported in Hartman and Olech (1962) and in Hartman (1964) where 0 is assumed to be the only rest point. Note that Mas-Colell only assumes X T f (x) = 0 implies xT[J(x) + J t ( x ) ] x < 0. Corollary 3. and it is assumed to be locally asymptotically stable.

bb (c) for all w = 0 . p. Hartman and Olech also treat the case of G depending on x. k). Let where I„ is the n x n identity matrix. and rewrite it as We now state and prove Theorem 3. their different methods of proof yield theorems that the methods presented in this section are unable to obtain.3 is closely related to a theorem of Hartman and Olech (1962. Note that zt az = .Stability in capital theory 285 Also. We have not been able to obtain their result for nonconstant G as a special case of our theorem.b (b) for all z=0. Corollary 3.1 to modified Hamiltonian dynamical systems.2. p. The rest of the proof is now routine. Assume that the MHDS has a singularity (q.b Then all trajectories that are bounded for t > 0 converge to 0 as t . 157) and to a theorem in Hartman's book (1964.3. 549).2ztz2. Assume (a)h0 = F(0) is the unique rest point of z = F(z). We turn now to an application of the general theorem 3. Since a2v(0)= A+At = 2A and (wtA)t(J(0)w)=-wtQ(0)w. theorem 14.1. 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. we have that (c) .oo. w t q(0)w >0. proof let v = 2t az where wher in is the n xn identity matrix. theorem 2. Thus.

There is a neat sufficient condition for the positive definiteness of Q.2. then Q is positive definite.4) is identical to (3b. It implies pseudoconvexity. for positive trajectory derivative are useful for computations. . Also [W(z)] T = zr(A + AT) = 2zTA.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. Remark 3. 147).1 follows. This is so because theorem 3. The hypothesis aB > p2/4 is the basic curvature assumption in Rockafellar's (1976) analysis. p. 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. (d) amounts to " But (3b. Therefore.286 Differential equations. k) of H(q. The proof of theorem 3. Sufficient conditions.3).0. V < 0 except at the rest point 0. k respectively. If H is convexo-concave. of local form such as the Q condition of theorem 3. Theorem 3.2 is a local sufficient condition for the hypothesis of the Cass and Shell stability theorem to hold. pseudoconcavity at (q. and hence.1. For the special case These statements may be easily checked by referring to the definition of pseudoconcavity in Mangasarian (1969. Furthermore. It is worth pointing out here that the hypothesis has a geometric interpretation for the case p .2. and that is the Cass and Shell hypothesis.2 also yields the result that the Liapunov function zT1z2 = (q — q)T(k — k) is monotonically increasing along trajectories. the matrix Q is clearly positive semidefinite for p = 0. Thus. Now (c) of theorem 3. (b) of theorem 3. Applications and economic interpretations of local conditions for stability to the adjustment cost literature are discussed in Brock and Scheinkman (1977b). which is trivially true. Furthermore.2 gives conditions for the trajectory derivative of V = z|z2 to be positive for all z = 0. VV(0) = 0. as an easy calculation will immediately show. The rest of the proof is routine by now. /c) in q. stability and chaos in dynamic economics implies (a) of theorem 3.

that is. almost contained in theorem 3. k(p)] be the steady state associated with p. We start by presenting a sketch of the proof of a result. Thus. Furthermore.1. the positive definiteness of Q in the directions [q'. 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'. 4.Stability in capital theory 287 The positive definiteness of Q is also related to the Burmeister and Turnovsky (1972) regularity condition. . in fact. k'] as p varies is equivalent to capital deepening response in the BurmeisterTurnovsky sense for each value of p. theorem 4. on convergence of bounded trajectories of MHDS that is related to a theorem of Hartman and Olech (1962). A more general result In this section we present a result. Let [q(p).2. q'] to get But the quantity is the Burmeister-Turnovsky (1972) regularity quantity. theorem 4.2 below. Burmeister and Turnovsky use the quantity 6 as an aggregate measure of capital deepening response.

1). Thus.l). Let u2e R" have unit norm. Reconsider the system (3b. we formulate a sufficient condition involving dF/dz alone. We are after sufficient conditions to guarantee that </>. A -{z0: there is M>0 such that for all t>0. Ws = {z0: <£.(z0)| ^ M}.(z"o)^0 as f->oo}. In most problems not much is known about g other than its existence and differentiability and other general properties. Let us proceed in a way that uncovers a natural set of sufficient conditions for the global asymptotic stability of (4.[g(z20). We could just apply the Hartman-Olech result to the reduced form but this requires knowledge of dg/dz 2 . let Ws be the stable manifold of (4. Assume the solution z2 = 02 is locally asymptotically stable for (4.1) given z0. that is.[g(z20).1) on bounded trajectories.1). and let A be the bounded manifold of (4.3). z20] -»0 as t -» oo}. This means that there is an open neighborhood N2(02) c: R" such that z 2 0 eN 2 implies </>. |0. but we shall ignore those here. Assume that for each z 20 e R" there is a unique z10 such that (z 10 . In some problems g is badly behaved.(zo) be the solution of (4. Write for this functional relation. z 20 ]-^0 as f-»op for all z20£R". So suppose that z20 is in the boundary of A 2 (0 2 ). stability and chaos in dynamic economics corollary 4. Consider the vector put . F is continuously differentiable. F ( z ) = 0 for z=0.1 below gives a nice geometric interpretation of the hypothesis in terms of quasi-convexity and quasi-concavity of the Hamiltonian function.288 Differential equations. If A 2 (0 2 ) is the whole of R". 02] = 02. Put Assume F(0) = 0.z 20 )e A. we have global asymptotic stability. and assume that g is differentiable. Here ^2[g(02). that is. z 20 ]->0 as f-»oo.[g(z20). Let A2(02) = {z20: <£. Let 0.

A theorem may now be stated. q).8) in light of the previous results and the Hartman-Olech technique.4). The method of proof is also different. Observe that The last follows from the definition of Hamiltonian orthogonal trajectories in (4. that it is natural to construct trajectories of type (4.4) are different from HartmanOlech. if a solution exists. u2)]/dp. Consider the following differential equation (we drop transpose notation except when needed for clarity). p) = d$ r [z 0 (/>. Let y [ T ( p .8) and the method of constructing the transverse trajectories (4.p) by xp.Stability in capital theory 289 Let yp(t. . We call the system of trajectories satisfying (4. however.p]^x(q. The reader will recall Notice here that both the Liapunov function (4.p) be a solution. We shall see.6) Hamiltonian orthogonal trajectories. They are not the same kind of orthogonal trajectories as in the original Hartman-Olech result.6). and denote (d/dp)x(q.6) for our type of problem. Consider It is natural to look at w of (4. Note that Also note that The latter follows from But (4.7) is identical to (4.

