Static and dynamic analysis: basic concepts and

examples
Ragnar Nymoen

Department of Economics, UiO

18 August 2009

ECON 3410/4410: Lecture 1

Lecture plan and web pages for this course

The lecture plan is at

http://folk.uio.no/rnymoen/ECON3410_h08_index.html,
which is the workpage of the course.
The workpage is for practical posting of slides, exercises sets etc.
But refer to the Department’s webpage

http://www.uio.no/studier/emner/sv/oekonomi/ECON4410/h09/
for all o¢ cial information: credits, overlap, exam dates and so on.

ECON 3410/4410: Lecture 1

3 main topics

1 Concepts and methods of dynamic analysis.

Introductory Dynamic Macroeconomics (IDM), posted on the
workpage.
2 Medium term macro dynamics: The dynamic AD-AS model.
Introducing Advanced Macroeconomics (IAM) by
Birch-Sørensen and Whitta Jacobsen
3 Critical assumptions of the standard model and alternative
models of the supply-side.

ECON 3410/4410: Lecture 1

The main focus: medium-run macro dynamics

Review of the "building blocks" of the dynamic AD-AS model

Closed economy AD-AS model:
The short run-and the long-run version of the model.
Full dynamic analysis
Application: Stabilization policy, rules versus discretion
A di¤erent perspective: The RBC model.
Open economy AD-AS model
Short-and long run (again)
Monetary policy regimes.

ECON 3410/4410: Lecture 1

Dynamics is a typical feature of the real world (1)
If it was not, what would the world look like?

Economic variables
would jump
110. 0

Blue line:a static variable determined

whenever incentives
by many small shocks
107. 5 changed.

105. 0
Time graphs would
show:
102. 5
a step-wise
100. 0
evolution, or
very erratic
97. 5 (volatile)
Red line: static variable determined behaviour, or
by a single large shock.
95. 0
0 50 100 150 200 250 300 350 400
a combination if
some incentives
are huge, and
some are small.

ECON 3410/4410: Lecture 1

Dynamics is a typical feature of the real world (2)

For some real world variables graphs look a little like the blue
graph in picture.
Daily data of stock prices, and exchange rates (under some
monetary poly regimes) are examples
But for most macroeconomic variables, persistence is a
dominant feature: It takes times before a change in incentives,
or in legislation, or in policy, obtain full e¤ect on macro
economic variables.
Main sources of persistence (and therefore of dynamics) are:
Information and recognition lags,
Adjustments cost,
Uncertainty and expectations,
Aggregation of individual decisions to the macro level.

ECON 3410/4410: Lecture 1

Persistence in the response to a shock is typical of
dynamics

The graph shows

107
static (red) and
106
dynamic (blue)
105
responses to the
104
same sequence of
103 A static resp o n se pattern
shocks
102

101
A dynamic response pattern Note how dynamics
100
add persistence to
99
the series, because
98
shocks are
0 50 100 150 200 250 300 350 400 propagated through
time

ECON 3410/4410: Lecture 1

Some Norwegian economic variables: GDP per capita

GDP per capita relative to 1900

16

14
GDP per capita can
12
‡uctuate in the
10 medium-run time
8 perspective
6 But in longer
4
perspective the
2
dominating trait is
growth!
1840 1860 1880 1900 1920 1940 1960 1980 2000

ECON 3410/4410: Lecture 1

Unemployment (long time series)

Ledighetsrate

0.10

0.09 The unemployment

0.08
rate can ‡uctuate
0.07
in the medium-run
0.06
time perspective
0.05

0.04
But in longer time
0.03 perspective, the
0.02 dominating trait is
0.01 no-growth!
1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

ECON 3410/4410: Lecture 1

Norway today: In‡ation and unemployment

12

Annual rate of inflation (AET) in Norway

10
The “end of
8
in‡ation” is typical
for many countries
6 Un emp lo y men t rate
Note the …nancial
4 crisis at the end of
the sample?
2

1980 1985 1990 1995 2000 2005 2010

ECON 3410/4410: Lecture 1

Norway and Sweden: In‡ation and unemployment

In flatio n (in red ) an d u n emp lo y men t (in b lu e). No rway : d ash ed lin es.

