Difference Equations

Dierence Equations for Economists
1
preliminary and incomplete
Klaus Neusser
November 22, 2012
1
c _Klaus Neusser
2
Preface
There are, of course, excellent books on dierent equations: for example,
Elaydi Elaydi (1999), Agarwal Agarwal (2000), or Galor Galor (2007). These
books do, however, not go into the specic problems faced in economics.
The books makes use of linear algebra. Very good introduction to this
topic is presented by the books of Strang Strang (2003) and Campbell and
Meyer Campbell and C.D. Meyer (1979).
Bern,
September 2010 Klaus Neusser
Contents
I Linear Deterministic Dierence Equations 5
1 Introduction 7
1.1 Notation and Preliminaries . . . . . . . . . . . . . . . . . . . . 7
2 Linear Dierence Equations 11
2.1 First Order Dierence Equation . . . . . . . . . . . . . . . . . 11
2.1.1 Amortization of a Loan . . . . . . . . . . . . . . . . . . 14
2.2 Steady State and Stability . . . . . . . . . . . . . . . . . . . . 16
2.3 Solutions to the rst order equation . . . . . . . . . . . . . . . 19
2.3.1 Examples . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.4 Dierence Equations of Order p . . . . . . . . . . . . . . . . . 34
2.4.1 Homogeneous Dierence Equation of Order p . . . . . 34
2.4.2 Nonhomogeneous Equation of Order p . . . . . . . . . 37
2.4.3 Limiting Behavior of Solutions . . . . . . . . . . . . . . 37
2.4.4 Examples . . . . . . . . . . . . . . . . . . . . . . . . . 43
3 Systems of Dierence Equations 55
3.1 First Order System of Dierence Equations . . . . . . . . . . . 57
3.1.1 Homogenous First Order System of Dierence Equations 57
3.1.2 Nonhomogeneous First Order System . . . . . . . . . . 63
3.1.3 Stability Theory . . . . . . . . . . . . . . . . . . . . . 64
3.1.4 Two-dimensional Systems . . . . . . . . . . . . . . . . 67
3.1.5 Linearized Systems . . . . . . . . . . . . . . . . . . . . 78
3.2 First Order System under Rational Expectations . . . . . . . . 78
3.3 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81
3.3.1 Exchange Rate Overshooting . . . . . . . . . . . . . . 81
3.3.2 Optimal Growth Model . . . . . . . . . . . . . . . . . . 87
3.3.3 The New Keynesian Model . . . . . . . . . . . . . . . . 92
3.3.4 Sun Spots . . . . . . . . . . . . . . . . . . . . . . . . . 94
4 Singular Systems of Dierence Equations 95
3
4 CONTENTS
5 Stochastic Dierence Equation 97
5.1 The univariate case . . . . . . . . . . . . . . . . . . . . . . . . 99
5.1.1 Solution to the homogeneous equation . . . . . . . . . 99
5.1.2 Finding a particular solution . . . . . . . . . . . . . . . 100
5.1.3 Example: Cagans model of hyperination . . . . . . . 101
5.2 The multivariate case . . . . . . . . . . . . . . . . . . . . . . . 103
6 Computer Algorithms 109
A Complex Numbers 111
B Matrix Norm 115
Part I
Linear Deterministic Dierence
Equations
5
Chapter 1
Introduction
1.1 Notation and Preliminaries
A dierence equation or dynamical system describes the evolution of some
variable over time. The value of this variable in period t is denoted by X
t
.
The time index t takes on discrete values and typically runs over all integer
numbers Z, e.g. t = . . . , 2, 1, 0, 1, 2, . . . By interpreting t as the time
index, we have automatically introduced the notion of past, present and
future. A dierence equation is then nothing but a rule or a function which
instructs how to compute the value of the variable of interest in period t
given past values of that variable and time. The system may be initialized
at some point t
0
which in most cases is taken to be t
0
= 0. In this case t
runs over all natural numbers, i.e. t N.
In its most general form a dierence equation can be written as
F(X
t
, X
t1
, X
t2
, . . . , X
tp
, t) = 0 (1.1)
where F is a given function. The variable X
t
is called the endogenous or
dependent variable and is an n-vector, i.e X
t
R
n
, n 1. n is called the
dimension of the system. The dierence between the largest and the smallest
time index of the dependent variable explicitly involved is called the order of
the dierence equation. In the formulation above this is p with p 1. In the
dierence equation above the time index appears explicitly as an argument of
the function F. In this case one speaks of a nonautonomous or a time-variant
equation. If time is not a separate argument and enters only as a time index
of the dependent variable, the equation is said to be autonomous or time-
invariant. In many applications, time-variance enters the dierence equation
by replacing the time index in equation (1.1) by some variable Z
t
R
k
with
k 1. This variable is called the exogenous or independent variable.
7
8 CHAPTER 1. INTRODUCTION
With the exception of chapter 4, we will always assume that it is possible
to solve equation (1.1) uniquely for X
t
:
X
t
= f(X
t1
, X
t2
, . . . , X
tp
, t) (1.2)
The dierence equation is called normal in this case.
Given some starting values x
0
, x
1
, . . . , x
p+1
for X
0
, X
1
, . . . , X
p+1
, the
dierence equation (1.2) uniquely determines all subsequent values of X
t
, t =
1, 2, . . . , by iteratively inserting into equation (1.2).
A solution to the dierence equation is a function g : Z R
n
such that
g(t) fullls the dierence equation, e.g.
F(g(t), g(t 1), g(t 2), . . . , g(t p), t) = 0 holds for all t Z. (1.3)
The aim of the analysis is to assess the existence and uniqueness of a solu-
tion to a given dierence equation; and, in the case of many solutions, to
characterize the set of all solutions.
One way to pin down a particular solution is to require that the solution
must satisfy some boundary conditions. In this case, we speak of a boundary
value problem. The simplest way to specify boundary conditions is to require
that the solution g(t) must be equal to p prescribed values x
1
, . . . , x
p
, called
initial conditions, at given time indices t
1
, . . . , t
p
:
g(t
1
) = x
1
, . . . , g(t
p
) = x
p
. (1.4)
In this case we speak also of an initial value problem. In economics boundary
conditions also arise from the condition that lim
t
g(t) must be nite or
equal to a prescribed value, typically zero. Such terminal conditions often
arise as transversality conditions in optimal control problems.
Dierence equations, like (1.2), transform one sequence (X) = (X
t
) into
another one. The dierence equation therefore denes a function or better
an operator on the set of all sequences, denoted by R
Z
, into itself. Dening
addition and scalar multiplication in the obvious way, R
Z
forms a vector or
linear space over the real numbers. For many economic applications, it makes
sense to concentrate on the set of bounded sequences, i.e. on sequences (X
t
)
for which there exists a real number M such that |X
t
| M for all t Z.
The set of bounded sequences is usually denoted by
. It can be endowed
with a norm |.|
in the following way:

|(X)|
= sup|X
t
|, t Z
where |X
t
| denotes the Euclidean norm of X
t
in R
n
. If n = 1, |X
t
| = [X
t
[.
It can be shown that
endowed with the metric induced by this norm is

1.1. NOTATION AND PRELIMINARIES 9
a linear complete metric space or a Banach space (see, f.e., Naylor and Sell
Naylor and Sell (1982)).
For the analysis of dierence equations it is useful to introduce the lag
operator or back shift operator denoted L. This operator shifts the time index
one period into the past. The sequence (X
t
) is then transformed by the lag
operator into a new sequence (Y
t
) = L(X
t
) such that Y
t
= X
t1
. In order
to ease the notation we write LX
t
instead of L(X
t
). It is easy to see that
the lag operator is a linear operator on R
Z
. Given any two sequences (X
t
)
and (Y
t
) and any two real numbers a and b, L(aX
t
+ bY
t
) = aLX
t
+ bLY
t
=
aX
t1
+ bY
t1
. For any natural number p N, L
p
is dened as the p-times
application of L:
L
p
X
t
= LL L
. .
p-times
X
t
= X
tp
For p = 0, L
p
= I the identity operator. Thus, the action of a lag polynomial
of order p, (L) = I
1
L
2
L
2