S. symmetric.1.2) holds. Consequently G. Jg = R". c T Q[z(0]c>0 for all c satisfying (d) of theorem 4.1 holds if and only if cjFj = c]"F2 = 0. we could have stated the stronger hypothesis that for all zetf 2 ". .1. and is. Hence. Since in theorem 4. Assume that (a) F is continuously differentiable.1 only the fact that Jg is symmetric was used. and (d) for all bounded trajectories z ( f ) .1.1. Given a MHDS like (3b. all bounded trajectories of z=/(z) converge to 0 as f-»oo. thus. if a value function R exists and is twice continuously differentiable. c = (c l s c2). for z2 = F2[g(z2). z ( t ) is a bounded trajectory and (4. That is. (d) of theorem 4. suppose Jg is symmetric and that the Hamiltonian function satisfies for all z = (g(z 2 ). stability and chaos in dynamic economics Theorem 4. Remark 4. we have Then z2 = 02 is G. c 1 F 2 [z(f)] + c2Fl[z(t)] = 0 hold.[z(r)] = 0 implies c T Q[z(f)]c > 0. we have Since if a*id only if (/gc2)TF2 + c^JgF2 = 0. which does not use any properties of Jg. c7F2[z(0] + clF.A.A. By (i) and (ii). c.S.1.1.290 Differential equations. (b) F(0) = 0.l) under hypotheses (a)-(c) of theorem 4. z2) Then global asymptotic stability of bounded trajectories holds. The reason theorem 4. 22]. must hold. for all ce/? 2 " with |c| = l. for all vectors ce R2n such that |c| = 1. (c) z2 — 02 is a locally asymptotically stable solution of ^2= F2[g(z2). Notice that although in hypothesis (d) of the theorem we used information on the Jacobian matrix of g. As in remark 2.1. Corollary 4. Proof. F ( z ) ^ 0 for z 7^ 0. z2]. = /gc2 where Jg = g'(z2). In corollary 4.1 is stated in the form above is that one can obtain the following corollary.

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

For example. Hartman and Olech's basic result in Hartman (1964. therefore. of optimal controls generated by MHDSs. It is. Its interest lies in applicability to systems where the stable manifold W (where W={z0:</>. . For a proof see Brock and Scheinkman (1975).2 would not be interesting if all it did was restate Hartman and Olech. stability and chaos in dynamic economics implies Then all trajectories in the bounded manifold converge to 0 as / -> oo. This kind of theory where sets more general than points.A. the important special case of MHDS that we are interested in generates systems where W is n-dimensional.S. and is done in a sequence of lemmas. necessary to build a theory that allows more general limit sets than rest points. Assumption 1 then becomes Hartman and Olech's (H-O) assumption. for example. and find sufficient conditions on preferences and technology for a minimal limit set to be stable in some sense.(z0)^0 as /-»oo}) is not all of R2n. Several topics for future research follow in the next section. 5.292 Differential equations. cycles and tori can be attractors. To see this.1) is closely related to this theorem. There is really no economic reason to rule out limit cycles. let G(z) = / 2n . Assumption 1 becomes Note that where We have reported in this chapter some recent progress toward providing a comprehensive analysis of G. put a(z) — — 2G(z). Theorem 4. In particular. will be treated in the next chapter. The proof of this theorem is long and involved. the 2nx2n identity matrix. Miscellaneous applications and exercises (1) A more general notion of long-run behavior needs to be formulated. theorem 14.

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

Although the amount of literature on problem 1 is extensive there are no general results on global stability. (7) Kurz (1968a.S. the one good optimal growth model. Kurz (1968a). but G. except around the steady state.S.A. The first branch of the literature on problem 1 is fairly complete. Koopmans (1965) and Burmeister and Dobell (1970). (6) Araujo and Scheinkman (1977) obtain conditions for G. Cass and Shell (1976a) present the Hamiltonian formulation of competitive dynamical systems that arise in capital theory. 1969) studies the general instability of a class of competitive growth and the inverse optimal control problem respectively.1. This class is basically the class where the Liapunov function V = k^H^k together with concavity of the value function yields V < 0. Samuelson (1972a) and Levhari and Liviatan (1972) are some representative references. 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. Ryder and Heal (1973) analyze a case of (1.1) for n -1. does hold. that is. is well understood. 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.1) in a neighborhood of a rest point. They generate a .294 Differential equations. 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.A. Eigenvalues have a well-known symmetric structure that determines the local behavior. 6. Standard references are Cass (1965). 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. It studies the linear approximation of (1. for discrete time models that are independent of the discount rate. 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. Chang (1988) extends the inverse optimal problem to the stochastic case. The simplest case with n . 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. Further remarks and references The qualitative study of optimal economic growth has attracted the attention of economic theorists for a number of years.

roughly speaking. Benhabib and Nishimura (1981). that if H(q. 149). See Burmeister and Graham (1973.1) that are optimal converge to a unique steady state (q. Burmeister (1980) gives a comprehensive exposition of dynamic capital theory. McKenzie (1968). Feinstein and Oren (1983). Boyd (1986a. 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. k0). McFadden (1967) and Brock (1970) for the n goods model in discrete time and by Rockafellar (1970a) for continuous time. Chang (1987. DasGupta (1985). These results state. p. k) is strictly convex in q and strictly concave in k and p — Q.1988). The case p = 0 is the famous Ramsey problem. the value of q along an optimal path is independent of k. Epstein (1987) and Becker et al. k) as tH»OO independently of (q0. 1986b). 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. McKenzie (1982). studied first by Ramsey (1928) for the one good model. Some additional recent references are Becker (1980). then by Gale (1967). . then all solution paths of (1. (1987).Stability in capital theory 295 variety of examples of different qualitative behavior of optimal paths.

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

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

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

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

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

i.1).e. In general. The measure u is an invariant measure for map f if u(/~'(S)) = u(S) for all measurable sets 5. an invariant measure of the map / turns out to be the uniform measure on [0. there are many of them. Kydland and Prescott (1982). Eckmann and Ruelle (1985) discuss criteria for selecting particular ones and conditions for convergence of time averages to that particular one. 1]. 1]. for almost all in the sense of Lebesgue measure. invariant measure. ergodic.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). In this case the autocorrelation function and the spectrum generated by most trajectories are the same as that of white noise. this recursion generates. Collet and Eckmann (1980) discuss sufficient conditions on maps for the existence of a unique.302 Differential equations. 1]. 1). stability and chaos in dynamic economics The case a . the ordinary Lebesgue measure on [0. initial conditions x0 e (0.3): the long run fraction of x ( t ) contained in [a. one must forecast x ( t ) based on the knowledge (1. This is the meaning of (1. Two basic properties of deterministic chaos are well illustrated by the simple tent map recursion (1. For simplicity. absolutely continuous with respect to Lebesgue. the IID sequence {u(t}}. In the case of (1. one only knows that x ( t ) lies in [0. Second. In general the long run fraction of x ( t ) in some set S converges to u ( S ) .. b] is just b — a. and others that are used in macroeconomics.. 1]. 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.e. 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. for a given map f..3)) to it. Care must be taken with invariant measures in chaos theory. Almost all trajectories converge (in the sense of (1. .l). we will assume that we have a unique ergodic. the long run fraction of x(r) in S is u(S).\ is especially striking. First. i. invariant measure in the sense that we have a unique u such that for all measurable sets S. and for almost all initial conditions x0 in [0. i. trajectories such that That is to say the map (1. 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.e.4).1).