1 2 .5

1 0 .0
Note again the
7 .5
typical propagation
of shocks.
5 .0
In Swedish
2 .5
unemployment in
particular
0 .0

1980 1985 1990 1995 2000 2005 2010

ECON 3410/4410: Lecture 1

Beliefs about dynamics and propagation mechanism give
premises for decision making

Norges Bank [The Norwegian Central Bank] is typical of many

central banks’view:
“Monetary policy in‡uences the economy with long and
variable lags. Norges Bank sets the interest rate with a
view to stabilizing in‡ation at the target within a
reasonable time horizon, normally 1-3 years”

Policy decisions are based on Norges Banks beliefs about the

dynamic nature of the monetary transmission mechanism.
In economics, beliefs means models, implicit or explicit.
Therefore the citation illustrates two theses: policy is model
based, and policy models are dynamic.

ECON 3410/4410: Lecture 1

Dynamic and static model: de…nition

Formal dynamic analysis in economics is a relatively new

invention.
Ragnar Frisch worked intensively with the foundations of the
discipline he dubbed macrodynamics in the early 1930s. His
de…nition of dynamics was:

A dynamic theory or model is made up of

relationships between variables that refer to di¤erent time
periods. Conversely, when all the variables included in the
theory refer to the same time period (or, more generally,
the model is conceptualized without time as an entity),
the system of relationships is static.

In a dynamic model: time plays an essential role.

ECON 3410/4410: Lecture 1

A static model demand schedule

A linear demand function is

Xt = aPt + b + "d ;t ,

with a < 0 and b > 0 as parameters.

The three variables: X and P;and "d (denoting a random
demand shock) are all provided with time subscript t.
t might represent for example a year (the time period is
annual); or a quarter (the period is quarterly); or month (the
period is monthly).
This model of demand is static.
Note that the “appearance of time” (in the from of the time
subscript) is not enough to make the model dynamic, because
time does not play an essential role!

ECON 3410/4410: Lecture 1

A static equilibrium model

If we supplement the demand equation with a static supply

equation, we obtain the static market equilibrium model

Xt = a Pt + b + "d ;t ,
<0
Xt = c Pt + d + "s ;t ,
>0

determining the endogenous variables Xt and Pt for known

values of the exogenous variables "d ;t and "s ;t (and …xed and
known values of the 4 parameters a; b; c; d).
We assume that "d ;t and "s ;t are completely random variables.
Their role is to represent shocks, or in Frischean terminology,
impulses to the system. A variable that represents random
technology shocks is important in the Real Business Model
(RBC) that we will discuss later in the course.

ECON 3410/4410: Lecture 1

Solution of the static model (analytical)

The model written in structural form

1 Xt aPt = b + "d ;t
1 Xt cPt = d + "s ;t

Cramer’s rule gives:

1 b + "d ;t a ad bc + a"s ;t c"d ;t

Xt = =
a c d + "s ;t c a c
1 1 b + "d ;t d b + "s ;t "d ;t
Pt = =
a c 1 d + "s ;t a c

ECON 3410/4410: Lecture 1

Solution of the static model (graphical)
t
P

The initial (before

D eman d cu rv e Su p p ly cu rv e (av erag e p o sitio n )
(av erag e p o sitio n ) C the shock)
P 1
B
D
equilibrium is at A
P 0

A
B, C and D are new
equilibria,
corresponding to
di¤erent types of
shocks.
X X
1 0 X t

ECON 3410/4410: Lecture 1

Solution of the static model (numerical)

