1.

2 Higher-Order Systems of Difference

Equations and Simultaneous Systems

1.2.1. Mathematical Background

Higher-order equations of n-th order:

c0 yt + c1 yt 1 + ... + cn yt n = g (t )
Solution of homogeneous equation:

( g (t ) = 0) : try t

c0t + c1t 1 + c2t 2 + ... + cn t n = 0

t n (c0n + c1n 1 + ... + cn ) = 0
144424443
characteristic equation

1
1.2.1 Mathematical Background

n n 1 ci
Can be written as: + a1 + ... + an = 0 , ai =
c0

Solution with n roots: 1 ,..., n
Hence: yt = A11t + A2 t2 + ... + An tn

If some of the roots are complex, some terms could be replaced by trigonometric
functions.
Particular solution: like before
e.g., if g (t ) = G try const y
G
c0 y + c1 y + c2 y + ... + cn y = G y =
c0 + c1 + ... + cn

2
1.2.1 Mathematical Background

Determination of constants Ai via n initial conditions

( y0 , t = 0), ( y1 , t = 1), ... ( yn 1 , t = n 1)

y0 = A1 + A2 + ... + An + y

M A1 , ... , An
yn 1 = A11n 1 + A2 n21 + ... + An nn1 + y

Stability conditions: for all real roots i : i < 1

For complex conjugate roots (which always appear in pairs of two): modulus r <1

All roots should lie within the unit circle of the complex plane.

Comprehensive conditions become successively more complicated with increasing n

(cf. Gandolfo, p.98). 3
1.2.1 Mathematical Background

Simultaneous Systems: lags in different variables

Simplest type: first order system
yt +1 = a11 yt + a12 zt + g1( t )
zt +1 = a21 yt + a22 zt + g 2 ( t )
(called normal form because in each
equation only one variable appears with
time index t+1)

Solution of homogenous equation: (g1(t) = g2(t) = 0)

Transform it to a second-order system

1 a
zt = yt +1 11 yt
a12 a12
1 a a a a
yt + 2 11 yt +1 = a21 yt + 22 yt +1 11 22 yt
a a a a12
1124442412443 112444244 43 4
zt +1 zt
1.2.1 Mathematical Background

yt + 2 (a11 + a22 ) yt +1 (a11a22 a12 a21 ) yt = 0

yt (a11 + a22 ) yt 1 (a11a22 a12 a21 ) yt 2 = 0
in compact form:

yt = A11t + A2 t2
yt = A1t1 + A2t2
1 a
zt =
a12
( ) (
A11t +1 + A2t2+1 11 A11t + A2t2
a22
) zt = A12( 1)1t + A22( 2)t2

Hence, first-oder system of two variables is equivalent to second-order diff. equation.

"a1 "
647 48 644"7 a2 "
448
Characteristic equation 2 (a11 + a22 ) + (a11a22 a12 a21 ) = 0
a11 a12
is equivalent to Det ( A I ) = =0
a21 a22 5
1.2.1 Mathematical Background

Particular solution: like before, but for two variables; e.g.

g1 (t ) = b1 , g 2 (t ) = b2 try y = 1 , z = 2

1 = a111 + a12 2 + b1


2 = a211 + a22 2 + b2

b1 ( a22 1 ) + b2 a12
1 =
( a11 1 )( a22 1 ) a12 a21

b2 ( a11 1 ) + b1a21
2 =
( a11 1 )( a22 1 ) a12 a21
6
1.2.1 Mathematical Background

n x n systems:

y ( 1 ) = a11 y ( 1 ) + a12 y ( 2 ) + ... + a1n y ( n ) + g1( t )

t +1 t t t

y ( 2 ) = a21 y ( 1 ) + a22 y ( 2 ) + ... + a2 n y ( n ) + g 2(t)

t +1 t t t
M
y ( n ) = an1 y ( 1 ) + an 2 y ( 2 ) + ... + ann y ( n ) + g n ( t )
t +1 t t t

7
1.2.1 Mathematical Background

The characteristic equation is

a11 a12 L a1n

a21 a22 L a2 n
D( ) = A I = =0 n roots i
M M O M
an1 an 2 L ann

In matrix notation:

y t +1 = Ay t (notation: Bold for vector or matrix)

Try solutions:

y t = t , = (1 , 2 ,..., n )

8
t +1 = At i.e., 1 t +1 = a111t + a122t + ...
1.2.1 Mathematical Background

t [A I ] = 0 0

Non-trivial solutions only if A I = 0

n solutions i: eigenvalues with corresponding eigenvectors (i) obtained fromy = t
t
with known .

General solution then:

y (1) = A1 (1) 1t + A2 ( 2) t2 + ...
t 123 1 1213
~ ~
A1 A2
M
y ( n) = A1 n(1) 1t + A2 n( 2) t2 + ...
t

Stability: check whether |i |< 1 holds for all roots of the characteristic equation.
Note that coefficient of the characteristic equation are combinations of coefficients aij
However, many stability conditions are available which directly apply to the aij
9
(cf. Gandolfo, pp. 127)
1.2.1 Mathematical Background

10
1.2.1 Mathematical Background

11
1.2.1 Mathematical Background

12
1.2.1 Mathematical Background

Particular solution for constants g(t)=b

Try y: y = Ay + b (matrix notation)

y = (I A ) b
1

Higher-order systems not in normal form:

Either derive characteristic roots directly or transform to normal form.