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. lies on a one dimensional set embedded in a two dimensional space. in the case of (1. a test for deterministic chaos is simple: calculate the dimension of {x(t}} and examine if it is small. if we could measure x 0 with infinite accuracy. Unfortunately.. A popular notion of dimension used in natural science is the notion of correlation dimension due to Grassberger and Procaccia (1983a. Example (1.1). b) and Takens (1983) which is discussed in what follows. . An efficient way to test for chaos is to consider the following quantity Brock and Dechert (1987) show that for almost all initial conditions. lies in an r dimensional space for all embedding dimensions ra.e. They prove (1.1) then the sequence of ordered pairs.7) for noisy chaotic systems also. { ( x ( t ) . if {x(t}} is generated by deterministic chaos then the sequence of ordered m-tuples... Simply plotting x(t + l) against x ( t ) will not do because examples like can be generated that are chaotic. In general.Chaos and other aspects of nonlinearity 303 This property means that we have the potential ability.1) illustrates the need for a test for stochasticity beyond spectral and autocovariance analysis. it is not easy to come up with a notion of dimension that is easy to calculate and gives reliable results. Thus.. 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..1). the empirical spectrum and autocovariance function is the same as that of white noise. More precisely. to forecast x ( t ) perfectly. After all if the time series {x(t)} is generated by (1. i. {(x(t). x ( t + l))}. 1] random variables. as a matter of pure theory. big enough. x(t + m — 1))}. the same as that generated by independently and identically distributed uniform [0.

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

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

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

Chaos and other aspects of nonlinearity

307

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

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

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Differential equations, stability and chaos in dynamic economics

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

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

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

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

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

Chaos and other aspects of nonlinearity

309

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

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

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

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Differential equations, stability and chaos in dynamic economics

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

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

#prs

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

W

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

Series

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

N

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

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

Chaos and other aspects of nonlinearity

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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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Differential equations, stability and chaos in dynamic economics

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

3. Roads to chaos in macroeconomics

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

Chaos and other aspects of nonlinearity

313

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

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Differential equations, stability and chaos in dynamic economics

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

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

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

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

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

hence. deterministic chaos. that is. equilibria that are random. Indeed Grandmont (1985. . whenever cycles like those in figure 10. stability and chaos in dynamic economics Figure 10. 3. u. even though the model is deterministic. 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.2.2 of Azariadis and Guesnerie (1986) shows that there are sunspot equilibria. of the representative old person play the role of Ruelle and Takens' parameter.1 so that you get the situation in figure 10.2. 1030) displays a period doubling cascade generated by letting the relative risk aversion parameter. 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). a2. Notice how cycles appear when the offer curve is bowed out to the left more than in figure 10. (Caution: Grandmont's u is our limiting value of {x(t}} and his a2 is our u. figure 4.) Let us explain how Grandmont generates the Feigenbaum scenario. and.316 Differential equations. p.2 are present. We are not concerned with sunspot equilibria here.

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

Commodity money. 3. This strategy was pursued by Bewley's paper in Sonnenschein (1986). E. 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 . and 9 of this book. 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). a set of positive weights exist. to our knowledge. 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. 7. He constructs examples where equilibrium trajectories are chaotic. 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.3. Woodford (1987) has built a class of models where one type of agent is liquidity constrained and the other type is not. However. stability and chaos in dynamic economics 5. 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. Epstein's results show that when markets are complete (so that for a given competitive equilibrium. 7.318 Differential equations. facing discount rates (like those discount rates implicit in observed bond prices) on future utilities would indulge in optimal smoothing behavior to such an extent that cycles of modal length of three to four years could not exist. The 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. One way to do this is to introduce restraints on borrowing and lending. 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. and 9 of this book to argue that optimizing agents. Hence. 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.

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

3. w0) as before. Just draw the offer curve of the young through the same endowment point (wy. A payment of y > 0 of earnings on fiat money. c0): cy + c0=wy + w0 + y}. no matter how small is y. L. tends to force efficiency of all equilibria in overlapping generations models provided that free disposal or limited liability obtains. Also. The offer curve diagram for an asset market The offer curve apparatus can be easily amended to depict equilibria when y > 0.320 Differential equations. Recall that free disposal eliminates these and that they are the analogues of Gale's hyperinflationary equilibria when y = Q. Figure 10.3 depicts steady state equilibrium. but replace the PPF. under limited liability. forces the interest rate to be positive enough of the time to force efficiency by the Cass-BenvenisteGale criterion. Figure 10.5.4 depicts three positive steady state equilibria and a continuum of positive Figure 10. This finding allows us to state Proposition. But introduction of a market for claims to y > 0.3 . with Ry = {(cv. recall that the case y = 0 is the case of pure fiat money. R. stability and chaos in dynamic economics and Benveniste and Gale (1975) efficiency criterion. and a sequence of equilibria that converge to the lower steady state L" where the value of the asset is negative.

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

Scadding (1974) and references for discussions of the strong evidence supporting Denison's Law. See P. As we have said before. Fama (1976) has adduced evidence that the expected real return on T-bills is constant across time. A dramatic graph that shows the historical movement of real interest rates is in Rostow (1983. stochastic processes. Applications to finance In the first three sections we outlined some concepts from chaos theory. it is difficult to formulate a chaotic model in macroeconomics that is consistent with the existing evidence already mentioned. real interest rates do not move much across time except for the recent Reagan period. known as Denison's Law.S. some concepts from empirical nonlinear science. it is an irresolvable question whether macroeconomic fluctuations are generated by high dimensional chaos or infinite dimensional. 4. 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. 34). Pent up demand for automobiles after World War II in the U. Third. In summary.. and applications to macroeconomics.322 Differential equations. What is potentially resolvable is whether the fluctuations are generated by a low dimensional deterministic chaotic generator or a stochastic generator. David and J. p. i. Low dimensional chaos involves instability and overshooting. stability and chaos in dynamic economics Second. Automobiles might be a good example. Lucas (1987). 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). and McCallum's review (1986) of evidence for and against the real business cycle paradigm. 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). p. savings as a fraction of GNP seems to be a rather stable fraction of GNP over time. A graph of auto sales in Rostow (1983.e. The behavior of nominal and real interest rates will be discussed in section 4 of this chapter. 98) reveals a relatively smooth path to trend in auto sales after World War II. is a natural place to look for cycles and chaos in auto sales. In this section we try to tie these ideas together with . Fourth.