Static marked equilibrium model

0.03
P t
ε d ,t − ε s ,t

0.02 The graph shows 50

simulated
0.01 equilibrium values
for Pt .
0.00
Pt is direct
re‡ection of “excess
-0.01
demand”.
5 10 15 20 25 30 35 40 45 50

ECON 3410/4410: Lecture 1

The e¤ect of a single shock
(A graph of a dynamic multiplier from a static model)

In the static model,

1 .0
Price resp o n se to temp o rary d eman d sh o ck . Static mark ed eq u ilib riu m mo d el
the full e¤ect of a
0 .8
temporary shock
occurs in the …rst
0 .6
period.
0 .4
In the periods after
the shock, there are
0 .2 no responses in Pt .
The impact
0 5 10 15 20
multiplier is
non-zero, all other
dynamic multipliers
are zero.

ECON 3410/4410: Lecture 1

Summary of properties of the static model

The whole e¤ect of a shock is contained in the equilibrium

values of P and X in the period of the shock.
There are no spill-over e¤ects of a shock in period t = 1 to
period 2; 3, and later periods
We say that impulses in period 1 are not propagated to later
periods
The time series of Pt (and Xt ) are perfect mirror images of the
shocks "d ;t and "st .
The sequence of dynamic multipliers, for example @Pt =@"s ;1
(t = 1; 2; 3:::) are zero, expect for @P1 =@"s ;1 .

ECON 3410/4410: Lecture 1

A dynamic equilibrium model

Xt = a Pt + b + "d ;t , demand, and

<0
Xt = c P t 1 + d + "s ;t , supply.
>0

The only change is in the supply equation, where Pt 1

replaces Pt .
Interpretation: In some markets supply is …xed in the
short-run. No matter how high or low the price is in the
current period, the supply of the good is ‘frozen’by decisions
of the past.
Classic example: agricultural products such as pork and
wheat. Relevance today: “Salmon farming”, and China food
price in‡ation; but also the market for oil and for raw
materials.
ECON 3410/4410: Lecture 1
Solution of the dynamic model (graphical)

The long-run supply

function is
X = cP + d
t
P

Long-run supply curve

After a temporary
P 1
Demand curve
(average position)
B demand shock, the
D
sequence of
P 0
A
equilibria is A
P 2
C
(t = 0), B (t = 1),
C (t = 2), D
(t = 3) and so on
in a cobweb pattern
X X
0 2 X t
In the long-run, the
equilibrium is back
at A

ECON 3410/4410: Lecture 1

Solution of the dynamic model (numerical)

0 .0 5 0
D y n amic mark ed eq u ilib r iu m mo d el

mark et p r ice n et d eman d sh o ck

1 .0
D y n amic mark ed eq u ilib r iu m mo d el

D y n amic mu ltip liers

Graph a) shows
0 .5
solution of Pt from
0 .0 2 5
the dynamic model,
0 .0
0 .0 0 0
b) shows the
-0 .0 2 5
-0 .5
sequence of
10 20 30 40 50 0 5 10 15 20

Static mark ed eq u ilib riu m mo d el

dynamic responses
1 .0 0 Static mark ed eq u ilib riu m mo d el
0 .0 3
mark et p r ice n et d eman d sh o ck D y n amic mu ltip liers in Pt ( @Pt =@"d ;1
0 .0 2 0 .7 5
t = 1; 2; :::)
0 .0 1

0 .0 0
0 .5 0
Graph c) and d)
-0 .0 1
0 .2 5 show the
10 20 30 40 50 0 5 10 15 20
corresponding for
the static model

ECON 3410/4410: Lecture 1

Characteristic di¤erences form the static model

In the dynamic model, the whole e¤ect of a shock is not

contained in the equilibrium values of P and X in the period
of the shock.
The sequence of the dynamic multipliers, for example
@Pt =@"d ;1 (t = 1; 2; 3:::) are generally non-zero, but may
approach zero for large values of t, if the dynamics is stable.
There are spill-over e¤ects of a shock in period t = 1 to
period 2; 3, ....
Impulses in period 1 are propagated to later periods
The solution doe Pt (and Xt ) are not perfect mirror images of
the shocks "d ;t and "st . in each period.
The cobweb pattern is however not general, as a second
example will show.