Example:

yt +1 = a11 yt 2 + a12 zt yt +3 a11 yt a12 zt + 2 = 0

zt +1 = a21 yt + a22 zt zt +3 a21 yt + 2 a22 zt + 2 = 0

13
1.2.1 Mathematical Background

Try: yt = 1t , zt = 2t
1t +3 a111t a12 2t + 2 = 0
2 t +3 a211t + 2 a22 2t + 2 = 0

[
t 13 a111 a12 2 2 = 0 ]
t + 2 [ 2 a211 a22 2 ] = 0

3 a11 a122
(1 , 2 ) = 0
a21 a22

14
1.2.1 Mathematical Background

Alternatively, xt +1 = yt , wt +1 = xt

yt +1 = a11wt + a12 zt 0 a12 a11 0

zt +1 = a21 yt + a22 zt a21 a22 0 0
A= 0
wt +1 = xt 0 0 1

xt +1 = yt 1 0 0
0

Transformation to normal form with coefficient matrix A.

15
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

(1) Transform multiplier-accelerator into first-order system:

Ct +1 = bYt
Yt +1 = Ct +1 + I t +1 + G
= bYt + k (bYt Ct ) + G
= kCt + b(1 + k )Y t+G

b
Det ( A I ) =
k b(1 + k )
= 2 b(1 + k ) + bk = 0

16
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

(2) Inventory cycles: Metzler (1941) proposed a model of the business cycle along the
lines of Samuelson, but with inventory adjustment instead of the investment accelerator

( )
(1) Yt = U t + Q t Qt 1 + I 0
1424 3
expected adjustment of autonomous component
demand inventories to
their desired
level

(2) Q t = kU t constant ratio between expected sales

and desired inventory

accelerator

17
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

( 3 ) U t = Ct 1 + (Ct 1 Ct 2 )
extrapolative adjustment of expectations of producers, 0
( 4 ) Ct = bYt Keynesian consumption function

( 5 ) Qt 1 = Qt 1 (Ct 1 U t 1 ) = (1 + k )U t 1 Ct 1
14 4244 3
unintended
This is at t-1 for
convenience intended

Putting all equations together yields:

Yt [( +4k2
1b414
)(14
+4 )41]Yt 1 + b1
+3 (14+4k2
)(14+ 4 )Yt 2
23 ( 1 + k )b Yt 3 = I 0
14243
a1 a2 a3
18
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

Stability conditions for third-order system:

1 + a1 + a2 + a3 > 0
1 a1 + a2 a3 > 0
1 a2 + a1a3 a32 > 0
a2 < 3
I0
Particular solution: try yy=
1 b
8application of stability conditions yields:
3
3 b (2k + 3) > 0 b <
2k + 3
(1 + k )(2 + k ) b 2 (1 + k )(1 + 2 ) b + 1 > 0
After elimination of conditions which are necessarily fulfilled (2 out of 4). 19

Insights: dependency of stability/instability on parameters
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

1
For =0 stability condition becomes b<
1+ k
The higher , the smaller the parameters b and k have to be (cf. Gandolfo, Fig. 8.1)

The sufficient condition a i <1

1 + b[(1 + k )(1 + ) + 1] + b(1 + k )(1 + 2 ) + (1 + k )b < 1

b[(1 + k )(2 + 4 ) + 1] < 0

is not satisfied!

20
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

From Gandolfo, Fig. 8.1

21
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

(3) A more modern macro model with RE

Phillips curve: pt = pte+1 + yt (1)

{
output
gap

Goods market: (
yt = g + yte+1 it pte+1 ) (2)

Taylor rule: ( )
it = r * + pte+1 + pte+1 p * + yte+1 (3)

Perfect foresight: yte+1 = yt +1 , pte+1 = pt +1

(1) becomes: pt = pt +1 + yt

pt +1 = pt yt
22
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

(3) in (2): yt = g + yt +1 (r * + pt +1 + ( pt +1 p *) + yt +1 pt +1 )
1
yt +1 = yt + ( pt +1 p *) + 1 (1 r * g )
1 1 1 42 =!0
4
3

1
yt +1 = yt + ( pt yt p* )
1 1
1-
= yt + ( pt p *)
1- 1

23
1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

System of 2 first-order equations

Particular solution: try y, p :
p = p y
1
y= y+ ( p p *)
1 1
p = p*, y = 0
1
Stability: A = 1


1 1
(
14243
) (
2 1 + 11

+ 1
1
14
+
4244

)
1
3
=0
a1 a2

24
 1.2.2 Economic Applications of
Higher- Order Equations and
Simultaneous Systems

(1) 1 + a1 + a2 > 0
1 1
11 + >0
1 1

(2) 1 a1 + a2 > 0
1 1
1+1+ + >0
1 1

(3) a2 < 1 1 < 1

1

General conclusion: stability can be achieved if policy parameter , are not set too high!
25