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

4. Measured returns may show spurious dependence due to measurement difficulties such as "bid/ask bounce". Details of market micro structure are very important at this frequency. This is formalized by Sims' (1984).a 508 point drop accompanied by a huge volume of trading.3 billion shares traded during this week was more than the total number of shares traded during all of 1964.69 at Monday's open to 1738.2.74 at Monday's close .} is an increasing sequence of sub sigma fields of a master sigma field. such as the stock markets. A process {P(t}} is instantaneously unpredictable if and only if. fall over the first 20-30 min. The whole week of October 19-23 was turbulent with the Dow falling from 2178. almost surely. 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.. The volume of 1. and rise in the last 20-30 min to the close. Similar patterns emerged in most of the world's major stock exchanges during the same week.t. an apparent disequilibrium panic like the Monday Massacre of October 19.r. For reasons of measurement error problems as well as a theoretical presumption that chaos should not be likely at the minute to minute frequency. ({/. the information set /. /. look unpredictable in the middle.) In words. (ii) trading volume and price volatility follow the same pattern near the opening and the close. Here E. See Marsh and Rock (1986) for details. 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.324 Differential equations. we will not spend any time analyzing stock price dynamics for chaos in this case. Incidents like these are worth keeping in mind as we discuss the standard theory of unpredictability of stock prices. is taken w. 1987 might generate evidence of chaotic dynamics. stability and chaos in dynamic economics returns tend to be higher at the opening of the exchange. Markets seesawed while volume skyrocketed. "for an instantaneously unpredictable process prediction error is the dominant component . Definition. Actually.

3. Malliaris (1981) gives a detailed mathematical description of (4. 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. on any variable in It have R2^> 0. for any dividends paid out. Hence. y(t+l).2) is exactly 1". arbitraging on the part of traders should destroy it provided it is easy to be recognized by traders over very short time intervals. if a predictable structure is present. regressions of Pt+s — P. They calculate another estimate of dimension due to Takens (1984) which is also close to 6.3) is adjusted for discounting. G(t+l).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. for a martingale (4.3) below with finite second moments. Short periods for Sims are daily to weekly.Chaos and other aspects of nonlinearity 325 of changes over small intervals. nonlinear dynamicists sometimes say that chaotic dynamics are unpredictable.2) doesn't rule out predictability over longer time periods. Sims points out that. s^O. and adjusting P.3) with illustrations from financial economics. 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. After all. They . 4. t+1]. He then argues that this is consistent with empirical evidence in finance. Under (4. and net cash flow. He also points out that (4. The discount process {G} and the net cash flow process {y} can also be random. Of course. The martingale hypothesis is Notice that (4.3). over the period [t. In practice (4. then forecasts of the future state become worthless at an exponential rate. stock returns index for the mid 60s. R2 = Q. This is the intuitive content of the Sims argument. But if you measure the state today with error. They find roughly 6. under (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). the subjective discount rate equal to zero.S. Recall that chaos theory teaches that trajectories generated by chaotic maps are potentially perfectly predictable provided that you can measure the state perfectly. the ratio in (4.2).

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

0 9.912 7.99 0.97 e 0.914 7. This table is drawn from Brock (1987b).910 7.8 0.913 7.5 8.6 7.3 BLVW[ 601: 1226]: N --= 626.0 6.1 5C 3.9 10.5 10.2 4.01 for VW in contrast to 7.8 Code for Table: EW.1 7.0 0.0 0.0 0.7 0.6 3.7 5.4 SCsf 3. returns on value weighted CRISP index.1 0.910 1. The Brock.915 9.6 SC 5. m = 10 0.0 11.97 e 0.4 4. residuals of an AR(8) fit to first difference's of tbill returns.6 7.910 5.8 10.915 1.911 7.8 7.96 7.96 3. m = 10 0.2 0.3 0.6 0.0 SC 2.5 6.6 7. SCsf denote the empirical slope of the GP diagram for the original series and the shuffled series.910 7.97 e 0. KODAK equals returns on equal weighted CRISP index.6 6. 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.6 SCsf 5.3 8.912 8.98 0.6 VW: N = 696.96 7. m = 10 0.8 5.0 5.7 SCsf 6.7 14.4 0.98 0. Dechert and Scheinkman statistic fell to 2.23 for EW and 4.912 5. BLVW[ 1:600].0 6.913 6.6 0.6 0.1 5.9 6.7 DSE8TBLM: N = 628 .2 4.913 9.915 7.913 8.2 EW: N = 696. m = 10 0.7 0.1 0.915 6.9 7.8 8.99 4.96 0.6 8.97 e 0.1 8.0 0.96 0.3 7.3 6.9 0.3 0.6 1.4 7.9 8.9° 7.4 0.98 0.911 8. DSE8TBLM.0 7. VW. Dechert .5 SC 5.0 6. the 5% level of the Brock.1 12. m = 10 0.910 4.2 0.914 1.1 0. first 600 returns on SIB's value weighted index.0 5.96 1.4 4.4 6.911 8.912 2.910 7.1 SC 5.1 7.913 1.5 645.98 0. All data were divided by the standard deviation and multiplied by 0.9 KODAK: N == 720.911 5. N equals number of observations.912 6.3 BLVW[ 1:600] : N = 600.2 SCsf 6.9" 1.9 0.7 9.6 0.6 5. BLVW[601:1226]. SC. next 626 returns on SIB's value weighted index.8 1.Chaos and other aspects of nonlinearity Table 10.5 0.99 0.9 7.3 0.7 644.5 3.8 7.7 10.97 e 0. and returns on Kodak stock.0 9.9 5.98 0.98 0.911 4.2.9 4.8 0.97 e 0.0 327 0.99 0.914 8.8 7.1 0. But Gennotte and Marsh took out the January effect.2 8.39 for VW for the whole sample.9 0.45 for EW and 1.915 8.2 9.4 19.9 6. m = 10 0.914 0. Gennotte and Marsh looked at the subsample January 1942-December 1971.2 7. respectively.5 10.3 4.3 0.914 0.912 7.5 SCsf 6. 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.4 SC 1.9 SC 4.914 9.0 5.99 5.1 0.0 9.7 0. m equals embedding dimension.7 0.1 8.9 7.7 7.6 7.3 0.7 0.915 9. modulo estimation error.97 0.

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

plus . This tradeoff depends upon the state of the economy. Thus government activity in the financial markets makes it even harder to interpret the evidence. The meaning of the (APT/CAPM) equation is intuitive. . What may explain the evidence for nonlinearity There are well known anomalies in finance.__l[G(T}eil] = 0. Movements in this tradeoff have the potential for explaining the findings in table 10._}[G(t)eit] terms are zero and rewriting (LFM. Let's take a brief look at this theory. It is typical in finance to search for an explanation in terms of systematic movements in risk return tradeoffs. . K « N. of systematic sources of risk.4. Form widely diversified portfolios to diversify away the unsystematic risks {ejt}. B are deterministic at date t. Ait. e are random and independent of each other at date / and have conditional mean 0 at each date t.1 as well as the Scheinkman and LeBaron findings. A. As a quick idea of how the CAPM and APT models work assume returns on stock i at date f. L0.Chaos and other aspects of nonlinearity 329 watches the central bank very carefully.covariance with the market as a whole. say 3 to 5. Let us explain. 8. Note that Ait is expected returns on asset i at date t conditional on date t — 1 information. . It states that expected returns on stock /. {Rit can be written as a linear factor model: Here the sum runs from k = 1 . Arbitrage Pricing Models (APT) adjust returns for a small number.l) into the pricing equation below where the discounting process is {G} to get Assume that K « N and the structure in (LFM. 4.2) gives. The Capital Asset Pricing Model (CAPM) adjusts returns for one source of risk . is the sum of the risk free return. Insert (LFM. 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. Assuming that the E.l) allows enough diversification opportunities so that the market acts as if E. . 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.