p
L
p
on X
t
is
(L)X
t
= (I
1
L
2
L
2

p
L
p
)X
t
= X
t
1
X
t1
2
X
t2

p
X
tp
The minus signs are arbitrary. The polynomial is written in this way as this
is exactly the form in which it will appear later on.
10 CHAPTER 1. INTRODUCTION
Chapter 2
Linear Dierence Equations
with Constant Coecients
This chapter is entirely devoted to the analysis of linear nonhomogeneous
dierence equations of dimension one (n = 1) and order p 1 with constant
coecients:
X
t
=
1
X
t1
+
2
X
t2
+ +
p
X
tp
+ Z
t
,
p
,= 0, (2.1)
where
1
, . . . ,
p
are given constant real numbers. The variable Z
t
repre-
sents the non-autonomous part of the equation and usually denotes some
exogenous or independent variable which inuences the evolution of X
t
over
time.
2.1 First Order Dierence Equation
As a starting point of the analysis consider the simplest case, namely the
rst order (p = 1) linear nonhomogeneous equation:
X
t
= X
t1
+ Z
t
, ,= 0. (2.2)
To this nonhomogeneous equation corresponds a rst order linear homoge-
nous equation:
X
t
= X
t1
. (2.3)
Starting in period 0 at some initial value X
0
= x
0
, all subsequent values can
be recursively computed by iteratively inserting into the dierence equation
11
12 CHAPTER 2. LINEAR DIFFERENCE EQUATIONS
(2.3)
X
1
= x
0
X
2
= X
1
=
2
x
0
. . .
X
t
= X
t1
=
t
x
0
.
This suggests to take
X
t
=
t
c (2.4)
as the general solution of the rst order linear homogenous dierence equa-
tion (2.3). Actually, equation (2.4) provides a whole family of solutions
indexed by the parameter c R. This parameter can be pinned down using
a single boundary condition such as: X
t
0
= x
t
0
at some period t
0
. The value
of c can then be retrieved by solving the equation x
t
0
=
t
0
c for c. This leads
to the solution: c =
x
t
0
t
0
. In many instances we are given the value at t
0
= 0
so that c = x
0
.
Suppose that we are given two solutions of the homogenous equation,
(X
(1)
t
) and (X
(2)
t
). Then it is easy to verify that any linear combination of
the two solutions, a
1
(X
(1)
t
) + a
2
(X
(2)
t
), a
1
, a
2
R, is also a solution. This
implies that the set of all solutions to the homogenous equation forms a
linear space. In order to nd out the dimension of this linear space and its
algebraic structure, it is necessary to introduce the following three important
denitions.
Denition 1. The r sequences (X
(1)
), (X
(2)
), . . . , (X
(r)
) with r 1 are said
to be linearly dependent for t t
0
if there exist constants a
1
, a
2
, . . . , a
r
R,
not all zero, such that
a
1
X
(1)
t
+ a
2
X
(2)
t
+ + a
r
X
(r)
t
= 0 t t
0
.
This denition is equivalent to saying that there exists a nontrivial linear
combination of the solutions which is zero. If the solutions are not linearly
dependent, they are said to be linearly independent.
Denition 2. A set of r linearly independent solutions of the homogenous
equation is called a fundamental set of solutions.
Denition 3. The Casarotian matrix ((t) of (X
(1)
), (X
(2)
), . . . , (X
(r)
) with
r 1 is dened as
((t) =
_
_
_
_
_
X
(1)
t
X
(2)
t
. . . X
(r)
t
X
(1)
t+1
X
(2)
t+1
. . . X
(r)
t+1
.
.
.
.
.
.
.
.
.
.
.
.
X
(1)
t+r1
X
(2)
t+r1
. . . X
(r)
t+r1
_
_
_
_
_
.
2.1. FIRST ORDER DIFFERENCE EQUATION 13
These denitions allow us to the tackle the issue of the dimension of
the linear space given by all solutions to the homogenous rst order linear
dierence equation.
Theorem 1. The set of solutions to the homogenous rst order linear dif-
ference equation (2.3) is a linear space of dimension one.
Proof. Suppose we are given two linearly independent solution (X
(1)
) and
(X
(2)
). Then according to denition 1, for all constants a
1
and a
2
, not both
equal to zero,
a
1
X
(1)
t
+ a
2
X
(2)
t
,= 0
a
1
X
(1)
t+1
+ a
2
X
(2)
t+1
,= 0.
Inserting in the second inequality X
(1)
t
for X
(1)
t+1
and X
(2)
t
for X
(2)
t+1
leads to
a
1
X
(1)
t
+ a
2
X
(2)
t
,= 0
a
1
X
(1)
t
+ a
2
X
(2)
t
,= 0.
Since this must hold for any a
1
, a
2
, not both equal to zero, the determinant
of the Casarotian matrix (see denition 3)
((t) =
_
X
(1)
t
X
(2)
t
X
(1)
t
X
(2)
t
_
must be nonzero. However, det ((t) = X
(1)
t
X
(2)
t
X
(1)
t
X
(2)
t
= 0. This
is a contradiction to the initial assumption. Thus, there can only be one
independent solution.
The only independent solution is therefore given by (2.4). In section 2.4
we will give a general proof and show that the dimension of the linear space
generated by the solutions to the homogenous equation of order p is p.
Consider now two solutions of the nonhomogeneous dierence equation
(2.2), (X
(1)
t
) and (X
(2)
t
), then, as can be easily veried, (X
(1)
t
) (X
(2)
t
) sat-
ises the homogenous equation (2.3). This fact is called the superposition
principle.
1
The superposition principle implies that X
(1)
t
X
(2)
t
=
t
c which
leads to following theorem.
1
The superposition principle means that the net response of X
t
caused by two or
more stimuli is the sum of the responses which would have been caused by each stimulus
individually. In the rst order case one stimulus comes from the general solution to the
homogeneous equation, the other from the particular solution to the nonhomogeneous
equation.
Theorem 2 (Superposition Principle). Every solution, (X
t
), to the rst or-
der nonhomogeneous linear dierence equation (2.2) can be represented as
the sum of the general solution to homogenous equation (2.3), (X
(g)
t
), and a
particular solution to the nonhomogeneous equation, (X
(p)
t
):
X
t
= X
(g)
t
+ X
(p)
t
. (2.5)
The proof of this theorem is easily established and is left as an exercise to
the reader. In the case of a rst order equation X
(g)
t
=
t
c. The Superposition
Principle then implies that the solution of the rst order equation is given
by:
X
t
=
t
c + X
(p)
t
.
Below we will discuss how to obtain a particular solution. We will also
see in subsection 2.4 that this principle extends to higher order equations.
The superposition principle thus delivers a general recipe for solving linear
dierence equations in three steps:
1. Find the general solution of the homogeneous equation (X
(g)
). This is
usually a technical issue that can be resolved mechanically.
2. Find a particular solution to the nonhomogeneous equation (X
(p)
).
This step is usually more involved and requires additional (economic)
arguments. For example, we might argue that if the forcing variable Z
t
remains bounded then also X
t
should remain bounded.
3. The superposition principle (see Theorem 2) then delivers the general
solution of the nonhomogeneous equation as the sum of (X
(g)
) and
(X
(p)
). However, this solution still depends through (X
(g)
) on some
constants. To pin down the solution uniquely and therefore solving
the boundary value problem requires additional conditions. These con-
ditions can come in the form of initial values (starting values) or in
the form of requirements that the solution must obey some qualitative
feature. A typical feature in this context is boundedness, a condition
which usually can be given an economic interpretation.
Before continuing with the theoretical analysis consider the following ba-
sic example.
2.1.1 Amortization of a Loan
One of the simplest settings in economics where a dierence equation arises
naturally, is the compound interest calculation. Take, for example, the evolu-
tion of debt. Denote by D
t
the debt outstanding at the beginning of period t,
2.1. FIRST ORDER DIFFERENCE EQUATION 15
then the debt in the subsequent period t +1, D
t+1
, is obtained by the simple
accounting rule:
D
t+1
= D
t
+ rD
t
Z
t
= (1 + r)D
t
Z
t
(2.6)
where rD
t
is the interest accruing at the end of period t. Here we are using a
constant interest rate r. The debt contract is serviced by paying the amount
Z
t
at the end of period t. This payment typically includes a payment for the
interest and a repayment of the principal. Equation (2.6) constitutes a linear
nonhomogeneous rst order dierence with = 1 + r.
Given the initial debt at the beginning of period 0, D
0
, the amount of
debt outstanding in subsequent periods can be computed recursively using
(2.6):
D
1
= (1 + r)D
0
Z
0
D
2
= (1 + r)D
1
Z
1
= (1 + r)
2
D
0
(1 + r)Z
0
Z
1
. . .
D
t+1
= (1 + r)
t+1
D
0
(1 + r)
t
Z
t
Z
t
(1 + r)Z
t1
(1 + r)
t
Z
0
= (1 + r)
t+1
D
0
i=0
(1 + r)
i
Z
ti
Note how D
t+1
is determined as the sum of two parts: (1 + r)
t+1
D
0
and
t
i=0
(1 +r)
i
Z
ti
which correspond to the general solution to the homoge-
neous equation and a particular solution to the nonhomogeneous equation in
accordance with Theorem 2.
2
As the initial value of the debt is given, this
value naturally pins down the parameter c to equal D
0
.
If the repayments Z
t
are constant over time and equal to Z, as is often
the case, we can bring Z outside the summation sign and use the formula for
geometric sums to obtain:
D
t+1
= (1 + r)
t+1
D
0
_
(1 + r)
t+1
1
_
Z
r
Suppose that the debt must be completely repaid by the beginning of period
T +1, then the corresponding constant period payment Z can be calculated
by setting D
T+1
= 0 in the above equation and solving for Z.
3
. This gives:
Z =
r
1 (1 + r)
T1
D
0
2
The reader is invited to check that the second expression is really a solution to the
nonhomogeneous equation.
3
The repayments are, of course, only constant as long as D
t
> 0. Once the debt is paid
back fully, payments cease and Z = 0 from then on.
Note that the payment Z required to pay back the debt diminishes with
T. If T approaches innity Z equals rD
0
. In this case the payment is just
equal to interest accruing in each period so that there is no repayment of the
principal. In this case the debt is never paid back and equals the initial debt
D
0
in each period. If the payment Z exceeds rD
0
, the debt is repaid in a
nite amount of time.
Suppose that instead of requiring that the debt must be zero at some
point in time (including innity), we impose the condition that the present
discounted value of the debt must be non-positive as T goes to innity:
lim
T
D
T+1
(1 + r)
T+1
0 (2.7)
This condition is referred to as the no Ponzi game (NPG) condition in eco-
nomics. A Ponzi game is a scheme where all principal repayments and interest
payments are rolled over perpetually by issuing new debt.
4
If the above limit
is positive, the borrower would be able to extract resources (in present value
terms) from the lenders (See OConnell and Zeldes (1988) and the literature
cited therein for an assessment of the signicance of the NPG condition in
economics). Given the dierence equation for the evolution of debt, the NPG
condition with constant payment per period is equivalent to:
lim
T
D
T+1
(1 + r)
T+1
= lim
T
D
0
_
1 (1 + r)
T1
_
Z
r
= D
0
Z
r
0
which implies that Z rD
0
. Thus, the NPG condition holds if the constant
repayments Z are at least as great as the interest.
2.2 Steady State and Stability
Usually we are not only interested in describing the evolution of the depen-
dent variable over time, but we also want to know some qualitative proper-
ties of the solution. Just for the sake of the denition consider the nonau-
tonomous n-dimensional rst order, possibly nonlinear, dierence equation
X
t
= f(X
t1
, t) R
n
. Then we can give the following denition of an
equilibrium point.
Denition 4. A point X
R
n
is called an equilibrium point or a steady
state if it is a xed point of the function f(X, t), i.e. if X
satises the
4
Charles Ponzi was an Italian immigrant who promised to pay exorbitant returns to
investors out of an ever-increasing pool of deposits. A historic account of Ponzi games can
be found in Kindleberger (1978).
2.2. STEADY STATE AND STABILITY 17
equation
X
= f(X
, t) (2.8)
In the case of a rst order autonomous equation of dimension one, it is
convenient to represent the location of equilibrium points and the dynamics
of (X
t
) as a graph in the (X
t
, X
t+1
)-plane. For this purpose draw rst the
graph of the function y = f(x) in the (X
t
, X
t+1
) plane. Then draw the graph
of the identity function y = x which is just a line through the origin having
an angle of 45
0
with the x-axis. The equilibrium points are the points where
the 45
0
-line intersects with the graph of the function y = f(x). Starting
at some initial value X
0
= x
0
, the evolution of X
t
is then represented in
the (X
t
, X
t+1
)-plane by the following sequence of points: (0, x
0
), (x
0
, f(x
0
)),
(f(x
0
), f(f(x
0
))), (f(f(x
0
))), f(f(f(x
0
)))), . . . . Connecting these points by
line segments gives the so-called stair step or Cobweb diagram.
The logistic function with > 0
f(x) =
_
x(1 x), if 0 x 1;
0, otherwise.
(2.9)
provides an example with two steady states. The steady states are deter-
mined by the equation: X
= X
(1 X
). This leads to two steady states

given by X
= 0 and X
=
1
. Figure 2.1 shows the two steady states and

the evolution of X
t
starting at X
0
= x
0
= 0.1 and taking = 2.5.
Consider the linear rst order nonhomogeneous dierence equation where
the independent variable Z
t
is constant over time, i.e. Z
t
= Z. It is easy to
compute the steady in this simple case:
X
= X
+ Z X
=
Z
1
for ,= 1 (2.10)
For = 1, there exists no equilibrium point, unless Z = 0 in which case
every point is an equilibrium point. As the steady state fullls the dierence
equation, it is a valid candidate for a particular solution. Thus, the general
solution in this case is:
X
t
=
t
c + X
=
t
c +
Z
1
for ,= 1.
Sometimes it is convenient to rewrite the nonhomogeneous equation as a
homogeneous equation in terms of deviations from steady state, X
t
X
:
X
t
X
= (X
t1
X
)
0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
X
t
X
t
+
1
f(x)
45
0
line
steady
state
steady
state
Figure 2.1: Equilibrium points of the logistic function: y = 2.5x(1 x) and
x
0
= 0.1
A major objective of the study of dierence equations is to analyze its be-
havior near an equilibrium point. This topic is called stability theory. In the
context of linear dierence equations the following basic concepts of stability
are sucient.
Denition 5. An equilibrium point X
is called
stable if for all > 0 there exists a
> 0 such that

|X
0
X
| <
implies |X
t
X
| < t > 0. (2.11)

If X
is not stable, its is called unstable.

The point X
is called attracting if there exists > 0 such that

|X
0
X
| < implies lim

t
X
t
= X
. (2.12)
If = , X
is called globally attracting.

