Monetary Economics

Matlab code for Lecture 5

Numerical simulation of dynamic models
Johan Sderberg
Spring 2012
Provided below is code for solving the basic NK model

1 b
it Et t+1 rtn
xt = Et xt+1

t = xt + Et t+1
bit = t + y xt
n
rbtn = r rbt1
+ t

numerically using the Blanchard-Kahn method, QZ-method, and Dynare program. The QZ-algorithm
requires Chris Simss qzdiv.m and qzswitch.m routines, which can be downloaded from his website.
The Blanchard-Kahn method:
clear all
% calibration
beta =0.99;
sigma =1;
phi =1;
theta =2/3;
phi_y =0.1;
phi_pi =1.5;
rho_r =0.8;
kappa =(1 - theta )*(1 - theta * beta )/ theta *( sigma + phi );
n =1; % number of pre - determined variables
m =2; % number of forward - looking variables
% define matrices A , B and C
A =[1
0
0
beta

0;
0;
1

-1/ sigma
B =[ rho_r
0
0

-1/ sigma

-1]

0
1
- phi_pi / sigma

0;
- kappa ;
-(1+ phi_y / sigma )]

C =[1;
0;
0]

F = inv ( A )* B ;
G = inv ( A )* C ;
[ P J ]= eig ( F ); % get eigenvectors and eigenvalues
J = diag ( J ); % vectorize J
[ unused order ]= sort ( abs ( J ) , ascend ); % sort eigenvalues in ascending order
J = diag ( J ( order )); % reorder J and make diagonal again
P = P (: , order ); % reorder eigenvectors

% check number of eigenvalues outside unit circle equal to m

if ( sum ( abs ( diag ( J )) >1)~= m )
break ;
end
% partition matrices
Pinv = inv ( P );
Phat11 = Pinv (1: n ,1: n );
Phat21 = Pinv ( n +1: m +n ,1: n );
Phat12 = Pinv (1: n , n +1: m + n );
Phat22 = Pinv ( n +1: m +n , n +1: m + n );
F11 = F (1: n ,1: n );
F21 = F ( n +1: m +n ,1: n );
F12 = F (1: n , n +1: m + n );
F22 = F ( n +1: m +n , n +1: m + n );
J1 = J (1: n ,1: n );
J2 = J ( n +1: m +n , n +1: m + n );
G1 = G (1: n );
G2 = G ( n +1: n + m );
% calculate coefficients
C11 = real ( F11 - F12 * inv ( Phat22 )* Phat21 )

C12 = real ( G1 - F12 * inv ( Phat22 )* inv ( J2 )*( Phat21 * G1 + Phat22 * G2 ))

C21 = real ( - inv ( Phat22 )* Phat21 )
C22 = real ( - inv ( Phat22 )* inv ( J2 )*( Phat21 * G1 + Phat22 * G2 ))
% calculate imp . resp .
j =20; % number of periods
x1 = zeros (n , j );
x2 = zeros (m , j );
e = zeros (1 , j );
e (1 ,1)=0.01;

% size of shock

for i =1:1: j ;
x1 (: , i +1)= C11 * x1 (: , i )+ C12 * e (: , i );
x2 (: , i ) = C21 * x1 (: , i )+ C22 * e (: , i );
end
% plot imp . resp
figure
plot ( x2 *100)
legend ( Inflation , Output gap )
break ; % remove if simulate
% simulate model
j =700; % number of periods
x1 = zeros (n , j );
x2 = zeros (m , j );
e = randn (1 , j )*0.01; % draw shocks from normal distribution
for i =1:1: j ;
x1 (: , i +1)= C11 * x1 (: , i )+ C12 * e (: , i );
x2 (: , i ) = C21 * x1 (: , i )+ C22 * e (: , i );
end

The QZ-method:
clear all
% calibration
beta =0.99;
sigma =1;
phi =1;
theta =2/3;
phi_y =0.1;
phi_pi =1.5;
rho_r =0.8;
kappa =(1 - theta )*(1 - theta * beta )/ theta *( sigma + phi );
n =1; % number of pre - determined variables
m =2; % number of forward - looking variables
% define matrices A , B and C
A =[1
0
0
beta
-1/ sigma
-1/ sigma
B =[ rho_r
0
0

0;
0;
-1]

0
1
- phi_pi / sigma

0;
- kappa ;
-(1+ phi_y / sigma )]

C =[1;
0;
0]

[ S T Q Z ]= qz (A , B ); % qz - decomposition
lambda = eig (B , A ); % get generalized eigenvalues
% check number of eigenvalues on or inside unit circle equal to n
if ( sum ( abs ( lambda ) <=1)~= n )
break ;
end
[S ,T ,Q , Z ] = qzdiv (1 ,S ,T ,Q , Z ); % rearrange matrices
R=Q*C;
% partition matrices
S11 = S (1: n ,1: n );
S21 = S ( n +1: m +n ,1: n );
4

S12 = S (1: n , n +1: m + n );