Evidence for and against the above theory is mixed. Rothschild (1986) reviews some of the evidence that is pertinent here. times the quantity. the return from Friday's close to Monday's open) appears to be negative.. Lkt. This movement of tastes for risk bearing impacts on stock prices through the above equations. With this background look at some evidence presented in Haugen's (1987) textbook and its references. Monday's return (that is. where excess returns adjusted for risk appear to exist. This is a version of the consumption beta model where returns are predicted to vary with aggregate consumption.. But so also does own risk. These differentials are not large enough to return a profit if you have to pay commissions (Haugen (1987. Note that G(t) = bu'(c. °f type k risk borne by stock i. This will be relevant in trying to interpret some of the evidence. 478))..19% for all other months.e.}. Stock returns are higher in January for nearly every other country with highly organized stock markets. Most of it occurs in the first five trading days of January and most of it is in the smaller firms. compared with an average of 0.63%. 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. These tastes may change through time. This has been confirmed for later periods. beta risk) as measured by the CAPM helps explain average returns. The association between size and average return is as good as the association between measured beta and average return. Systematic risk (i. For the CAPM case {5.)/u'(c. stability and chaos in dynamic economics the sum over k = 1 to K of the price of risk of type k. In January. Bkit. K = 1. The CAPM can be viewed as the special case of one source of systematic risk that cannot be diversified away.e. The t subscripts denote that this relationship can shift over time. Over 1929-1940. For the Standard and Poor's Index of 500 stocks. These models are operationalized by constructing indices to proxy for the unobservable to the scientist {5^. In general G ( t ) is determined by tastes of the public for risk bearing. Wednesdays and Fridays tend to have higher returns than Tuesdays and Thursdays. for daily returns over 1962-1968. The APT is the more general case of several sources of undiversifiable risk. January's average return was 6. i.} 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. So the relationship between expected returns .330 Differential equations. p.-l) for a representative infinitely lived consumer as in Lucas (1978). high beta (large covariance with the aggregate market) stocks produce higher than average rates of return.

and has stimulated a lot of effort in finance to explain it.r.3.3.S. rather it is the low return of T-bills relative to stocks. This is so because the consumption beta model is soundly rejected by data. see also Prescott and Mehra (1985).44. T-bills. and inflation over 1925-1975 in the U.25. The puzzle is not so much that stocks behave oddly w.5%/day and —0. It is fair to say that the January effect is striking. The CAPM risk premium for January was 3. 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. theory. long term bonds. The January average daily excess return falls as value increases. 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. This is dramatically vivid on page 3 of Ibbotson and Sinquefield (1977). For example. Scheinkman and LeBaron (1987). small firms are a factor.36% for the rest of the months over 1935-1980. are 90. See Person and Merrick (1987) and references especially to Hansen and Singleton. that is the CAPM/APT is not wildly rejected across risky portfolios.Chaos and other aspects of nonlinearity 331 and beta also changes in January.2. Cumulation of an initial investment of $1 on common stocks.3%/day for the largest ranking 10% of stocks. It is approximately 0%/day for all other months for all value classes. Consumption beta models are more consistent with data when nonstationarities and business cycle effects are accounted for (Person and Merrick . Researchers are looking for a source of systematic risk that differentially impacts upon small firms during the December-January period. robust. 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.t. This is so because Gennotte and Marsh (1986) took out the January effect and still got similar results. Most of the research uses a context like APT/CAPM to search for plausible explanations. yielding a real return on T-bills of about 0 during 1947-1975.31 respectively. We doubt that the January effect can explain the dimension findings of table 10.1.57.5.02% in comparison with 0.5. From 1947-1975 inflation and T-bills march in tandem. and Frank and Stengos (1986) that is dependent upon the consumption beta model. 4.

Furthermore. y. (iii) large linear forecast errors tend to come together but appear unpredictable in sign. The GARCH-M class of models is an attempt to parameterize this kind of data in a way to do statistical inference. There is sure to be controversy whether Lehman controlled for all sources of systematic risk. 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. Here y. it appears that volatilities move together across financial assets (even exchange rates) at a point in time. Autoregressive conditional heteroscedasticity Even though returns may not be predictable on average it still may be true that their variances may be predictable.6. appear to have no systematic risk in them. dependent upon current conditional volatility. stability and chaos in dynamic economics (1987)). Furthermore. Turn next to evidence of mean reversion in stock returns at the weekly frequency.\t-i. Bollerslev fits the model. but yet earn significantly positive returns when closed out. (ii) volatilities are persistent. 4.332 Differential equations. 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". 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. . Lehman's findings are a potential explanation for the Scheinkman and LeBaron (1987) results. Lehman's results appear to contradict many versions of the CAPM/APT equation because his portfolios are wealth free. is monthly returns on the S&P. This is an example of a Generalized Autoregressive Conditional Heteroscedastic (GARCH-M) model with conditional mean. stylized facts dating back to Mandelbrot and others are these: (i) unconditional distributions of stock returns are fat tailed.

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

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

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. 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. N ( t ) . in equilibrium. The 1947-1975 Ibbotson and Sinquefield evidence on T-bills and inflation is consistent with the close substitute view. (3) Another story for the evidence: the business cycle. Holding the quantity supplied of stock fixed at unity for all time and imposing supply of stock = demand for stock. 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. Modest conditions show that G(t+l) is increasing in the number of active investors. T-bills cumulated much faster than inflation during this period. Corporate profits covary with general activity such as real GNP but are more volatile. than in the pre World War II period. the details have not yet been worked out. Let each investor plan as if they live for two periods and let all active investors have identical tastes to keep the analysis simple.Chaos and other aspects of nonlinearity 335 story that we are going to propose. 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. Hence this cyclical change in the attitudes toward risk bearing should magnify swings in stock returns over the cycle. makes G(t+l) a function of the current number of investors this period. One would expect a bear market. 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. However. It seems possible to get chaos or complex dynamics for plausible specifications of N ( t ) .S. (ii) the amplitude (severity) of business cycles is less in the post World War II period in the U. Their evidence from 1925-1946 is not. 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. The marginal rate of substitution between this period's consumption and next period's consumption determines G(t + l). . the contradiction may be resolved when government activity to control interest rates and when government monetary and fiscal policy is taken into account. It is also important to realize that T-bills may be a close substitute for fiat money. Swings in the public's tastes for risk bearing may be tied to the business cycle. Now contrast this with investors at the peak anticipating a fall in economic activity. N ( t ) .