The point X
is asymptotically stable or is an asymptotically stable

equilibrium point
5
if it is stable and attracting. If = , X
is called
globally asymptotically stable.
In this denition |X| denotes the norm of X R
n
. If n = 1 the norm
can be replaced by the absolute value of X.
5
In economics this is sometimes called stable
2.3. SOLUTIONS TO THE FIRST ORDER EQUATION 19
2.3 Solutions to the rst order linear dier-
ence equation
This section discusses a more systematic way of nding a particular solution
to the rst order linear dierence equation (2.2). For this purpose insert
recursively equation (2.2) into itself:
X
t
= X
t1
+ Z
t
X
t
= (X
t2
+ Z
t1
) + Z
t
=
2
X
t2
+ Z
t1
+ Z
t
. . .
X
t
=
t
X
0
+
t1
Z
1
+
t2
Z
2
+ + Z
t1
+ Z
t
=
t
X
0
+
t1
j=0
j
Z
tj
Taking the norm of the dierence between X
t
and the second term of the
right hand side of the equation leads to:
_
_
_
_
_
X
t
t1
j=0
j
Z
tj
_
_
_
_
_
=
_
_
t
X
0
_
_
= [
t
[|X
0
|
When there is a starting period as in the example of the amortization of a
loan, say period 0 without loss of generality, we stop the backwards iteration
at this period and take X
(p)
t
=
t1
j=0
j
Z
tj
as the particular solution. How-
ever in many instances there is no natural starting period so that it makes
sense to continue the above iteration into the innite past. As [
t
[ vanishes
as t if [[ < 1, this suggests to consider
X
(b)
t
=
j=0
j
Z
tj
(2.13)
as a particular solution to the equation (2.2). The superscript (b) indicates
that the solution was obtained by iterating the dierence equation backward
in time. For this to be a meaningful choice, the innite sum must be well
dened. This is, for example, the case if (Z
t
) is a bounded sequence, i.e. if
(Z)
. In particular, if Z
t
is constant and equal to Z, the above particular
solution becomes
X
(b)
t
=
j=0
j
Z =
Z
1
which is just the steady state solution described in equation (2.10) of section
2.2. The requirement that Z
t
remains bounded is, for example, violated if Z
t
itself satises the homogenous dierence equation Z
t
= Z
t1
which implies
that Z
t
=
t
c for some c ,= 0. Inserting this into equation (2.13) then leads
to
X
(b)
t
=
j=0
tj
c =
j=0
t
c =
This shows besides that besides the stability condition [[ < 1, some addi-
tional requirements with respect to the sequence of the exogenous variable are
necessary to render X
(b)
t
in equation (2.13) a meaningful particular solution.
Consider now the case [[ > 1. In this situation the above iteration is
no longer successful because X
(b)
t
in equation (2.13) is not well dened even
when Z
t
is constant. A way out of this problem is to consider the iteration
forward in time instead of backward in time:
X
t
=
1
X
t+1
1
Z
t+1
=
1
_
1
X
t+2
1
Z
t+2
_
1
Z
t+1
=
2
X
t+2
2
Z
t+2
1
Z
t+1
. . .
=
h
X
t+h
1
h
j=1
j+1
Z
t+j
for h 1.
Taking the norm of the dierence between X
t
and the second term on the
right hand side of the equation leads to:
_
_
_
_
_
X
t
+
1
h
j=1
j+1
Z
t+j
_
_
_
_
_
=
_
_
h
X
t+h
_
_
= [
h
[|X
t+h
|.
As the economy is expected to live forever, there is no end period and the
forward iteration can be carried out indenitely into the future. Because
[[ > 1, the right hand side of the equation converges to zero as h ,
provided that X
t+h
remains bounded. This suggests the following particular
solution:
X
(f)
t
=
1
j=1
j+1
Z
t+j
where the superscript (f) indicates that the solution was obtained by iter-
ating the dierence equation forward in time. For this to be a meaningful
choice, the innite sum must be well-dened. This will be guaranteed if, for
example, Z
t
remains bounded, i.e if (Z)
.
In the case [[ = 1 neither the backward nor the forward iteration strategy
leads to a sensible solution even when Z
t
is constant and equal to Z ,=
0. Either an equilibrium point does not exist as in the case = 1 or the
equilibrium point exists as is the case for = 1, but X
t
oscillates forever
between X
0
and X
0
+ Z so that the equilibrium point is unstable.
To summarize, the rst order linear dierence equation (2.2) led us to
consider the following two representations of the general solutions:
X
t
=
t
c
b
+ X
(b)
t
, whereby X
(b)
t
=
j=0
j
Z
tj
X
t
=
t
c
f
+ X
(f)
t
, whereby X
(f)
t
=
1
j=1
j+1
Z
t+j
Note that these equations imply that c
b
= X
0
X
(b)
0
, respectively that c
f
=
X
0
X
(f)
0
. Depending on the value of , we have the following situation:
[[ < 1: the backward solution is asymptotically stable in the sense that X
t
approaches X
(b)
t
as t . Any deviation of X
t
from X
(b)
t
vanishes
over time, irrespective of the value chosen for c
b
. The forward solution,
usually, makes no sense because X
(f)
t
does not remain bounded even if
the forcing variable Z
t
is constant over time.
[[ > 1: both solution have an explosive behavior due to the term
t
. Even
small deviations from either X
(b)
t
or X
(f)
t
will grow without bounds.
There is, however, one solution which remains remains bounded. It is
given by c
f
= 0 which implies that X
t
always equals its equilibrium
value X
(f)
t
.
[[ = 1: neither the backward nor the forward solution converge for constant
Z
t
,= 0.
Which solution is appropriate depends on the nature of the economic prob-
lem at hand. In particular the choice of the boundary condition requires
some additional thoughts and cannot be determined on general grounds. As
the exercises below demonstrate, the nature of the expectations formation
mechanism is sometimes decisive.
2.3.1 Examples
The simple Cobweb model
The Cobweb model, originally introduced by Moore Moore (1914) to analyze
the cyclical behavior of agricultural markets, was one of the rst dynamic
models in economics. It inspired an enormous empirical as well as theoretical
literature. Its analysis culminated in the introduction of rational expections
by Muth Muth (1961). The model, in its simplest form, analyzes the short-
run price uctuations in a single market where, in each period, the price level
is determined to equate demand and supply denoted by D
t
and S
t
, respec-
tively. The good exchanged on this market is not storable and is produced
with a xed production lag of one period. The supply decision of producers
in period t 1 is based on the price they expect to get for their product
in period t. Denoting the logarithm of the price level in period t by p
t
and
assuming a negatively sloped demand curve, the simple Cobweb model can
be summarized by the following four equations:
6
D
t
= p
t
, > 0 (demand)
S
t
= p
e
t
+ u
t
, > 0 (supply)
S
t
= D
t
(market clearing)
p
e
t
= p
t1
(expectations formation)
where u
t
denotes a supply shock. In agricultural markets u
t
represents. for
example, weather conditions. Given the naive expectations formation, p
e
t
=
p
t1
, the model can be solved to yield a linear rst order dierence equation
in p
t
:
p
t
=
p
t1
u
t
= p
t1
+ Z
t
(2.14)
where =
and Z
t
=
u
t
. Due to the negative value of , the price

oscillates: high prices tend to be followed by low prices which are again
followed by high prices. If u
t
is independent of time and equal to u, the
equilibrium price of the Cobweb model can be computed as follows:
p
=
u
+
(2.15)
The gure 2.2 depicts several possible cases depending on the relative
slopes of supply and demand. In the rst panel = 0.8 so that we have
an asymptotically stable equilibrium. Starting at p
0
, the price approaches
the steady state by oscillating around it. In the second panel = 1 so
that independently of the starting value, the price oscillates forever between
p
0
and p
1
. In the third panel, we have an unstable equilibrium. Starting at
p
0
,= p
, p
t
diverges.
6
The logarithm of the price level is taken to ensure a positive price level.
0
0
.
2
0
.
4
0
.
6
0
.
8
1
1
.
2
1
.
4
0
0
.
2
0
.
4
0
.
6
0
.
8 1
1
.
2
1
.
4
P
t
P
t + 1
P
1
P
2
P
0
P
1
s
t
e
a
d
y
s
t
a
t
e 4
5
l
i
n
e
)
p
t

+

1
(
a
)
c
o
n
v
e
r
g
e
n
c
e
(
=
1
a
n
d
=
0
.
8
)
0
0
.
2
0
.
4
0
.
6
0
.
8
1
0
0
.
1
0
.
2
0
.
3
0
.
4
0
.
5
0
.
6
0
.
7
0
.
8
0
.
9 1
P
t
P
t + 1
s
t
e
a
d
y
s
t
a
t
e
p
1
p
2
p
0
p
1
4
5
l
i
n
e
)
p
t

+

1
(
b
)
o
s
c
i
l
l
a
t
i
n
g
(
=
1
a
n
d
=
1
)
0
0
.
2
0
.
4
0
.
6
0
.
8
1
0
0
.
1
0
.
2
0
.
3
0
.
4
0
.
5
0
.
6
0
.
7
0
.
8
0
.
9 1
P
t
P
t + 1
4
5
l
i
n
e
)
p
t

+

1
s
t
e
a
d
y
s
t
a
t
e
p
0
p
1
p
2
p
1
(
c
)
e
x
p
l
o
d
i
n
g
(
=
1
a
n
d
=
1
.
1
)
F
i
g
u
r
e
2
.
2
:
P
r
i
c
e
d
y
n
a
m
i
c
s
i
n
t
h
e
c
o
b
w
e
b
m
o
d
e
l
The Solow Growth Model
Although this monograph only deals with linear dierence equations, the
local behavior of nonlinear dierence equations can be studied by linearizing
the dierence equation around the steady state. A general treatment of this
subject is postponed to until section 3.1.5. We will exemplify this technique
by studying the famous Solow (see Solow (1956)) growth model. A simple
version of this model describes a closed economy with no technical progress.
Output in period t, denoted by Y
t
, is produced with two essential production
factors: capital, K
t
, and labor, L
t
. Production possibilities of this economy
in period t are described by a neoclassical production function Y
t
= F(K
t
, L
t
).
The production function is assumed to have the following properties:
F is twice continuously dierentiable;
strictly positive marginal products, i.e.
F(K,L)
K
> 0 and
F(K,L)
L
> 0;
diminishing marginal products, i.e.

2
F(K,L)
K
2
< 0 and

2
F(K,L)
L
2
< 0;
F has constant returns-to-scale, i.e. F(K, L) = F(K, L) for all
> 0;
F satises the Inada conditions:
lim
K
F(K, L)
K
= 0, lim
L
F(K, L)
L
= 0
lim
K0
F(K, L)
K
= , lim
L0
F(K, L)
L
=
The classic example for a production function with these properties is the
Cobb-Douglas production function: F(K, L) = AK
(1)
L
, A > 0, 0 < <

1. The Inada conditions are usually not listed among the properties of a
neoclassical production function, however, they turn out to be necessary to
guarantee a strictly positive steady state.
Output can be used either for consumption, C
t
, or investment, I
t
:
Y
t
= C
t
+ I
t
. (2.16)
The economy saves a constant fraction s (0, 1) of the output. Because
saving equals investment in a closed economy, we have
I
t
= sY
t
. (2.17)
Investment adds to the existing capital stock which depreciates in each period
by constant rate (0, 1):
K
t+1
= (1 )K
t
+ I
t
= (1 )K
t
+ sY
t
= (1 )K
t
+ sF(K
t
, L
t
) (2.18)
Whereas capital is a reproducible factor of production, labor is a xed factor
of production which grows at the exogenously given constant rate > 0.
Thus, L
t
evolves as L
t+1
= (1 + )L
t
. Dividing equation (2.18) by L
t+1
and
making use of the constant returns to scale assumption results in:
k
t+1
=
K
t+1
L
t+1
=
1
1 +
k
t
+
s
1 +
f(k
t
) = g(k
t
) (2.19)
where k
t
=
K
t
L
t
denotes the capital intensity and f(k
t
) = F
_
K
t
L
t
, 1
_
.
The economy starts in period zero with an initial capital intensity k
0
> 0.
The nonlinear rst order dierence equation (2.19) together with the initial
condition uniquely determines the evolution of the capital intensity over time,
and consequently of all other variables in the model. Note that the concavity
of F is inherited by f and thus by g so that we have g
> 0 and g
< 0.
Moreover, lim
k0
g(k) = 0 and lim
k
g(k) = .
The nonlinear dierence equation has two steady states. The rst one is
given by zero because g(0) = 0. This point is of no economic signicance.
The existence and uniqueness of the second strictly positive steady state can
be deduced from the following properties of g(.): g(0) = 0, lim
k0
g
(k) =
, lim
k
g
(k) =
1
1+
< 1, and g
(k) > 0. These properties ensure that

the function g is suciently steep at the origin and becomes eventually at
enough to cross the 45-degree line once. The situation is described by gure
2.3. Note that the derivative g
(k
) must be smaller than one for g to cross

the 45-degree line.
The asymptotic stability of k
is easily established by observing that (k

t
)
is monotonically increasing for k
0
(0, k
) and monotonically decreasing

for k
0
> k
. Thus, (k
t
) converges monotonically to k
independently of the
initial value k
0
> 0.
The local behavior of (k
t
) around the steady state can be analyzed by
linearizing the function g around its steady state by a rst order Taylor
approximation:
k
t+1
k
+
g(k)
k
k=k
(k
t
k
) (2.20)
We can therefore study the local behavior of the nonlinear dierence equa-
tion (2.19) around the steady state by the rst order homogenous dierence
equation:
k
t+1
k
= (k
t
k
) (2.21)
0 0.05 0.1 0.15 0.2 0.25 0.3
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
capital intensity
c
a
p
i
t
a
l

i
n
t
e
n
s
i
t
y
steady state
k
*

k
*

45degree line
g(k)
linearized g(k) function
Figure 2.3: Capital Intensity in the Solow Model
where 0 < =
g(k)
k
k=k
< 1. Starting in period zero with an initial

capital intensity k
0
> 0, the solution to this initial value problem is: k
t
=
k
+
t
(k
0
k
). As 0 < < 1, the steady state k
is asymptotically stable.
That the original nonlinear dierence equation and the linearized version
deliver the same conclusion with respect to the stability of the equilibrium
point is not specic to the example just discussed. In particular, the following
theorem holds:
Theorem 3. Let X
be an equilibrium point of the nonlinear autonomous

dierence equation
X
t+1
= f (X
t
)
where f is continuously dierentiable at X
. Then
1. If [f
(X
)[ < 1, then X
is an asymptotically stable equilibrium point.