S22 = S ( n +1: m +n , n +1: m + n );
T11 = T (1: n ,1: n );
T21 = T ( n +1: m +n ,1: n );
T12 = T (1: n , n +1: m + n );
T22 = T ( n +1: m +n , n +1: m + n );
Zinv = inv ( Z );
Zhat11 = Zinv (1: n ,1: n );
Zhat21 = Zinv ( n +1: m +n ,1: n );
Zhat12 = Zinv (1: n , n +1: m + n );
Zhat22 = Zinv ( n +1: m +n , n +1: m + n );
R1 = R (1: n );
R2 = R ( n +1: n + m );
% calculate coefficients
C11 = real ( inv (( Zhat11 - Zhat12 * inv ( Zhat22 )* Zhat21 ))* inv ( S11 )...
* T11 *( Zhat11 - Zhat12 * inv ( Zhat22 )* Zhat21 ))
C12 = real ( - inv ( Zhat11 - Zhat12 * inv ( Zhat22 )* Zhat21 )* inv ( S11 )...
*( T11 * Zhat12 * inv ( Zhat22 )* inv ( T22 )* R2 + T12 * inv ( T22 )* R2 - R1 ))
C21 = real ( - inv ( Zhat22 )* Zhat21 )
C22 = real ( - inv ( Zhat22 )* inv ( T22 )* R2 )
% calculate imp . resp .
j =20; % number of periods
x1 = zeros (n , j );
x2 = zeros (m , j );
e = zeros (1 , j );
e (1 ,1)=0.01;

% size of shock

for i =1:1: j ;
x1 (: , i +1)= C11 * x1 (: , i )+ C12 * e (: , i );
x2 (: , i ) = C21 * x1 (: , i )+ C22 * e (: , i );
end
% plot imp . resp
figure
plot ( x2 *100)
legend ( Inflation , Output gap )
break ; % remove if simulate

% simulate model
j =700; % number of periods
x1 = zeros (n , j );
x2 = zeros (m , j );
e = randn (1 , j )*0.01; % draw shocks from normal distribution
for i =1:1: j ;
x1 (: , i +1)= C11 * x1 (: , i )+ C12 * e (: , i );
x2 (: , i ) = C21 * x1 (: , i )+ C22 * e (: , i );
end

Dynare:
var x pi i r_n ;
varexo e_r ;
parameters beta sigma phi theta phi_y phi_pi rho_r kappa ;
beta =0.99;
sigma =1;
phi =1;
theta =2/3;
phi_y =0.1;
phi_pi =1.5;
rho_r =0.8;
kappa =(1 - theta )*(1 - theta * beta )/ theta *( sigma + phi );
model ( linear );
x = x (+1) -1/ sigma *( i - pi (+1) - r_n );
pi = kappa * x + beta * pi (+1);
i = phi_pi * pi + phi_y * x ;
r_n = rho_r * r_n ( -1)+ e_r ;
end ;
shocks ;
var e_r =0.01^2;
end ;
stoch_simul ( irf =15);
Note that because we are working with a linear model, we need to tell Dynare not to linearize the
model by adding the option linear to the model block.

Dynare code for optimal monetary policy when a cost-push shock has been appended to the Phillips
curve:
var x pi i ;
varexo e_u ;
parameters beta sigma phi theta phi_y phi_pi rho_r kappa eta ;
beta =0.99;
sigma =1;
phi =1;
theta =2/3;
phi_y =0.1;
phi_pi =1.5;
rho_r =0.8;
eta =6;
kappa =(1 - theta )*(1 - theta * beta )/ theta *( sigma + phi );
model ( linear );
x = x (+1) -1/ sigma *( i - pi (+1));
pi = kappa * x + beta * pi (+1)+ e_u ;
end ;
shocks ;
var e_u =0.01^2;
end ;
pla nner_o bjecti ve pi ^2+( kappa / eta )* x ^2;
ramsey_policy ( planner_discount =0.99 , irf =15);

We can also let Dynare compute the linearization for us. As an example, consider a simple RBC
model with fixed labor supply, described by the equilibrium conditions:


Ct = Et Ct+1
Rt+1

Kt = ezt Kt1
+ (1 ) Kt1 Ct
1
Rt = 1 + ezt Kt1

zt = zt1 + t
where Ct is consumption, Kt is capital, Rt is the gross rental rate of capital, ezt is technology, and
t is an i.i.d. productivity shock with finite variance. Note that Dynare requires us to use the end
of period stock concept for stock variables.
The Dynare code for linearizing and solving this model is
var c k r z ;
varexo e ;
parameters alpha beta delta sigma rho ;
alpha =1/3;
beta =0.95;
delta =0.1;
sigma =5;
rho =0.8;
model ;
c ^( - sigma )= beta * c (+1)^( - sigma )* r (+1);
k = exp ( z )* k ( -1)^ alpha +(1 - delta )* k ( -1) - c ;
r =1+ alpha * exp ( z )* k ( -1)^( alpha -1) - delta ;
z = rho * z ( -1)+ e ;
end ;
initval ;
c =1;
k =1;
r =1;
z =0;
end ;
steady ;
shocks ;
var e =0.01^2;
end ;
stoch_simul ( irf =60 , order =1);

To compute a log-linear approximation instead, redefine each variable as the logarithm of the
original variable. The Dynare code then modifies to
var c k r z ;
varexo e ;
parameters alpha beta delta sigma rho ;
alpha =1/3;
beta =0.95;
delta =0.1;
sigma =5;
rho =0.8;
model ;
exp ( c )^( - sigma )= beta * exp ( c (+1))^( - sigma )* exp ( r (+1));
exp ( c )= exp ( z )* exp ( k ( -1))^ alpha +(1 - delta )* exp ( k ( -1)) - exp ( k );
exp ( r )=1+ alpha * exp ( z )* exp ( k ( -1))^( alpha -1) - delta ;
z = rho * z ( -1)+ e ;
end ;
initval ;
c =1;
k =1;
r =1;
z =0;
end ;
steady ;
shocks ;
var e =0.01^2;
end ;
stoch_simul ( irf =60 , order =1);
For a second-order approximation, set order = 2 (default if no order is given) in the stoch_simul
command. As of version 4.1, Dynare can also compute third-order approximations by setting
order = 3.

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