(II) If at the same time private savings and uncommitted cash is increasing. The fundamentals themselves move over the business cycle. French and Summers.336 Differential equations. This is an attempt to capture the mean reverting idea of Shiller. 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. can be translated into other examples of public hysteria quite easily. 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. a pure fads interpretation of the Fama and French findings is not very attractive. There is evidence that stock prices are systematically related to business cycle movements. If this is completely random then we have a reconciliation problem with the stock market . 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. Fama. We use the words of the stock exchange. With this perspective look at the distillation of the history of speculation by Montroll and Badger (1974). We will entertain the notion that the theory describes a central tendency for stock prices over time. So we are going to identify "fad" with magnification effects ignited by the business cycle. 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). the rise attracts new investors and enlarges the depth of involvement of those already in the market. After all. There is also the problem that this is a consumption beta type of story.business cycle evidence. but the basic ideas are general and. 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. in fact. We have the problem of explaining when fads start and when they die. It also links swings in asset prices to relative swings in generalized profitability or generalized productivity across the economy. We quote them verbatim. "We close this historical review of speculational orgies with a brief summary of the mechanism behind practically all these events. . The model of Scheinkman and Weiss (1986) generates equations related to CAPM/APT but contains two agent types.

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

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

(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 (iii) Brock (1987b) discusses conflicts between GARCH and ARCH models as currently applied and theory and evidence in macroeconomics and finance. This nonlinearity may have been channeled into stock returns through this equilibration of the market.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. (7) It would be interesting to use the methodology of this chapter to investigate the behavior of volume of trading in equity. This new perspective has already led to a new statistical test (Brock. 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. Dechert. Real GNP failed to show nonlinear structure but it may have been eliminated by aggregation. deseasonalization. transformation of variables. Shiller (1984) and Montroll and Badger (1974) deserve as much attention as investigation of dependence upon conditional variance (ARCH and its cousins). Nothing said here proves that there are chaotic dynamics driving stock returns at business cycle frequencies or that business cycle data are chaotic. This test has been generalized to multivariate series by E. (c) unemployment rate. and Scheinkman (1987)) for nonlinearity and intertemporal dependence that has good power against alternatives for which many tests have weak power. and detrending) do not account for all of the temporal dependence in these data. But the best fit linear models (after reduction to linearity by units changes. Investigation of dependence of stock returns on variables like measure of the "depth of interest" in the market. (b) civilian employment. (5) Brock and Sayers (1988) have presented evidence of strong nonlinear dependence in (a) industrial production. (6) Multivariate test. Back's test has excellent size and power characteristics. (d) pigiron production. 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. (ii) Brock. 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. futures or options . Dechert and Scheinkman have shown that GARCH processes generate zero bispectra and cite evidence that the bispectrum of stock returns is significantly nonzero.

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

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

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

159).) If f ( x ) is continuous in the interval a < x < b. and if F ( x ) = J /(x) dx is an indefinite . |/n (*) —/™ (*)| < e for all x in D.1. Friedman (1971. Next we recall a few important theorems. We say that {/„(*)} is a Cauchy sequence if for any £ >0 there exists a positive integer n0 such that whenever n > m > n0.2. Suppose that a function / is denned on a domain D. If a function is continuous at all points of a domain D. (Taylor's Theorem.3. stability and chaos in dynamic economies number in an open and connected set called the domain of f and denoted by D. for any e > 0 there is a positive integer n0 such that. Theorem 2. Theorem 2. and only if. 102). |/ n (x) ~/(x)| < e whenever n > n0. Let {/„(*)} be a sequence of real valued functions defined on a domain DCI R".) Let /(x) be a function that is continuous and has n +1 first derivatives on an open interval containing the points a and x. then it is said to be continuous on D. for all x in D. and only if. The uniform limit of a sequence of continuous functions is a continuous function. to each e > 0 there corresponds a 5>0 such that \ f ( x ) — f ( c ) \ < e whenever \x — c\<8 and xeD. p. p. If for any e > 0 there exists a number 5 > 0 such that |/(x) —/(c)| < e when |x . For a proof see A. Then the value of the function at x is given by where is called the remainder.c\ < 8 and x e D holds for all c e D. A sequence {/„(*)} defined on a domain DC R" is uniformly convergent to some function/(x) on D if. For a proof see Friedman (1971. (Fundamental theorem of integral calculus. then we say that/(x) is uniformly continuous on D. Theorem 2.344 Differential equations. Then f is continuous at c if.

t . pp. p. f ( x ) > 0 and h ( x ) are continuous real functions for a < x < b which satisfy then Theorem 2.4.b. 253). (Generalized Gronwall inequality. Theorem 2.) If c is a real constant.5. B ( t ) > 0 is integrable on [a. a are real valued and continuous functions for a .Appendix 345 integral of f(x).) If O. b] and then For proofs of these two theorems see Hale (1969. then the definite integral where the derivative of For details see Kamien and Schwartz (1981. (Gronwall's inequality. . 36-37).

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

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

In fact. that is AA-1 = I = A. Division is not defined for matrix algebra. is an n x n matrix with ones as the elements on the main diagonal and zeros elsewhere. However. to add two matrices. For example. The product of AB is an m x n matrix defined by with It is not in general true that AB = BA. A matrix A that does not have an inverse is called singular. 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 defined by Thus. to subtract two matrices.348 Differential equations. 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. and only if. det A = 0. is performed by multiplying every element of the matrix by k.1 A. the product BA may not be capable of being formed. (iii) A matrix A is invertible if. 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. . Now consider two matrices A and B with A an m x p matrix and B a p x n matrix. Matrix multiplication is possible only when the number of columns of A equals the number of rows of B. Thus. in matrix algebra the product of a matrix A and its inverse A-1 is the identity matrix /. one simply adds the corresponding entries. denoted by /. The identity matrix. Multiplication of a matrix by a scalar k. although AB can be formed. one subtracts corresponding entries. the inverse of a matrix bears the same relationship to that matrix that the reciprocal of a number bears to that number in ordinary algebra.

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

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

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

(2) A quadratic form is positive semidefinite if and only if characteristic roots are all nonnegative. starting at state y at time t0. For a quadratic form Q .R" x Rm x R -» R. pp. B:R" x R ->• R. (1) A quadratic form is positive definite if and only if characteristic roots are all positive. for all real x = 0 we define The basic result of this section is Theorem 5. 6. and x = dx/dt = f(x.xTAx. also called the indirect utility function.R'\ v. u. (3) A quadratic form is negative definite if and only if characteristic roots are all negative.1. Under modest regularity conditions the solution to the discrete time problem converges to the solution to the continuous time problem as h -0.1) and (6. Here V is the state valuation function.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. (4) A quadratic form is negative semidefinite if and only if characteristic roots are all nonpositive. Optimal control In continuous time the general optimal control problem is stated thus: where V:R" x R. 255-256).R f : R " x Rm x R. (5) A quadratic form is indefinite if and only if at least one characteristic root is positive and one is negative. The horizon T may be finite or infinite. . The discrete time version of step size h of (6. B is a bequest or scrap value function giving the value of the state x(T) at date T.352 Differential equations. For a proof see Hadley (1961. v is the instantaneous utility or payoff when the system is in state x = x(s)e R" at time s. 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. t) gives the law of motion of the state.