2. If [f
(X
)[ > 1, then X
is unstable.
Proof. The proof follows Elaydi (Elaydi, 1999, 2728). Suppose that [f
(X
)[
M < 1. Then, because of the continuity of the derivative, there exists an
interval J = (X
, X
+ ), > 0, such that [f
(X)[ M < 1 for all

X J. For X
0
J,
[X
1
X
[ = [f (X
0
) f (X
)[
The mean value theorem then implies that there exists , X
0
< < X
, such
that
[f (X
0
) f (X
)[ = [f
()[ [X
0
X
[ .
Hence we have
[X
1
X
[ M[X
0
X
[ .
This shows that X
1
is closer to X
and is thus also in J because M < 1. By

induction we therefore conclude that
[X
t
X
[ M
t
[X
0
X
[ .
For any > 0, let
= min, then [X
0
X
[ <
implies [X
t
X
[ <
for all t 0. X
is therefore a stable equilibrium point. In addition, X
is attractive because lim

t
[X
t
X
[ = 0. Thus, X
is asymptotically
stable.
The case [f
(X
)[ = 1 is not treated by this theorem. It involves a more

detailed analysis which can be found in (Elaydi, 1999, 2932).
A model of equity prices
Consider an economy where investors have two assets at their disposal. The
rst one is a riskless bank deposit which pays a constant interest rate r > 0
in each period. The second one is a common share which gives the owner the
right to a known dividend stream per share. The problem is to gure out
the share price p
t
as a function of the dividend stream (d
t+h
)
h=0,1,...
and the
interest rate r. As we abstract from uncertainty in this example, arbitrage
ensures that the return on both investments must be equal. Given that the
return on the investment in the share consists of the dividend payment d
t
and the expected price change p
e
t+1
p
t
, this arbitrage condition yields:
r =
d
t
+ p
e
t+1
p
t
p
t
p
e
t+1
= (1 + r)p
t
d
t
(2.22)
where p
e
t+1
denotes the price expected to prevail in the next period. Assuming
that expectations of the investors are rational which is equivalent to assum-
ing perfect foresight in the context of no uncertainty, the above arbitrage
equation turns into a simple rst order dierence equation:
p
t+1
= (1 + r)p
t
d
t
(2.23)
with = 1 + r and Z
t
= d
t1
. Because = 1 + r > 1, we can disregard
the backward solution as the innite sum will not converge for a constant
dividend stream. Turning to the forward solution, we note that X
(f)
t
is well
dened even for a constant dividend stream. In this case the particular
solution X
(f)
t
is nothing but the present discounted value of the dividend
stream. Thus, we envision the following general solution to the dierence
equation (2.23):
p
t
= (1 + r)
t
c
f
+ X
(f)
t
=
_
p
0
X
(f)
0
_
(1 + r)
t
+ X
(f)
t
(2.24)
where X
(f)
t
= (1 + r)
1
j=0
(1 + r)
j
d
t+j
. The term (1 + r)
t
c
f
is usually
called the bubble term because its behavior is unrelated to the dividend
stream; whereas the term X
(f)
t
is referred to as the fundamentals because it
is supposed to reect the intrinsic value of the share.
Remember that we want to gure out the price of a share. Take period
0 to be the current period and suppose that c
f
= p
0
X
(f)
0
> 0. This
means that the current stock price is higher than what can be justied by
the future dividend stream. According to the arbitrage equation (2.22) this
high price (compared to the dividend stream) can only be justied by an
appropriate capital gain, i.e. an appropriate expected price increase in the
next period. This makes price in the next period even more dierent from the
fundamentals which must be justied by an even greater capital gain in the
following period, and so on. In the end the bubble term takes over and the
share price becomes almost unrelated to the dividend stream. This situation
is, however, not sustainable in the long run.
7
Therefore the only reasonable
current share price p
0
is X
(f)
0
. This eectively eliminates the bubble term
and we are left with the solution:
p
t
= X
(f)
t
= (1 + r)
1
j=0
(1 + r)
j
d
t+j
(2.25)
Thus, the price of a share always equals the present discounted value of the
corresponding dividend stream. Such a solution is reasonable in a situation
with no uncertainty and no information problems. Note this solution implies
that the price immediately responds to any change in the expected dividend
stream. The eect of a change in d
t+h
, h = 0, 1, 2, . . . on p
t
is given by
p
t
d
t+h
= (1 + r)
h1
h = 0, 1, . . .
Thus, the eect diminishes the further the change takes place in the future.
Consider now a permanent change in dividends, i.e. a change where all
7
A similar argument applies to the case c
f
= p
0
X
(f)
0
< 0.
dividends increase by some constant amount d. The corresponding price
change p
t
equals:
p
t
= (1 + r)
1
j=0
(1 + r)
j
d =
d
r
Similarly a proportional increase of all dividends would lead to the same pro-
portional increase in the share price. These comparative exercises demon-
strate that the rational expectations solution which eliminates the bubble
term makes sense.
Cagans model of hyperination
In periods of hyperination the price level rises by more than 50 percent a
month. As these periods are usually rather short lived, they can serve as
a laboratory for the study of the relation between money supply and the
price level because other factors like changes in real output can be ignored.
Denoting by m
t
the logarithm of the money stock in period t and by p
t
the
logarithm of the price level in period t, the model rst proposed by Cagan
(1956) consists of the following three equations.
8
m
d
t
p
t
= (p
e
t+1
p
t
), < 0 (money demand)
m
s
t
= m
d
t
= m
t
(money supply)
p
e
t+1
p
t
= (p
t
p
t1
), > 0 (adaptive expectations)
The rst equation is a money demand equation in logarithmic form. It
relates the logged demand for the real money stock, m
d
t
p
t
, where the
superscript d stands for demand, to the rate of ination expected to prevail
in period t + 1, p
e
t+1
p
t
, where the superscript e stands for expectation.
This relation is negative because households and rms want to hold less
money if they expect the real value of money to deteriorate in the next
period due to high ination rates. Thus, < 0. In this model the central
bank perfectly controls the money stock and sets it independently of the
development of the price level. The model treats the logarithm of the supply
of the money stock, m
s
t
, where the the superscript s stands for supply, as
exogenous. The money stock injected in the economy is completely absorbed
by the economy so that in each point in time the supply of money equals
the demand of money. Combining the rst two equation, i.e. replacing m
d
t
by m
t
in the rst equation, leads to a portfolio equilibrium condition. As
we will see the behavior of the model depends crucially on the way in which
8
See also the analysis in Sargent (1987).
expectations are modelled. Following the original contribution by Cagan, we
postulated that expectations are formed adaptively, i.e. agents form their
expectations by extrapolating past ination. The third equation postulates
a very simple adaptive expectation formation scheme: ination expected
to prevail in the next period is just proportional to the current ination.
Thereby the proportionality factor is assumed to be positive, meaning that
expected ination increases if current ination increases. Combining all three
equation of the model and solving for p
t
, we arrive at the following linear
nonhomogeneous rst order dierence equation.
p
t
=

1 +
p
t1
+
1
1 +
m
t
= p
t1
+ Z
t
(2.26)
where =

1+
and where Z
t
=
1
1+
m
t
.
From our previous discussion we know that the general solution of this
dierence equation is given as the sum of the general solution to the ho-
mogenous equation and a particular solution, p
(p)
t
, to the nonhomogeneous
equation:
p
t
=
t
c + p
(p)
t
One particular solution can be found by recursively inserting into equation
(2.26):
p
1
= p
0
+ Z
1
p
2
= p
1
+ Z
2
=
2
p
0
+ Z
1
+ Z
2
. . .
p
t
=
t
p
0
+
t1
Z
1
+
t2
Z
2
+ + Z
t1
+ Z
t
=
t
p
0
+
t1
i=0
i
Z
ti
This is again an illustration of the superposition principle. The logged price
in period t, p
t
, is just the sum of two components. The rst one is a function
of p
0
whereas the second one is a weighted sum of past logged money stocks.
In economics there is no natural starting period so that one may iterate the
above equation further, thereby going back into innite remote past:
p
t
= lim
i
t
p
ti
+
i=0
i
Z
ti
From a mathematical point of view this expression only makes sense if the
limit and the innite sum converge. Thus, additional assumptions are re-
quired. Suppose that logged money remained constant, i.e. m
t
= m < for
all t, then the logic of the model suggests that the logged price level should
remain nite as well. In mathematical terms this means that
i
should
converge. This is, however, a geometric sum so that convergence is achieved
if and only if
[[ =
1 +
< 1 (2.27)
Assuming that this stability condition holds, the general solution of the dif-
ference equation (2.26) implied by the Cagan model is:
p
t
=
t
c +
i=0
i
Z
ti
(2.28)
where the constant c can be computed from some boundary condition.
The stability condition therefore has important consequences. First, irre-
spective of the value of c, the rst term of the solution (the general solution
to the homogenous equation),
t
c, becomes less and less important as time
unfolds. Thus, for a large enough t, the logged price level will be dominated
by the particular solution to the nonhomogeneous equation,
i=0
i
Z
ti
. In
this innite sum, the more recent values of the money stock are more impor-
tant for the determination of the price level. The importance of past money
stocks diminishes as one goes further back into the past. Third, suppose
that money stock is increased by a constant percentage point, m, in every
period, then the eect on the logged price level, p
t
is given by
p
t
=
i=0
i
_
1
1 +
m
_
=
1
1
1
1 +
m = m.
Thus, the price level moves up by the same percentage point. Such a once-
and-for-all change is termed a permanent change. In contrast a transitory
change is a change which occurs only once. The eect of a transitory change
of m
t
by m in period t on the logged price level in period t + h for some
h 0 is given by
p
t+h
=
h
1
1 +
m =
_

1 +
_
h
1
1 +
m
The values
p
t+h
m
seen as a function of h 0 are called the impulse response
function. It gives the reaction of the logged price level over time to a transi-
tory change of the logged money stock. As is clear from the above formula,
the stability condition implies that eect on the logged price level dies out
exponentially over time. Usually the impulse response function is plotted as
a function of h as in gure 2.4 below.
0 2 4 6 8 10 12 14 16 18 20
2
1.5
1
0.5
0
0.5
1
1.5
2
h
Figure 2.4: Impulse response function of the Cagan model with adaptive
expectations taking = 0.5 and = 0.9
The character of the model changes dramatically if rational expectations
are assumed instead of adaptive expectation. In the context of a deterministic
model this amounts to assuming perfect foresight. Thus, the third equation
of the model is replaced by
p
e
t+1
= p
t+1
(2.29)
With this change the new dierence equation becomes:
p
t+1
=
1
p
t
+
m
t
= p
t
+ Z
t
(2.30)
with Z
t
= m
t
/. As =
1
> 1, the stability condition is violated. One