ECON 3410/4410: Lecture 1

A second dynamic model of market equilibrium

Xt = aPt + b1 Xt 1 + b0 + "d ;t , demand

Xt = c0 P t + c1 P t 1 + d + "s ;t :supply

The demand function is now a dynamic equation. The

parameter b1 measures by how much an increase in Xt 1
shifts the short-run demand curve. This can be rationalized by
consumer habits for example.
0 < b1 < 1.
In any given period, Xt 1 is determined from history and
cannot be changed. Hence in this model there are two
pre-determined variables: Pt 1 and Xt 1 .
The supply equation is a generalization of the cobweb model:
If we set c0 > 0, short run supply is no longer completely
inelastic as in the cobweb model.
ECON 3410/4410: Lecture 1
Numerical solution of the model with habit formation

Dynamic market equilibrium model, habit formation. Dynamic market equilibrium model, habit formation.
1.00
0.050 market price net demand shock

dynamic multipliers
Compare panel a)
0.75
0.025 with c), and panel
0.000
0.50
b) with d).
-0.025
0.25
It is typical that
10 20 30
Dynamic market equilibrium model, cobweb.
40 50 0 5 10
Dynamic market equilibrium model, cobweb.
15 20 small changes in
1.0
0.05
market price net demand s hock
Dynamic multipliers
the model
0.5
speci…cation can
0.00
0.0 signi…cantly a¤ect
-0.5
the solution of the
10 20 30 40 50 0 5 10 15 20
dynamic model.

ECON 3410/4410: Lecture 1

When is a static model relevant for the real world?
Frisch:
“Hence it is clear that the static model world is best
suited to the type of phenomena whose mobility (speed
of reaction) is in fact so great that the fact that the
transition from one situation to another takes a certain
amount of time can be discarded. If mobility is for some
reason diminished, making it necessary to take into
account the speed of reaction, one has crossed into the
realm of dynamic theory.”

We would add: Static models are also relevant when we only

claim to analyze the very short-run e¤ects (what we will call
the impact multiplier) of a shocks, i.e. we know that the
dynamic e¤ects of a shock “are there”, but we do not (know
how to) analyze them.
In this way we can interpret the Keynesian IS-LM model as a
short-run model.
ECON 3410/4410: Lecture 1
The three steps in a dynamic analysis

The question we typically want to answer is: “What are the

dynamic e¤ects of a shock (of a certain type) on the
endogenous variables of the model?”
It is often practical to break this question down to 3 “smaller”
questions:
1 What are the short-run e¤ects of the shock?
2 What are the long-run e¤ects of the shock, given that the
dynamic adjustment process is stable?
3 What are the properties of the dynamic adjustment process
(regarding stability in particular)?
To answer Q1 and Q2 we use two separate models!

ECON 3410/4410: Lecture 1

Market equilibrium: the short-run model

Xt = aPt + b1 Xt 1 + b0 + "d ;t , (1)

Xt = c0 P t + c1 P t 1 + d + "s ;t : (2)

Since Pt 1 and Xt 1 are pre-determined from history in each

period t, they are exogenous in this short-run model. The
analytical solution:
ad b 0 c0 c0 b 1 Xt + ac1 Pt 1 + a"s ;t
1 c0 "d ;t
Xt =
a c0
d b0 b1 Xt 1 + c1 Pt 1 + "s ;t "d ;t
Pt =
a c0
gives the short-run e¤ects of the shocks "d ;t and "s ;t as
derivatives,see Table 1.1 in IDM

ECON 3410/4410: Lecture 1

Market equilibrium: The long-run model
The long-run model applies to a hypothetical (or counterfactual)
stationary situation where there are no new shocks, and all past
shocks have worked their way through the system.
The long-run model is therefore de…ned for the situation:
Xt = Xt 1 = X ; Pt = Pt 1 = P and "d ;t = "d , "s ;t = "s . The
model is given by

X = aP + b1 X + b0 + "d , long-run demand

X = c0 P + c1 P + d + "s ; long-run supply

or
a 1
X = P+ (b0 + "d );
1 b1 1 b1
X = (c0 + c1 )P + (d + "s ).