3)-(6.1) may be written: The first equation is obvious. T]. The terminal conditions (6.6) are the workhorses of optimal control theory. These variables are introduced for the same reasons and have the same interpretation that Lagrange-Kuhn-Tucker multipliers have in nonlinear programming.6) are sometimes called transversality conditions. the third follows from the definition of the state valuation function. the fourth follows from the integral mean value . Equation (6. 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. T] you must maximize the subtotal of the sum of payoffs from x(t0+h) over [t0+h. We briefly explain their derivation and meaning here following Brock (1987a) and other standard references such as Athans and Falb (1966) or Miller (1979). adjoint variable. furthermore the state and costate necessary conditions must be satisfied with p = Vx: The variable p is called the costate variable.Appendix 353 Under regularity assumptions by dynamic programming the value function V satisfies the Hamilton-Jacobi-Bellman (HJB) equation. Equations (6. and the function H* is called the Hamiltonian. or dual variable.

the fifth follows from Ax = x(t0 + h) — x(t0) = fh + o(h). Finally (6. The condition p(T)x(T) = Q means that nothing of value is left over at the terminal date T.3) is nothing but the principle of optimality in differential form. called the costate variable. thus putting p = Vx. This follows directly from equation (6.7). u.3).7). tQ+h)) in a Taylor series about x(t0) = y and t0.9) might be necessary for optimality. It is called the maximum principle. For any date T with terminal date in (6. Equation (6. Here o(h) is any function of h that satisfies Subtract V(y.354 Differential equations. but B = 0. So (6. To motivate this definition rewrite equation (1. is the marginal value of the state variable. The relation x = H*° follows from x=f(x. Araujo and Scheinkman (1983). the transversality condition. p ( T ) = Bx(x. M°. It measures the incremental sum of payoffs from an extra unit of state variable. Observe that the Hamiltonian function H* just collects the terms that contain the control u. When T is infinite. assume the state valuation function V(y. The relation p = -H*° follows from substitution of the derivative of (1. The quantity p. T) takes the form p(T)x(T) = Q. and Weitzman (1973) show that (6. t0) from the LHS and the extreme RHS of the above equation. t0). stability and chaos in dynamic economies theorem and expansion of V(x(t0+ h). p = Vx. t0) and future instantaneous value px — pf(y. Benveniste and Scheinkman (1982). u. T) is .4) is just a definition.9) is necessary and sufficient for optimality for a large class of problems.5) is easy to derive. then. The principle that the optimal control u0 must maximize H* is important. If there is an inequality constraint x ( t ) > b for all t. Equation (6. The control u must be chosen to maximize H* along an optimum path. One chooses the control to maximize the sum of current instantaneous payoff v(y. 0 and the envelope theorem.3) wrt x into the expression for d/Vdf = (d/dt)V x .1) set equal to infinity.6) is simple. divide by h and take limits to get (6. for a large class of problems the condition takes the form and is called the transversality condition at infinity. It is instructive to give a rough heuristic argument to motivate why (6.

1) may be written in the time stationary form By the change of units W(y.1) here.oo. (Note that t0 is replaced with T and T is replaced by x in (6. Examples exist where (6. t0). the transversality condition becomes . If x(T) >0 and p(T)>Q (more x is better than less) then which is (6.Appendix 355 concave in y.10) will go to 0 as T. H = e s 'H* and we may write the optimality conditions (6. 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. TH-x for any state path z.9) is not necessary for optimality. W becomes independent of T so that W. T ) .) Use concavity and p(T)= V x ( x ( T ) . 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.9). See Benveniste and Scheinkman (1982).6) in the form: When the horizon T = oo. T) to get the bound Now suppose that the distant future is insignificant in the sense that V ( z ( T ) . = 0. q = e5'/>. f0) = es' V(y.3)-(6. Then it is plausible to expect that the LHS of (6. and Araujo and Scheinkman (1983) for the details and references.0 .

15) to be optimal. Finally. stability and chaos in dynamic economies and (6.17) is necessary as well as sufficient. For further details see Mangasarian (1966). Brock (1987a). (1987) use monotone control methods to solve certain problems in economics. The condition (6. 7. for a solution of (6. Arrow and Kurz (1970) or Kamien and Schwartz (1981). Pindyck (1973). Barron et al. . Friedman (1975) apply control theory to stabilization policies.356 Differential equations. chapters 5. Turnovsky (1974) and B. 9 and 10 use elementary notions from measure theory which are presented in Royden (1968).17) determines q0.

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

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

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

7 Efficient markets. 286 Daily and weekly stock price changes. 190-193. 42. 261 Existence of solutions. 83 Forcing function. 161-176 Focal point. 234. 139-140 Generic. 7 of linear systems. 19 Exp(AO convergence. 132 Feigenbaum cascade. 272 e-approximate solution. 110 [see also Global asymptotic stability] General competitive equilibrium. 258 Current value Hamiltonian. 192-193. 51 Exponential asymptotic stability. 98. 344 Domain of attraction. 153 D-stability. 322 Dependence on initial data and parameters. 73. 282.A. 190 Critical behavior. 120. 343-344 uniformly bounded. 207. 79. 275 economic meaning. 190. 123 Dominant diagonal.384 Index of chaotic rational expectations. 347 Equilibrium-disequilibrium adjustment process. 232 [see also Steady state] examples of. 41. 139 Curvature matrix. 326 Equicontinuous sequence. 74. 129. 133. 237. 9 [see also Cauchy polygon.. 316 Equilibrium manifold. 174. 243-245 sunspot. 111. 107. 42. 275 Curvature assumption. 125 Differentiability of solutions. 353-354 Cost of adjustment theory. 200-201. Polygonal path] Euler's relation. 169. 105 existence of. 161. 10 continuity and. 299 Eigenvalue. 188. 139. 324340 Debt-equity ratio. 7 and initial value. 221 Cost of capital. 273 Correspondence principle. 50 Future invariant. 150 Gale equilibria. 260 informational. 195 manifold. 24. 32 Picard-Lindelof theorem of. 153 Differential games. 39 examples. 39 definition. 329-331 Excess demand function. 188. 105. 237. 347 uniformly continuous. 23-25 Destabilization. 7 Domain. 202 General nonlinear nonquadratic problem. 157 Deterministic chaotic explanation. 127 Crowding out. 313. 318 definitions. 317 First best regulation. 276 geometric meaning. 5 as a local property. 27. 204. 227. 265-267 . 154 Dirichlet function. 141. 307 Global asymptotic stability. 344 Fundamental matrix solution. 321 structure. 336 Exchange rate. 266. 306 Diffeomorphism. 68 EM. 123. 238. 272 modified Hamiltonian. 110-124. 160. 300. 191 Duration. 249. 5-11. 249. 241 Equity value. 172 Decreasing returns. 195 Dynamical systems.S. 7 Cauchy-Peano theorem. 127 Denison's Law. 147. 57. 123. 262 Cournot oligopoly. 265. 203 Excess volatility. 5. 157 [see also Samuelson's correspondence principle] Costate variables. 32 Function bounded. 267 Equity-debt ratio. 299. 241. 265 [see also Equilibrium manifold] Empirical derivative. 2. 219 Equilibrium solutions. 139. 347 continuous. 346 Evidence for nonlinearity. 63 Fads. 274. 146 Decrescent. 336 Feedback form. 314-318 G. 169 Euler polygon. 196. 29 and discontinuity. 33. 241 Decentralized regulated competitive equilibrium. 294. 232.