can nevertheless nd a meaningful particular solution of the nonhomogeneous
equation by iterating the dierence equation forwards in time instead of
backwards:
p
t
=
1
p
t+1
1
Z
t
=
1
_
1
p
t+2
1
Z
t+1
_
1
Z
t
=
2
p
t+2
2
Z
t+1
1
Z
t
. . .
=
h
p
t+h
1
h1
i=0
i
Z
t+i
for h > 0
The logged price level in period t, p
t
, now depends on some expected logged
price level in the future, p
t+h
, and on the development of logged money
expected to be realized in the future. Because the economy is expected to
live forever, this forward iteration is carried on into the innite future to
yield:
p
t
= lim
h
h
p
t+h
i=0
i
Z
t+i
As 0 <
1
< 1, the limit and the innite sum are well dened, provided
that the logged money stock remains bounded. Under the assumption that
the logged money stock is expected to remain bounded, the economic logic
of the model suggests that the logged price level should remain bounded as
well. This suggests the following particular solution to the nonhomogeneous
equation:
p
(p)
t
=
1
i=0
i
Z
t+i
by the superposition principle the general solution of the nonhomogeneous
dierence equation (2.30) is:
p
t
=
t
c + p
(p)
t
=
t
c
1
i=0
i
Z
t+i
(2.31)
Due to the term
t
c, the logged price level growth exponentially without
bound although the logged money stock may be expected to remain bounded,
unless c = 0.
To summarize, the Cagan model suggests the following two solutions:
p
t
=
t
c
b
+ p
(b)
t
, whereby p
(b)
t
=
i=0
i
Z
ti
p
t
=
t
c
f
+ p
(f)
t
, whereby p
(f)
t
=
1
i=0
i
Z
t+i
Which of the two solutions is appropriate depends on the value of . If
[[ < 1 only the rst solution delivers sensible paths for p
t
, i.e. paths which
do not explode for bounded values of Z
t
. However, we have a whole families
of paths parametrized by the constant c
b
. Only when we chose a particular
initial value for p
t
0
for some t
0
, or equivalently a value for c
b
, will the price
path be uniquely determined. In this sense, we can say that the price level
is indeterminate. In the case [[ > 1 which is implied by the assumption
of rational expectations, only the second solution is meaningful because it
delivers a well-dened particular solution for bounded Z
t
s. However, the
general solution to the homogenous equation implies an exploding price level
except for c
f
= 0. Thus, there is only one non-exploding solution in this case:
p
t
= p
(f)
t
. The price level therefore equals in each period its steady state level.
The assumption of rational expectations together with the assumption that
a bounded forcing variable should lead to a bounded price path pinned down
a unique solution. Thus, the price level is determined without the need of
an initial condition.
2.4 Dierence Equations of Order p
We now turn to the general case represented by equation (2.1). As can
be easily veried if (X
(1)
t
) and (X
(2)
t
) are two particular solutions of the
nonhomogeneous equation, (X
(1)
t
) (X
(2)
t
) is a solution to the homogeneous
equation:
X
t
=
1
X
t1
+
2
X
t2
+ +
p
X
tp
,
p
,= 0. (2.32)
Thus, the superposition principle stated in Theorem 2 also holds in the gen-
eral case: the general solution to the nonhomogeneous equations can be
represented as the sum of the general solution to the homogeneous and a
particular solution to the nonhomogeneous equation. Thus, we begin the
analysis of the general case by an investigation of the homogeneous equa-
tion.
2.4.1 Homogeneous Dierence Equation of Order p
In order to nd the general solution of the homogeneous equation, we guess
that it will be of the same form as in the rst order case, i.e. of the form
c
t
, c ,= 0. Inserting this guess into the homogeneous equation (2.32), we get:
c
t
=
1
c
t1
+
2
c
t2
+ +
p
c
tp
which after cancelling out c, dividing by
t
and substituting z for
1
leads to:
1
1
z
2
z
2

p
z
p
= 0 (2.33)
This equation is called the characteristic equation of the homogeneous equa-
tion (2.32). Thus, in order for c
t
to be a solution to the homogeneous
equation z =
1
must be a root to the characteristic equation (2.33). These

roots are called the characteristic roots. Note that the assumption
p
,= 0
implies that none of the characteristic roots is equal to zero.
2.4. DIFFERENCE EQUATIONS OF ORDER P 35
From the Fundamental Theorem of Algebra we know that there are p,
possibly complex, roots to the characteristic equation. Denote these roots
by z
1
, . . . , z
p
and there corresponding
s by
1
, . . . ,
p
. To facilitate the
discussion consider rst the standard case where all p roots are distinct.
distinct roots
In this case we have the following theorem.
Theorem 4. If all the roots of the characteristic equation are distinct, the
set
t
1
, . . . ,
t
p
forms a fundamental set of solutions.
Proof. It suces to show that det ((t) ,= 0 where ((t) is the Casarotian
matrix of
t
1
, . . . ,
t
p
.
det ((t) = det
_
_
_
_
_
t
1

t
2
. . .
t
p
t+1
1

t+1
2
. . .
t+1
p
.
.
.
.
.
.
.
.
.
.
.
.
t+p1
1

t+p1
2
. . .
t+p1
p
_
_
_
_
_
=
t
1
t
2
. . .
t
p
det
_
_
_
_
_
1 1 . . . 1
1

2
. . .
p
.
.
.
.
.
.
.
.
.
.
.
.
p1
1

p1
2
. . .
p1
p
_
_
_
_
_
This second matrix is called the Vandermonde matrix whose determinant
equals
1i<jp
(
j

i
) which is dierent from zero because the roots are
distinct. Thus, det ((t) ,= 0, because the roots are also dierent from zero.
The above Theorem thus implies that the general solution to the homo-
geneous equation X
(g)
t
is given by
X
(g)
t
= c
1
t
1
+ c
2
t
2
+ + c
p
t
p
(2.34)
multiple roots
When the roots of the characteristic equation are not distinct, the situa-
tion becomes more complicated. Denote the r distinct roots by z
1
, , z
r
,
r < p, and their corresponding multiplicities by m
1
, , m
r
. Writing the
homogeneous dierence equation in terms of the lag operator leads to
(1
1
L
p
L
p
) X
t
= (1
1
L)
m
1
(1
2
L)
m
2
(1
r
L)
m
r
X
t
= 0
(2.35)
where
i
, 1 i r equals
1
z
i
. In order to nd the general solution we will
proceed in several steps. First note if
t
is a solution to
(1
i
L)
m
i
t
= 0 (2.36)
it is also a solution to (2.35). Second, (
i
=
t
i
, t
t
i
, t
2
t
i
, , t
m
i
1
t
i
is
a fundamental set of solutions for equation (2.36). Before we prove this
statement in Lemma 2, we need the following lemma.
Lemma 1. For all k 1
(1 L)
k
t
s
= 0, 0 s < k
Proof. The application of the operator 1 L on t
s
leads to a polynomial of
degree s 1, because the term t
s
cancels in (1 L)t
s
= t
s
(t 1)
s
and only
terms of degree smaller than s remain. Applying 1 L again reduces the
degree of the polynomial again by one. Finally, (1L)
s
t
s
leads to a constant.
Thus, (1 L)
s+1
t
s
= 0. This proves the lemma because further applications
of 1 L will again result in zero.
Lemma 2. The set (
i
=
t
i
, t
t
i
, t
2
t
i
, , t
m
i
1
t
i
represents a fundamental
set of solutions to the equation (2.36).
Proof. Take s, 1 s m
i
1, then
(1
i
L)
m
i
(t
s
t
i
) =
t
i
(1 L)
m
i
t
s
= 0
because (1L)
m
i
t
s
= 0 according to Lemma 1.
9
Therefore t
s
t
i
is a solution to
(2.36). The set (
i
is linearly independent because the set 1, t, t
2
, , t
m
i
1
is linearly independent.
It is then easily seen that ( =
r
i=1
(
i
is a fundamental set of solutions
to the equation (2.35). Thus, the general solution can be written as
X
t
=
r
i=1
_
c
i0
+ c
i1
t + c
i2
t
2
+ + c
i,m
i
1
t
m
i
1
_
t
i
(2.37)
9
Here we made use of the relation p(L)(
t
i
g(t)) =
t
p(
i
L)g(t) where p(L) is a lag
polynomial and g is any discrete function.
2.4.2 Nonhomogeneous Equation of Order p
As in the case of homogeneous dierence equations of order one, the set of
all solutions forms a linear space. The dimension of this space is given by the
order of the dierence equation, i.e. by p. Consider now two solutions, (X
(1)
)
and (X
(2)
) of the nonhomogeneous equation. It is easy to verify that (X
(1)
)
(X
(2)
) is then a solution to the homogeneous equation. This implies that the
superposition principle also applies for nonhomogeneous equation of order p
greater than than one. Thus the general solution of the nonhomogeneous
equation can be written as
X
t
= X
(g)
t
+ X
(p)
t
where X
(g)
t
is the general solution to the homogeneous equation given by
equation (2.37) and X
(p)
t
is a particular solution to the nonhomogeneous
equation.
In the search for a particular solution, the same ideas as in rst order case
can be used. If the nonhomogeneous part is constant, i.e. Z
t
= Z, the steady
state, if it exists, qualies for a particular solution to the nonhomogeneous
equation. If the nonhomogeneous part depends on time, a particular solution
can be found by iterating the equation backwards and/or forwards depending
on the location of the roots.
2.4.3 Limiting Behavior of Solutions
The analysis of the limiting behavior can be reduced to the discussion of the
second order dierence homogenous equation:
X
t
1
X
t1
2
X
t2
= 0,
2
,= 0 (2.38)
The corresponding characteristic equation is given by the quadratic equation:
1
1
z
2
z
2
= 0.
The solutions of this equation are given by the familiar formula:
z
1,2
=
2
1
+ 4
2
2
2
.
Or in terms of =
1
z
:
1,2
=

1
2
1
+ 4
2
2
. (2.39)
In order to understand the qualitative behavior of X
t
, we distinguish three
cases:
1
and
2
are real and distinct: The general solution is given by
X
t
= c
1
t
1
+ c
2
t
2
=
t
1
_
c
1
+ c
2
_
1
_
t
_
Suppose without loss of generality that [
1
[ > [
2
[ so that
_
1
_
t
0
as t . This implies that the behavior of X
t
is asymptotically
governed by the larger root
1
:
lim
t
X
t
= lim
t
c
1
t
1
Depending on the value of
1
six dierent cases emerge:
1.
1
> 1: c
1
t
1
diverges to as t . The system is unstable.
2.
1
= 1: c
1
t
1
remains constant and equal to c
1
.
3. 0 <
1
< 1: c
1
t
1
decreases monotonically to zero. The system is
stable.
4. 1 <
1
< 0: c
1
t
1
oscillates around zero, alternating in sign, but
converges to zero.
5.
1
= 1: c
1
t
1
alternates between the values c
1
and c
1
6.
1
< 1: c
1
t
1
alternates in sign, but diverges in absolute value
to .
The behavior of X
t
in all six cases is illustrated in gure 2.5.
equal roots =
1
=
2
: According to (2.37) the solution is given by: X
t
=
(c
1
+ c
2
t)
t
. Clearly, if 1, X
t
diverges monotonically; or, if 1,
X
t
diverges by alternating signs. For [[ < 1, the solution converges to
zero, because lim
t
t
t
= 0.
complex roots: The two roots appear as complex conjugate pairs and may
be written as
1
= + and
2
= with ,= 0. In terms of polar
coordinates the two roots may alternatively be written as
1
= re
,
respectively
2
= re
, where r =
_
2
+
2
and = tan
1
_
_
. The
solution is then given by
X
t
= c
1
t
1
+ c
2
t
2
= c
1
( + )
t
+ c
2
( )
t
= c
1
r
t
e
t
+ c
2
r
t
e
t
= r
t
[c
1
(cos(t) + sin(t)) + c
2
(cos(t) sin(t))]
= r
t
[(c
1
+ c
2
) cos(t) + (c
1
c
2
) sin(t)]
Since X
t
must be a real number, c
1
+ c
2
must also be real whereas
c
1
c
2
must be imaginary. This implies that c
1
and c
2
must be complex
conjugate. In terms of polar coordinates they can be written as c
1
=
e
and c
2
= e
for some and some . Inserting into the above

equation nally gives:
X
t
= r
t
_
e
(t+)
+ e
(t+)
= 2r
t
cos(t + )
The solution therefore clearly oscillates because the cosine function
oscillates. Depending on the location of the conjugate roots three cases
must be distinguished:
1. r > 1: both roots are outside the unit circle (i.e. the circle of
radius one and centered in the point (0, 0)). X
t
oscillates, but
with ever increasing amplitude. The system is unstable.
2. r = 1: both roots are on the unit circle. X
t
oscillates, but with
constant amplitude.
3. r < 1: both roots are inside the unit circle. The solution oscillates,
but with monotonically decreasing amplitude and converges to
zero as t . The system is stable.
Figure 2.6 illustrates the three cases.
We can summarize the above discussion in the following theorem.
Theorem 5. The following statements hold in the case of linear homogenous
dierence equation of order two (equation (2.38)):
(i) All solutions oscillate around zero if and only if the equation has no
positive real characteristic root.
(ii) All solutions converge to zero (i.e. zero is an asymptotically stable
steady state) if and only if max[
1
[, [
2
[ < 1.
Although the limiting behavior of X
t
is most easily understood in terms of
the roots of the characteristic equation, it is more convenient to analyze the
properties of the dierence equation in terms of the original parameters
1
and
2
. Consider for this purpose a nonhomogeneous second order dierence
equation where the nonhomogeneous part is just a constant equal to Z:
X
t
=
1
X
t1
+
2
X
t2
+ Z, Z ,= 0. (2.40)
0 5 10
3
2
1
0
1
2
3
case 1:
1
= 1.1
X
t
0 5 10
3
2
1
0
1
2
3
case 2:
1
= 1
X
t
0 5 10
3
2
1
0
1
2
3
case 4:
1
= 0.8
X
t
0 5 10
3
2
1
0
1
2
3
case 5:
1
= 1
X
t
0 5 10
3
2
1
0
1
2
3
case 6:
1
= 1.1
X
t
0 5 10
3
2
1
0
1
2
3
case 3:
1
= 0.8
X
t
Figure 2.5: Behavior of X
t
=
t
1
depending on R
0 1 2 3 4 5 6 7 8 9 10
40
20
0
20
case 1: roots outside unit circle (
1
= 1+i,
2
= 1i)
X
t
0 1 2 3 4 5 6 7 8 9 10
1
0
1
case 2: roots on unit circle (
1
= (sqrt(2)/2)(1+i),
2
= (sqrt(2)/2)(1i))
X
t
0 1 2 3 4 5 6 7 8 9 10
1
0
1
case 3: roots in unit circle (
1
= 0.5(1+i),
2
= 0.5(1i))
X
t
Figure 2.6: Behavior of X
t
in case of complex roots
Zero is no longer an equilibrium point. Instead, the new equilibrium point
X
can be found by solving the equation:

