Lecture 3 Economic Applications of Linear Algebra

Lecture Outline: Linear Economic Models o Terminology Behavioural Equations and Identities; Endogenous and Exogenous variables. o Structural and Reduced Forms; o Comparative Statics; o Examples Supply and Demand, IS-LM.

 Input-Output Models o Input-output in a nutshell. o See Alan Beggs Lecture 4 if you want more detail. Introduction to Asset Pricing o Law of One Price o No Arbitrage o State Prices o Completeness o Replicating Portfolios and Pricing Derivatives o Pricing a Simple Call Option o See Alan Beggs Lecture 6.

1. Linear Economic Models Consider the following supply and demand model: q = 0 1 ( p + t ) + 2 y q = 0 + 1 p + 2 w where q is quantity, p is the pre-tax price, t is a lump sum tax, y is income and w is weather and all the and parameters are positive constants. If all the variables apart from t are in logs and t is a proportion, how would you interpret the slope parameters? Answer elasticities.

q = 0 1 ( p + t ) + 2 y q = 0 + 1 p + 2 w The first equation is a demand equation and the second equation is a supply equation. Both equations are behavioural equations as opposed to identities. You could write this model as a three equation model with two behavioural equations and one identity:
q d = 0 1 ( p + t ) + 2 y q s = 0 + 1 p + 2 w qs = qd However, you dont gain anything by doing so.

q = 0 1 ( p + t ) + 2 y q = 0 + 1 p + 2 w Quantity q and price p are the endogenous variables, the variables simultaneously determined within the model. The other variables (t, y and w) are the exogenous variables, the variables which are given from outside the model. Treating these variables as exogenous is only valid in a microeconomic model, because we can ignore the feedback from q, p and t to y. Whether we treat a variable as endogenous or exogenous depends on the purpose of the model. However, in general, we need as many as many equations as endogenous variables so that the model is complete.

The structural form of the model may be written as:

1 1 q 0 1t + 2 y 1 p = + w 0 2 1
A x b

or, in general terms as Ax = b where A, x and b are as shown. We can solve the structural form to get the reduced form of the model, which expresses the endogenous variables as a function of the exogenous variables only (so there is no simultaneity). In the general case, if Ax = b is the structural form, then x = A-1b is the reduced form, assuming A is non-singular (which is almost always the case).

In the supply and demand example:

1 1 A= 1 1

A = (1 + 1 ) 0

1 1 1 A = 1 + 1 1 1
1

and the reduced form is:

q 1 1 1 0 a1t + a2 y p = + 1 1 + w 0 2 1 1 q 1 1 ( 0 1t + 2 y ) + 1 ( 0 + 2 w ) = t + y + w + p ( ) ( ) 0 1 2 0 2 1 1
Note: the reduced form is a function of the exogenous variables only.

Some Comparative Statics

Given the reduced form it is easy to find the effect of a changes in the exogenous variables on the endogenous variables. In the general case we have:

Ax = b Structural Form x = A1b Reduced Form x = A1b Comparative Statics

From the reduced form, we have:

q 1 a11t + 2 1y + 1 2 w p = + t + y w 1 2 2 1 1

 q 1 a11t + a2 1y + 1 2 w p = + a t + a y w 1 2 2 1 1 Do these results correspond with your intuition? Draw the supply and demand curves and check them out. Remember that p is the pre-tax price. The post-tax price is p ' = p + t so:

a1t 1t p ' = p + t = + t = 1 + 1 1 + 1
For example, consider the case where supply is completely inelastic ( 1 = 0 ). If taxes rise by t , the change in post tax price is 0 and the change in the pre-tax price is - t . Who bears the incidence of the tax?

Example of a Closed Economy IS-LM Model

The structural model is:
Y = C + I +G C = c0 + c1 (Y T ) T = t1Y I = i0 i1r M P = l0 + l1Y l2 r

which may be re-written as:

(1 c1 (1 t ) ) Y + i1r = c0 + i0 + G
l1Y l2 r = l0 + M P

To save on notation, let s denote the tax adjusted savings rate 1 c1 (1 t ) . Then the structural form is:
s l 1 i1 Y c0 + i0 + G = l2 r l0 + M P

The reduced form is:

Y s r = l 1 i1 c0 + i0 + G 1 l2 = l2 l0 M P sl2 + i1l1 l1
1

i1 c0 + i0 + G l M P s 0

and our comparative static results are: Y 1 l2 ( c0 + i0 + G ) + i1 ( l0 + ( M P ) ) r = sl + i l l ( c + i + G ) + s ( l ( M P ) ) 0 0 0 2 11 1 For example, if investment does not depend on the interest rate ( i2 = 0 ), there is no crowding out effect when G rises, and the government expenditure multiplier, Y G , is just equal to one over the (tax adjusted) savings rate s.

2. Input-Output in a Nutshell
Consider the following two sector economy:

Sector
1 2

Gross Output 100 50

Inputs Sector 1 Sector 2 10 15 15 10

Final Demand 75 25

This may be written as gross output = intermediate inputs + final demands:

100 10 15 75 10100 50 = 15 10 + 25 = 15 100

Gross Ouput Intermediate Input Final Demand

100 75 + 10 50 25 50
15 50 Gross Ouput

Inputs Per Unit of Gross Output

Final Demand

Gross output = (inputs per unit of gross output) x (gross output) + final demand:

100 0.10 0.30 100 50 = 0.15 0.20 50 +

Gross Ouput x Inputs Per Unit of Gross Output A Gross Ouput x

75 25
Final Demand y

100 This may be compactly written as x = Ax + d , where x = is the 50 75 vector of gross outputs, d = is the vector of final demands and 25 0.10 0.30 is a matrix of input-output coefficients i.e. aij is the A= 0.15 0.20 input of sector i per unit of output of sector j.

The x = Ax + d representation is perfectly general so far, no assumptions have been made about the production technology etc.

Assumption
The basic assumption in input output analysis is that the unit input requirements aij are fixed i.e. inputs are used in fixed proportions irrespective of the scale of output or changes in relative prices. This type of Leontief technology is very unrealistic generally.

Basic Input Output Analysis

Now suppose you want to find the gross output vector x associated with some different vector d of final demands (assuming A is fixed). The required gross output vector is x = ( I A) 1 d .

The proof is simple:

x = Ax + d Ix = Ax + d ( I A) x = d Ix = ( I A) 1 d x = ( I A) 1 d

x = Ix

( I A) 1 ( I A) x = ( I A) 1 d ( I A) 1 ( I A) = I

Thus, the new gross output vector is simply found by pre-multiply the final demand vector d by ( I A) 1 . In practise, ( I A) 1 exists under very general conditions, e.g. the column sum of the aijs are all less than one.