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

90 semiorbit. 201 nonsingular. 32 fundamental matrix solution. 276 Martingale. 43. 71-72. 354 Mean reversion of stock prices. 33 orthogonal. 15-18. 113 Linear systems. 274-276 diagonal. 215 Multiple eigenvalues. 348 symmetric. 89. 189. 43 nonhomogeneous. 65 principal matrix solution. 118. 38-46 Lipschitz condition. 90. 312-322 offer curve and Gale equilibria. 39 fundamental. 47 existence of solutions of. 236-243 perfect foresight equilibrium. 33. 99. 301 Macroeconomic policy. 260 Tobin's. 57 examples. 101. 60. 293 Local instability (Liapunov). 325 Matrix curvature. 94. 68. 127. 228-234 optimal conditions for households. 106-110 Local stability (Liapunov) definition. 350 dominant diagonal. 38 with constant coefficients. 247-252 equilibrium structure and system dynamics. 63. 230-233 government sector. 350 transpose. 218. 200-201. 332-333. 32 examples of. 57 for autonomous systems. 239. 225-269. 74-76. 36. 299. 249 optimal rate. 2. 259 Mortensen's theorem. 43. 159-197 Modigliani-Miller propositions. 59-67 two dimensional. 69. 349 Maximum principle. 97. 339 Negative definite. 243-245 macroeconomic structure. 114 semidefinite. 32. 136. 106. 68.236 optimal conditions for firms. 32. 181-184 Multivariate test. 263-265 steady state. 70. 318-322. 32 Lipschitz constant. 190-192 Lotka-Volterra system. 228-234 corporate sector. 32 variation of constants for. 190 similar. 69. 50 homogeneous. 127 theorems. 347 triangular. 338 Microeconomic dynamics. 314-318 stock market prices. 241 Modern approach to differential equations. 247. 45. 339 Market value. 103.386 Index Macroeconomic structure. 305 anticipated event analysis. 201 limiting set. 46. 58. 20. 32 and input function. 103. 51 initial value problem of. 15-18 Local asymptotic stability (Liapunov) definitions. 256 stability of rational expectations. global stability. 33. 260 Multiple optimal paths. 37 and forcing function. 66. 154-155. 33 stability of. 350 principal. 245-247 unanticipated event analysis. 134. 268-269 characterizations of steady states. 33. 272 Monetary growth constant rate. 93-94. 71-72. 50 Multiple equilibria. 57. 267-268 . 248. 27. 227. 51 perturbed. 50 Jacobian.28 Modified Hamiltonian dynamical system. 255 perfect foresight. 66. 62. 233-234 household sector. 44. 33 quasidominant diagonal. 32. 110. 234-236. 273 examples. 324-340 Macroeconomic modelling. 234. 105 Macroeconomic chaos. 153 exponent of. 348 singular. 133. 77-84 uniqueness of solution of. 58. 37. 351 negative definite. 43. 109. 231 Marshallian demand curve for capital services. 41. 32-39 adjoint equation of. 228-230 Magnification effects. 336. 108 Local stability vs. 257-258 theorems. 93-106 for nonautonomous systems. 350 trace. 97-98.

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

153 e-approximation. 57-58. 190 Poisson. 247-252 Samuelsorfs correspondence principle. 186 nonuniqueness of. 55. 13-19. 80 Stability and continuous dependence of solutions on initial data. 273 Speculation. 193 hypothesis. 281-287 Stability in investment theory adjustment cost model. 266 as a methodological principle. 82-83 Stable tangent node. 261 stochastic. 132 Static first best regulation. 190 in the first approximation. 5-11 infinitely many. 27 uniqueness of.326 Significant behavior. 131-158 of two dimensional linear systems. 204-206. 258 Second best regulation. 273 continuation of. 130. 154-155. 204-206 Samuelson's correspondence principle. 129 local vs. 125-126 Stable node (or focus). 147. 77 variable. 157. 260. 308-312 Steady state. 153 structural. 129 Stability in capital theory. 214-219 capital deepening. 191 uniform asymptotic. 204 Sarkovskii sequence. 83 Stable improper node. 210. 176-180 Self-fulfilling expectations. 191 expectations and. 201-204. 7 Simple eigenvalue. 86 total. 130 perfect. 66-75 Stability of optimal control. 199-224 in oligopoly. 268 of homogeneous linear system. 89. 27 nonequilibrium. 115. 261. 120 definition. global. 71 Lagrange. 153. 67 weak. 265. 271-295 convergence of bounded trajectories. 190-192 methods. 79. 24. 337 Spiral sink. 84 bounded. 212-214. 147 State space. 190 in capital theory. 207-212. 25. 87. 161. 298 Social dynamics. 199. 134. 149. 3 dependence on initial data and parameters. 70 Slow moving parameters. 84. 206. 105. 53-87 successive approximations. 202 revised. 155. 232 existence of. 43 optimal. 190-193 of linear systems. 306-312 BDS test. 24. 211 Shuffling. 221. 175 Statistical theory for nonlinear dynamics. 245-247. 201-204 Stability in rational expectations. 271-295 in investment theory. 89-130 notions in rational expectations. 110-124 D-stability. 123. 224. 98. 298. 174.388 Index asymptotic (global). 43 of nonhomogeneous linear system. 14 maximal. 57 . 157 imperfect. 23-25 differentiability of. 73-74. 333 Solutions attractive. 59-66 of optimal control. 32. 11-13 continuity with respect to initial data and parameters. 215. 62. 193 asymptotic (local). 53-87. 352 vector. 104 Simple discontinuity. 75-77 saddle-path. 263-265 Stability of linear systems with constant coefficients. 130 practical. 57-58. 336 Speculative bubbles. 18-23. 49 Simple zero. 66-67 uniform. 272 stability methods of. 259-260. 7 equilibrium. 56 and permanent income hypothesis. 57. 226 Separable Hamiltonian. 11. 313 Saving rate. 110. 268. 77-84 orbital. 82 Stable manifold theorem. 287 optimal steady states. 64. 263-265 of competitive equilibrium. 131-158 Stationary solution. 65. 129 Routh-Hurwitz criterion for.

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

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