X
=
1
X
+
2
X
+ Z X
=
Z
1
1
2
Note that an equilibrium only exists if 1
1

2
,= 0. This condition is
equivalent to the condition that 1 cannot be a root. As the steady state
qualies for a particular solution of equation (2.40), the general solution is
given by
X
t
= X
+ X
(g)
t
Thus, X
t
converges to its equilibrium if and only if X
(g)
t
converges to zero as
t . Moreover, the solution oscillates around X
if and only if X
(g)
t
oscil-
lates around zero. Based on the theorem just above, the following theorems
hold.
Theorem 6. Assuming 1
1
2
,= 0, the following statements hold.
(i) All solutions of the nonhomogeneous equation (2.40) oscillate around
the equilibrium point X
if and only if the characteristic equation has

no positive real characteristic root.
(ii) All solutions to the nonhomogeneous equation (2.40) converge to X
(i.e. X
is an asymptotically stable) if and only if max[

1
[, [
2
[ < 1.
Theorem 7. The equilibrium point X
is an asymptotically stable (i.e. all

solutions converge to X
) if and only if the following three conditions are

satised:
(i) 1
1
2
> 0
(ii) 1 +
1
2
> 0
(iii) 1 +
2
> 0
Proof. Assume that X
is an asymptotically stable equilibrium point. Ac-

cording to the previous theorem this is means that both
1
and
2
must be
smaller than one in absolute value. According to equation (2.39) this implies
that
[
1
[ =
1
+
_
2
1
+ 4
2
2
< 1 and [
2
[ =
2
1
+ 4
2
2
< 1
Two cases have to be distinguished.
real roots:
2
1
+ 4
2
> 0: This implies the set of inequalities:
2 <
1
+
_
2
1
+ 4
2
< 2
2 <
1
2
1
+ 4
2
< 2
or, equivalently,
2
1
<
_
2
1
+ 4
2
< 2
1
2
1
<
_
2
1
+ 4
2
< 2
1
Squaring the second inequality in the rst line implies:
2
1
+ 4
2
<
4 4
1
+
2
1
which leads to condition (i). Similarly, squaring the rst
inequality in the second line yields: 4 + 4
1
+
2
1
>
2
1
+ 4
2
which
results in condition (ii). The assumption [
1
[ < 1 and [
2
[ < 1 imply
that [
1
2
[ = [
2
[ < 1 which gives condition (iii).
complex roots:
2
1
+ 4
2
< 0: This implies that 0 <
2
1
< 4
2
. There-
fore
4(1
1
2
) > 4 4
1
+
2
1
= (2
1
)
2
> 0
which is equivalent to condition (i). Similarly,
4(1 +
1
2
) > 4 + 4
1
+
2
1
= (2 +
1
)
2
> 0
which is equivalent to condition (ii). In order to obtain condition (iii),
note that the two complex conjugate roots are given by
1
=

1
2
+

2
_
2
1
+ 4
2
and
1
=

1
2

2
_
2
1
+ 4
2
.
Because [
1
[ < 1 and [
2
[ < 1 by assumption, we have that [
1
2
[ =
[
2
[ < 1 which is condition (iii).
Assume now that the three conditions are satised. They immediately imply
that 2 <
1
< 2 and that 1 <
2
< 1. If the roots are real then
1 <
2 +
_
2
1
+ 4
2
2
<
1
=

1
+
_
2
1
+ 4
2
2
<

1
+
_
2
1
+ 4 4
1
2
=
1
+
_
(2
1
)
2
2
=

1
1
+ 2
2
= 1
Similarly,
1 >
2
_
2
1
+ 4
2
2
>
1
=

1
2
1
+ 4
2
2
>

1
2
1
+ 4 + 4
1
2
=
_
(
1
+ 2)
2
2
=

1
1
2
2
= 1
If the roots are complex,
1
and
2
are complex conjugate numbers. Their
squared modulus then equals
1
2
=

2
1
(
2
1
+4
2
)
4
=
2
. As
2
< 1, the
modulus of both
1
and
2
is smaller than one.
The three conditions listed above determine a triangle with vertices given
by (2, 1),(0, 1) and (2, 1) in the
1
-
2
-plane. Points inside the triangle
imply an asymptotically stable behavior whereas points outside the triangle
lead to an unstable behavior. The parabola
2
1
+ 4
2
= 0 determines the
region of complex roots. Values of
1
and
2
above the parabola lead to
real roots whereas values below the parabola lead to complex roots. The
situation is represented in gure 2.7.
2.4.4 Examples
Multiplier Accelerator model
A classic economic example of a second order dierence equation is the
multiplier-accelerator model originally proposed by Samuelson Samuelson
(1939). It was designed the demonstrate how the interaction of the mul-
tiplier and the accelerator can generate cycles. The model is one of a closed
economy and consists of a consumption function, an investment function
which incorporates the accelerator idea and the income identity:
C
t
= + Y
t1
, 0 < < 1, > 0 (consumption)
I
t
= (Y
t1
Y
t2
), > 0 (investment)
Y
t
= C
t
+ I
t
+ G
t
, (income identity)
where C
t
, I
t
, Y
t
, and G
t
denotes private consumption expenditures, invest-
ment expenditures, income, and government consumption, respectively. The
parameter is called the marginal propensity of consumption and is assumed
3 2 1 0 1 2 3
3
2
1
0
1
2
3
2
damped oscillations
asymptotically
stable
expolosive oscillations
explosive
growth
explosive
oscillations
parabola:
1
2
+ 4
2
=0
Figure 2.7: Stability properties of equation: X
t
1
X
t1
2
X
t2
= 0
to be between zero and one. The remaining parameters of the model, and
, bear no restriction besides that they have to be positive. Inserting the
consumption and the investment equation into the income identity leads to
the following nonhomogeneous second order dierence equation:
Y
t
= ( + )Y
t1
Y
t2
+ ( + G
t
) (2.41)
If government expenditures remain constant over time and equal to G, the
equilibrium point Y
for equation (2.41) can be computed as follows:

Y
= ( + )Y
+ + G Y
=
+ G
1
The stability of this equilibrium point can be investigated by verifying if the
three conditions of Theorem 7 are satised:
(i) 1 ( + ) + = 1 > 0
(ii) 1 + ( + ) + = 1 + + 2 > 0
(iii) 1 > 0
Given the assumptions of the model, the rst two conditions are automat-
ically satised. Third condition, however, is only valid if the accelerator is
not too strong, i.e. if < 1. The steady state Y
is therefore asymptoti-
cally stable if one impose this additional requirement. Y
t
oscillates around
its steady state if, according to Theorem 5, there is no real positive inverse
root of the characteristic equation. The inverse of the characteristic roots
are given by
1,2
=
( + )
_
( + )
2
4
2
.
This shows that, if the roots are real, one of them will always be a positive
because + > 0. Thus, Y
t
can only oscillate around its steady state if and
only if ( + )
2
4 < 0.
In the general case where government expenditures are not constant, but
vary over time, we apply the method of undetermined coecients to nd a
particular solution, Y
(p)
t
, to equation (2.41). As the roots of the characteristic
function are all outside the unit circle, we guess that a particular solution is
of the form:
Y
(p)
t
= c +
i=0
i
G
ti
Inserting this solution into the dierence equation gives:
c +
i=0
i
G
ti
=c( + ) + ( + )
i=0
i
G
t1i
c
i=0
i
G
t2i
+ + G
t
Equating the constant terms leads to an equation for c:
c (1 ( + ) + ) = c =

1
> > 0
Equating the terms for G
ti
, i = 0, 1, leads to:
0
= 1
1
= ( + )
0

1
= +
2
= ( + )
1
j
= ( + )
j1
j2
, j 2
Thus, the coecients
j
, j 2, follow a homogenous second order dierence
equation with initial values
0
= 1 and
1
= + .
In order to illustrate the behavior of the multiplier-accelerator model, we
discuss several numerical examples.
=
4
5
and =
1
5
In this case both roots are real and equal to
1,2
=
1
2

5
10
=
_
0.7236
0.2764
Therefore the impulse response coecients
j
for j 0 are given by
j
= c
1
j
1
+ c
2
j
2
. The constants c
1
and c
2
can be recovered from the
initial conditions:
0
= 1 = c
1
+ c
2
and
1
= 1 = c
1
1
+ c
2
2
. Solving
these two equations for c
1
and c
2
yields:
c
1
=
1
2
2
= 1.6180
c
2
=

1
1
2
= 0.6180
The corresponding impulse response function is plotted in gure 2.8.
The initial increase of government expenditures by one unit raises out-
put in current and the subsequent period by one unit. Then the eect of
the impulse dies out monotonically. After ten periods the eect almost
vanished.
=
3
4
and =
1
4
In this case we have a multiple root equal to = 0.5. Ac-
cording to equation (2.37) the impulse response coecients are there-
fore given by
j
= (c
0
+ c
1
t)
t
. The constants c
0
and c
1
can again
be found by solving the equation system:
0
= 1 = c
0
and
1
= 1 =
(c
0
+ c
1
). The solution is given by c
0
= 1 and c
1
= 1. The corre-
sponding impulse response coecients are plotted in gure 2.8. They
resemble very much to those of the previous case. They even die out
more rapidly.
=
2
3
and =
2
3
In this case the discriminant is negative, so that we have
two complex conjugate roots:
1,2
=
1
3
_
2
2
_
The constants can again be found by solving the equation system:
0
=
1 = c
1
+ c
2
and
1
= 1 = c
1
1
+ c
2
2
. The solution is given by
c
1
=
1
2

1
2
2
c
2
=
1
2
+
1
2
2
The corresponding impulse response coecients are plotted in gure
2.8. As expected they clearly show an oscillatory behavior. Due to the
accelerator, the initial impulse is amplied in period one. The eect is
around 1.3. After period one the eect rapidly declines and becomes
even negative in period four. However, in period seven the eect starts
to increase and becomes again positive in period ten. As is also evident
from the gure, these oscillatory movements die out.
Cobweb model with Inventory
In this example we extend the simple Cobweb model analyzed in subsection
2.3.1 by allowing the good to be stored (see Sargent (1987)). In addition we
assume that expectations are rational which in the context of a deterministic
model is equivalent to perfect foresight. These modications lead to the
following set of equations:
D
t
= p
t
, > 0 (demand)
S
t
= p
e
t
+ u
t
, > 0 (supply)
I
t
= (p
e
t+1
p
t
), > 0 (inventory demand)
S
t
= D
t
+ (I
t
I
t1
), (market clearing)
p
e
t
= p
t
, (perfect foresight)
0 2 4 6 8 10 12 14 16 18 20
0.6
0.4
0.2
0
0.2
0.4
0.6
0.8
1
1.2
1.4
period
complex roots:
= 2/3, = 2/3
real roots:
= 4/5, = 1/5
multiple roots:
= 3/4, = 1/4
Figure 2.8: Impulse Response Coecients of the Multiplier-Accelerator
model
where u
t
denotes again a supply shock. The inventory demand shows a
speculative element because inventories will be built up if prices are expected
to be higher next period. The market clearing equation shows that the supply
which remains unsold is used to build up inventories; on the other hand
demand can not only be served by newly supplied goods, but can also be
fullled out of inventories. Combining these equations leads to the following
second order linear dierence equation in the price:
p
t+1
=
+ 2 +
p
t
p
t1
+
u
t
(2.42)
Setting =
+2+
, the characteristic equation becomes:

1 z + z
2
= 0
This equation implies that the two roots, z
1
and z
2
, are given by
z
1,2
=

_
2
4
2
First note that because > 2 the roots are real, distinct, and positive.
Second they come in reciprocal pairs as z
1
z
2
= 1. Thus, one root is smaller
than one whereas the other is necessarily greater than one. Thus, we have
one stable and one explosive root. The solution to the homogenous equation
can therefore be written as
p
t
= c
1
t
+ c
2
t
where, without loss of generality, z
1
= < 1 and z
2
=
1
. c
1
and c
2
are
constants yet to be determined.
Because the agents in this model have rational expectations which im-
plies that they are forward looking. They will therefore incorporate future
developments of the supply shock into their decision. However, past decision
are reected in the inventories carried over last period. Thus, we conjecture
that the solution will a forward and a backward looking component. Thus
we seek for a particular solution of the following form:
p
t
=
j=
j
u
tj
The method of undetermined coecients then leads to:
j=
j
u
t+1j
=
j=
j
u
tj

j=
j
u
t1j
+
u
t
Writing this equation in extensive form leads to:

+
1
u
t+2
+
0
u
t+1
+
1
u
t
+
2
u
t1
+
3
u
t2
+
= +
2
u
t+2
+
1
u
t+1
+
0
u
t
+
1
u
t1
+
2
u
t2
+

3
u
t+2
2
u
t+1
1
u
t
0
u
t1
1
u
t2

+
u
t
Equating terms gives:

1
=
2
0
=
1
1
=
0
1
+
1
2
=
1
3
=
2
1

This shows that the
j
s follow homogenous second order dierence equa-
tions:
j
=
j1
j2
j 1
j
=
j1
j2
j 1
The solution to these dierence equations are:
j
= d
1
j
+ d
2
j
= e
1
j
+ e
2
j
where the constants d
1
, d
2
, e
1
, e
2
have yet to be determined. A sensible eco-
nomic solution requires that, if the supply shock has been constant in the
past and is expected to remain constant in the future, the price must be
constant too. Thus, we can eliminate the exploding parts of the above so-
lutions, setting d
2
= 0 and e
2
= 0. Next observe that both solutions must
coincide for j = 0 which implies that d
1
= e
1
. Denote this value by d. d can
be determined by observing that the solutions must satisfy the initial value
condition:
1
=
0
1
+
1
. Inserting the solutions for

1
,
0
,
1
leads
to:
d = d d +
1
d =

1

1
The general solution to the Cobweb model with inventory represented by the
dierence equation (2.42) is therefore given by
p
t
= c
1
t
+ c
2
t
+

1

1
j=
|j|
u
tj
(2.43)
If we impose again the requirement that the price must be nite if the supply
shock has always been constant and is expected to remain constant in the
future, we have to set c
1
= 0 and c
2
= 0. This implies that p
t
is a bounded
sequence, i.e. that (p
t
)
In this case the price p

t
is just a function of all
past shocks and all expected future shocks.
In order to gain a better understanding of the dynamics, we will analyze
the following numerical example. In this example =
20
9
and the parameters
and are such that = 2.05. This implies that + =
1
9
. The roots are
then given by = 0.8 and
1
= 1.25. The bounded solution is then given
by
p
t
=
j=
0.8
|j|
u
tj
0 2 4 6 8 10 12 14 16 18 20
1
0.5
0
0.5
period
l
o
g
g
e
d

p
r
i
c
e

l
e
v
e
l

/

i
n
v
e
n
t
o
r
y
unexpected positive transitory supply shock
0 2 4 6 8 10 12 14 16 18 20
1
0.5
0
0.5
period
l
o
g
g
e
d

p
r
i
c
e

l
e
v
e
l

/

i
n
v
e
n
t
o
r
y
expected positive transitory supply shock in period 5
logged price level
logged price level
inventories
inventories
Figure 2.9: Impulse Response after a positive Supply Shock
Suppose that the supply shock has been constant forever and is expected
to remain constant at u. The above formula then implies that the logged
price level p
t
equals 9u and that I
t
= 0. Suppose that an unexpected and
transitory positive supply shock of value 1 hits the market in period 0. Then
according to the rst panel in gure 2.9 the price immediately falls by 1. At
the same time inventories rise because prices are expected to move up in the
future due to the transitory nature of the shock. Here we have a typical price
movement: the price falls, but is expected to increase. After the shock the
market adjusts gradually as prices rise to their old level and by running down
inventories. If the shock is not unexpected but expected to hit the market
only in period 5, we see a more complicated dynamics. In period zero when
the positive supply shock for period 5 is announced, market participants
expect the price to fall in the future. They therefore want to get rid of their
inventories by trying to selling them already now.
10
As a results the price
and the inventories start to fall already at before the supply actually takes
place. In period 5 when the supply shock nally hits the market, market
participants expect the price to move up again in the future which leads to
a build of inventories. Note that this build up is now done at very low price.
From period 5 on, the market adjusts like in the previous case because the
supply shock is again assumed to be transitory in nature.
10
In our example they actually go short as I
0
< 0.
Taylor model
In this example we analyze a simple deterministic version of Taylors stag-
gered wage contract model (see Taylor Taylor (1980) and Ashenfelter and
Card Ashenfelter and Card (1982)).
11
In this model, half of the wages have
to be contracted in each period for two periods. Thus, in each period half
of the wages are renegotiated taking the wages of the other group as given.
Assuming that the two groups are of equal size, wages are set according to
the following rule:
w
t
= 0.5w
t1
+ 0.5w
t+1
+ h(y
t
+ y
t+1
), h > 0. (2.44)
Thus, wage setting in period t takes into account the wages of contracts still
in force, w
t1
, and the expected wage contract in the next period, w
t+1
. As
the the two groups are of equal size and power, we weight them equally by
0.5. In addition wages depend on the state of the economy over the length
of the contract, here represented by aggregate demand averaged over the
current and next period. The aggregate wage in period t, W
t
, is then simply
the average over all existing individual contract wages in place in period t:
W
t
=
1
2
(w
t
+ w
t1
) (2.45)
The model is closed by adding a quantity theoretic aggregate demand equa-
tion relating W
t
and y
t
:
y
t
= W
t
+ v
t
, < 0. (2.46)
The negative sign of reects the fact that in the absence of full accom-
modation by the monetary authority, higher average nominal wages reduce
aggregate demand. v
t
represents a shock to aggregate demand.
Putting equations (2.44), (2.46), and (2.45) together one arrives at a
linear dierence equation of order 2:
(1 + h)w
t+1
2(1 h)w
t
+ (1 + h)w
t1
= 2h(v
t
+ v
t+1
)
or equivalently
w
t+1
w
t
+ w
t1
= Z
t
(2.47)
with = 2
(1h)
(1+h)
and Z
t
=
2h
(1+h)
(v
t
+ v
t+1
). The characteristic equation
for this dierence equation is
1 z + z
2
= 0.
11
The model could equally well be applied to analyze staggered price setting behavior.
The symmetric nature of the polynomial coecients implies that the roots
appear in pairs such that one root is the inverse of the other.
12
This means
that one root, say
1
, is smaller than one whereas the other one is greater
than one, i.e.
2
= 1/
1
. To see this note rst that the discriminant is equal
to = h > 0. Thus, the roots are real and second that
1
2
= 1. If we
denote
1
by then
2
= 1/ and we have = +
1
.
Applying the superposition principle, the solution becomes
w
t
= c
1
t
+ c
2
t
+ w
(p)
t
(2.48)
where the coecients c
1
and c
2
and a particular solution w
(p)
t
have yet to be
determined. In order to eliminate explosive solutions, we set c
2
= 0. The
other constant can then be determined by noting that (w
t
) is a predetermined
variable such that the wage negotiations in period one take wages from the
other group negotiated in period zero as given. Thus, c
1
= w
0
w
(p)
0
. To
nd the particular solution, set
w
(p)
t
=
j=
j
Z
tj
and insert this solution into the dierence equation (2.48) and perform a
comparison of coecients as in the previous exercise. This leads again to
two homogeneous dierence equations for the coecients (
j
) and (
j
),
j 1 with solutions
j
= d
1
j
+ d
2
j
= e
1
j
+ e
2
j
where the coecients d
1
, d
2
, e
1
and e
2
have still to be determined. The elim-
ination of explosive coecient sequences leads to d
2
= e
2
= 0. Furthermore,
both solutions must give the same
0
so that d
1
= e
1
. Denote this value by
d, then comparing the coecients for Z
t
and noting that = +
1
leads
to:
1
=
0
1
+ 1 d = d d + 1.
Therefore
d =
1

1
< 0.
The eect of a shock to aggregate demand in period j 0 is then
w
t+j
v
t
=
j
+
j1
=
2h
1 + h
d(1 + )
j
, j = 0, 1, 2, . . .
12
This conclusion extends to contracts longer than two periods (see Ashenfelter and
Card Ashenfelter and Card (1982)).
Chapter 3
Systems of Linear Dierence
Equations with Constant
Coecients
This chapter treats systems of linear dierence equations. For each variable
X
1t
, , X
nt
, n 1, we are given a linear nonhomogeneous dierence equa-
tion of order p where each variable can, in principle, dependent on all other
variables with a lag. Writing each dierence equation separately, the system
is given by
X
1t
=
(1)
11
X
1,t1
+
(1)
12
X
2,t1
+ +
(1)
1n
X
n,t1
+ +
(p)
11
X
1,tp
+
(p)
12
X
2,tp
+ +
(p)
1n
X
n,tp
+ Z
1t
X
2t
=
(1)
21
X
1,t1
+
(1)
22
X
2,t1
+ +
(1)
2n
X
n,t1
+ +
(p)
21
X
1,tp
+
(p)
22
X
2,tp
+ +
(p)
2n
X
n,tp
+ Z
2t

X
nt
=
(1)
n1
X
1,t1
+
(1)
n2
X
2,t1
+ +
(1)
nn
X
n,t1
+ +
(p)
n1
X
1,tp
+
(p)
n2
X
2,tp
+ +
(p)
nn
X
n,tp
+ Z
nt
Using matrix notation this equation system can be written more com-
pactly as
X
t
=
1
X
t1
+
2
X
t2
+ +
p
X
tp
+ Z
t
,
p
,= 0 (3.1)
where Z
t
denotes an n-vector of exogenous variables and where
i
, i =
1, 2, . . . , p, denote the matrices
k
=
_
(k)
i,j
_
i,j=1,2,...,n
for k = 1, 2, . . . , p. The
solution of this dierence equation is based again on the same principles as
55
56 CHAPTER 3. SYSTEMS OF DIFFERENCE EQUATIONS
in the univariate case (see page 14). Before doing so we show how to reduce
this p-th order system to a rst order system.
Any system of order p can be rewritten as a system of order 1. In order to
see this, dene a new variable Y
t
as the stacked vectors X
t
, X
t1
, , X
tp+1
.
This new variable then satises the following rst order system:
Y
t
=
_
_
_
_
_
_
_
_
_
X
t
X
t1
X
t2
.
.
.
X
tp+2
X
tp+1
_
_
_
_
_
_
_
_
_
=
_
_
_
_
_
_
_
1