Solve to obtain analytical expressions for long-run e¤ects, see

Table 1.1 in IDM.
ECON 3410/4410: Lecture 1
 Graphically, we can
Sh o rt- ru n su p p ly cu rv e
represent the
short-run and
P

Lo n g - ru n su p p ly cu rv e
long-run models in
one diagram,
C
B
Lines with di¤erent
A

slopes de…ne the

short-run and the
long-run.
Sh o rt- ru n d eman d cu r v e Lo n g - ru n d eman d cu r v e We can then
analyze the
X short-run e¤ect of a
shock, as well as
the long-run e¤ect.

ECON 3410/4410: Lecture 1

The third question

The short-run model and the long-run model of the

macroeconomy will be important tools in the following, in
particular for the medium-term AS-AS model covered by the
IAM book.
But we will also address systematically the third question:
What are the properties of the dynamic adjustment process
(regarding stability in particular)?
To do this we need to develop several concepts more precisely
than we have done in this introduction.
We do that within a class of dynamic equations which wide
enough to cover many economic interpretations as special
cases (Ch 2 of IDM).

ECON 3410/4410: Lecture 1

Discrete or continuous time?

The distinction between static models and dynamic modes is

fundamental.
Whether dynamic models are expressed in terms of discrete
time or continuous time is however not fundamental.
Often theories are expressed in continuous time, but since
actual data series are recorded in discrete time, choosing
discrete time keeps the theory closer to applications.
Refer to Box 1.1 in IDM for example. The point is that for
dynamics to occur, time must play an essential role in model
(discrete/continuous time is a secondary issue).

ECON 3410/4410: Lecture 1

Stock and ‡ow variables

Dynamic models often include both ‡ow and stock variables.

Flow: in units of (for example) million kroner per year
Stock: in units of (for example) million of kroner at a
particular period in time (for example start or end of the year).
Population size , and capital stock are examples of stock
variables. But so are also price indices: Pt may represent the
value of the Norwegian CPI in period t (a month, a quarter or
a year), and indicators of the wage level.
In practice: the values of P will be index numbers. The
number 100 (often 1 is used instead) refers to the base period
of the index. If Pt > 100 it means that relative to the base
period, prices are higher in period t.

ECON 3410/4410: Lecture 1

A ‡ow variable is often a change in a stock variable

Starting from a stock variable like Pt , a ‡ow variable results from

obtaining the change of that variable, hence

xt = Pt Pt 1, the (absolute) change

Pt Pt 1
yt = , the relative change, and
Pt 1
zt = ln Pt ln Pt 1 the approximate relative change

are examples of ‡ow variables. Note that:

yt 100 is in‡ation in percentage points. In this course we
often use to the rate formulation (hence, we omit the scaling
by 100)
zt yt by the properties of the (natural) logarithmic function,
see for example the appendix of IDM, if in doubt.

ECON 3410/4410: Lecture 1

A stock variable is the cumulated sum of a ‡ow

75
The Norwegian current account
debt = current account
50
+ lagged debt.
Billion kroner

25

0 If there is a primary
19 80 19 85

Norwegian net foreign debt

19 90 19 95 20 00 account surplus for some
0
time, this will lead to a
gradual reduction of
Billion kroner

-2 50

-5 00
debt— or an increase in
-7 50
the nation’s net wealth.
19 80 19 85 19 90 19 95 20 00

Conversely, a consistent
current account de…cit
raises a nation’s debt.

ECON 3410/4410: Lecture 1