2

3
. . .
p1

p
I
n
0 0 . . . 0 0
0 I
n
0 . . . 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 0 . . . I
n
0
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
_
X
t1
X
t2
X
t3
.
.
.
X
tp+1
X
tp
_
_
_
_
_
_
_
_
_
+
_
_
_
_
_
_
_
_
_
Z
t
0
0
.
.
.
0
0
_
_
_
_
_
_
_
_
_
= Y
t1
+ Z
t
(3.2)
where Z
t
is redened to be
_
Z
t
0 0 . . . 0 0
_
. I
n
denotes the identity
matrix of dimension n. The matrix is an np np matrix called the com-
panion matrix of (3.1).
1
Thus, multiplying out the equation system (3.2) one
can see that the rst equation gives again the original equation (3.1) whereas
the remaining p 1 equations are just identities. The study of a p-th order
system can therefore always be reduced to a rst order system.
Properties of the Companion Matrix in the Univariate Case
The one-dimensional dierence dierence equation of order p, equation (2.1),
can also be written in this way as a rst order system of dimension p. The
companion matrix is given in this case by
C =
_
_
_
_
_
_
_
1

2

3

p1

p
1 0 0 0 0
0 1 0 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 0 1 0
_
_
_
_
_
_
_
. (3.3)
For this companion matrix, we can derive the following properties:
The companion matrix is nonsingular if and only if
p
,= 0.
The characteristic polynomial of the companion matrix is: p() =
p

1
p1

p1

p
. Thus, the roots of the characteris-
tic polynomial of the companion matrix are just the inverses of the
roots of the characteristic polynomial of the dierence equation (2.33).
1
The literature distinguishes four forms of companion matrices depending on whether
the
i
s appear in the rst, as in equation (3.4), or last row or rst or last column.
3.1. FIRST ORDER SYSTEM OF DIFFERENCE EQUATIONS 57
The geometric multiplicity of each eigenvalue equals 1 i.e. there is only
one independent eigenvector for each
i
. These eigenvectors are of the
form
_
p1
i
,
p2
i
, ,
i
, 1
_
. Thus, in this situation there is no need to

rely on the Jordan canonical form (see Section 3.1.1).
3.1 First Order System of Dierence Equa-
tions
The introduction above demonstrated that the rst order system of dier-
ence equations encompasses single as well as systems of dierence equations
of order p. We therefore reduce our analysis to the rst order system of
dierence equations:
X
t
= X
t1
+ Z
t
, ,= 0 (3.4)
where X
t
denotes an n-vector and an nn matrix. The n-vector Z
t
denotes
a vector of exogenous variables. Without loss of generality we assume that
is nonsingular.
2
3.1.1 Homogenous First Order System of Dierence
Equations
As in the one-dimensional case, we start the analysis with the discussion of
the homogeneous equation:
X
t
= X
t1
(3.5)
We immediately see that starting with some initial vector X
0
= x
0
, all sub-
sequent values of X
t
, t > 0, are uniquely determined. In particular,
X
t
=
t
x
0
Suppose that we have two solutions to the homogenous system (3.5), X
(1)
t
and X
(2)
t
. Than it is clear that any linear combination of these two solutions,
c
1
X
(1)
t
+ c
2
X
(2)
t
, is also a solution. Thus, the set of all solutions to the
homogenous system (3.5) forms a linear space. As in the univariate case, we
analyze the algebraic structure of this space.
As we want this chapter to be self-contained, we repeat the denition for
the linear independence of r solutions.
2
A singular matrix implies that the system encompasses some redundant variables.
Denition 6. The sequences (X
(1)
), (X
(2)
), , (X
(r)
) with r 1 are said
to be linearly dependent for t 0 if there exist constants a
1
, a
2
, . . . , a
r
R,
not all zero, such that
a
1
X
(1)
t
+ a
2
X
(2)
t
+ + a
r
X
(r)
t
= 0 t t
0
.
This denition is equivalent to saying that there exists a nontrivial linear
combination of the solutions which is zero. If the solutions are not linearly
dependent, they are said to be linearly independent.
For given n sequences (X
(1)
), (X
(2)
), , (X
(n)
), we can dene the Casaro-
tian matrix of these sequence as follows:
((t) =
_
_
_
_
_
X
(1)
1t
X
(2)
1t
. . . X
(n)
1t
X
(1)
2t
X
(2)
2t
. . . X
(n)
2t
.
.
.
.
.
.
.
.
.
.
.
.
X
(1)
nt
X
(2)
nt
. . . X
(n)
nt
_
_
_
_
_
The Casarotian matrix is closely related to the issue whether or not the
sequences are independent.
Lemma 3. If det ((t) of n sequences (X
(i)
), 1 i n, is dierent from
zero for at least one t
0
0, then (X
(i)
), 1 i n, are linearly independent
for t 0.
Proof. Suppose that (X
(i)
), 1 i n, are linearly dependent. Thus, there
exists a nonzero vector c such that ((t)c = 0 for all t 0. In particular,
((t
0
)c = 0. This stands, however, in contradiction with the assumption
det ((t
0
) ,= 0.
Note that the converse is not true as can be seen from the following
example: X
(1)
t
=
_
1
t
_
and X
(2)
t
=
_
t
t
2
_
. These two sequences are linearly
independent, but det ((t) = 0 for all t 0. The converse of Lemma 3 is true
if the sequences are solutions to the homogenous equation (3.5).
Lemma 4. If (X
(i)
), 1 i n, are n linearly independent solutions of the
homogenous system (3.5), then det ((t) ,= 0 for all t 0.
Proof. Suppose there exists a t
0
such det ((t
0
) = 0. This implies that there
exists a nonzero vector c such that ((t
0
)c =
n
i=1
c
i
X
(i)
t
= 0. Because the
X
(i)
t
are solutions so is the linear combination Y
t
=
n
i=1
c
i
X
(i)
t
. For this
solution Y
t
0
= 0 thus Y
t
= 0 for all t because uniqueness of the solution. As
the solutions are, however, linearly independent c must be equal to 0 which
stands in contradiction to c ,= 0.
We can combine the two Lemmas to obtain the following theorem.
Theorem 8. The solutions (X
(i)
), 1 i n, of the homogenous system
(3.5) are linearly independent for t 0 if and only if there exists t
0
0 such
that det ((t
0
) ,= 0.
The above Theorem implies that the n solutions U
(1)
t
, , U
(n)
t
of the
homogenous system (3.5) which satisfy the initial conditions
U
(i)
0
= e
(i)
=
_
0 0 1
..
i-th element
0 0
_
, 1 i n, (3.6)
are linearly independent. Thus, we have at least n linearly independent so-
lutions. Suppose now that we are given any solution to the homogenous
system (3.5), say X
t
. Then it is easy to see that we can express X
t
as
X
t
=
n
i=1
X
i,0
U
(i)
t
where U
(i)
t
is the solution to the homogenous system
(3.5) satisfying the initial condition (3.6). As the solutions are uniquely
determined, we have thus shown that the space of all solutions to the ho-
mogenous system (3.5) is a linear space of dimension n. Thus, any solution
can be written as
X
t
=
n
i=1
X
i,0
U
(i)
t
= |(t)X
0
(3.7)
where |(0) = I
n
, the identity matrix of dimension n n, and |(t) =
(U
(1)
t
, . . . , U
(n)
t
).
Because each column of |(t) is a solution to the homogenous system
(3.5), |(t) satises the homogenous linear matrix system:
|(t + 1) = |(t) (3.8)
This leads to the following denitions.
Denition 7. Any nn matrix |(t) which is nonsingular for all t 0 and
which satises the homogenous matrix system (3.8) is called a fundamental
matrix. If in addition the matrix satises |(0) = I
n
then it is called a
principal fundamental matrix.
Note that if 1(t) is any fundamental matrix then |(t) = 1(t)1
1
(0)
is a principal fundamental matrix. Note also if a 1(t) is a fundamental
matrix then 1(t)C is also a fundamental matrix where C is any nonsingular
matrix. This implies that there are innitely many fundamental matrices for
a given homogenous matrix system. There is, however, only one principal
fundamental matrix because the matrix dierence equation (3.8) uniquely
determines all subsequent matrices once an initial matrix is given. In the
case of a principal fundamental matrix this initial matrix is the identity
matrix. In this monograph we will not pursue the concept of the fundamental
matrix further because it does not payo in the context of constant coecient
systems.
3
Only note that |(t) =
t
where |(t) is a principal fundamental
matrix. Thus, any solution to the homogenous system (3.5) has the form:
X
t
= |(t)c =
t
c (3.9)
where c R
n
is a constant vector. In order to nd the general solution of the
homogenous system (3.5) and to understand its properties, we therefore need
to nd an expression for
t
. Such an expression can be found in terms of the
eigenvalues and eigenvectors of the matrix .
4
It is useful to distinguish in
this context two cases.
Distinct Eigenvalues
If all the eigenvalues,
1
, ,
n
of are distinct, then is diagonalizable,
i.e. similar to a diagonal matrix. Thus, there exists a nonsingular matrix
Q such that Q
1
Q = where = diag(
1
, ,
n
). The columns of Q
consist of the eigenvectors of . With this similarity transformation in mind
it is easy to compute
t
:
t
= QQ
1
QQ
1
QQ
1
. .
t times
= Q
t
Q
1
= Q
_
_
_
_
_
1
0 0
0
2
0
.
.
.
.
.
.
.
.
.
.
.
.
0 0
n
_
_
_
_
_
t
Q
1
= Q
_
_
_
_
_
t
1
0 0
0
t
2
0
.
.
.
.
.
.
.
.
.
.
.
.
0 0
t
n
_
_
_
_
_
Q
1
In the case of distinct eigenvalues, it is easy to proof the following theorem.
Theorem 9. If the spectrum of , () =
1
, ,
n
, consists of n dis-
tinct eigenvalues with corresponding eigenvectors q
i
, i = 1, . . . , n then the
set
X
(i)
t
= q
i
t
i
, i = 1, . . . , n
represents a fundamental set of solutions to the homogenous system (3.5).
3
See Elaydi (1999) and Agarwal (2000) for a further elaboration and the relations to
Greens matrix.
4
Recommended books on linear algebra are among others Meyer (2000) and Strang
(2003)
Proof. As q
i
is an eigenvector of corresponding to
i
, we have
X
(i)
t+1
= q
i
t+1
i
=
i
q
i
t
i
= q
i
t
i
= X
(i)
t
, t 0.
The third equality follows from Q = Q. Thus, the X
(i)
t
, i = 1, , n
are solutions to the homogenous system (3.5). In addition, we have that the
determinant of the corresponding Casarotian matrix evaluated at t = 0 is
det ((0) = det
_
q
1
, , q
n
_
= det Q ,= 0 because Q consists of n linearly
independent eigenvectors and is therefore nonsingular. Thus, according to
Theorem 8 these solutions are linearly independent.
Thus, the general solution to the homogenous system (3.5) can be written
as
X
t
=
n
i=1
c
i
q
i
t
i
, t 0 (3.10)
for some constants c
1
, , c
n
.
Another way to understand the result of Theorem 9 is to observe that
the similarity transformation actually decomposes the interrelated system in
X
t
into n unrelated univariate rst order dierence equations. This decom-
position is achieved by the variable transformation Y
t
= Q
1
X
t
:
Y
t+1
= Q
1
X
t+1
= Q
1
QQ
1
X
t
= Y
t
_
_
_
Y
1,t+1
.
.
.
Y
n,t+1
_
_
_
=
_
_
_
1
0
.
.
.
.
.
.
.
.
.
0
n
_
_
_
_
_
_
Y
1,t
.
.
.
Y
n,t
_
_
_
Thus, through this transformation we have obtained n unrelated univariate
rst order dierence equation in Y
i,t
, i = 1, . . . , n:
Y
1,t+1
=
1
Y
1,t

Y
n,t+1
=
1
Y
n,t
These equations can be solved one-by-one by the methods discussed in chap-
ter 2. The general solutions to these univariate rst order homogenous equa-
tions are therefore Y
i,t
= c
i
t
i
, i = 1, , n. Transforming the system in Y
t
back into in the original system by multiplying Y
t
from the left with Q yields
exactly the solution in equation (3.10).
Repeated Eigenvalues
The situation with repeated eigenvalues is more complicated. Before dealing
with the general case, note that even with repeated eigenvalues the matrix
can be diagonalizable. This is, for example, the case for normal matrices,
i.e. matrices for which
. Examples of normal matrices include

symmetric matrices ( =
), skew symmetric matrices ( =
) and
unitary matrices (
= I). More generally, is diagonalizable if and

only if, for each eigenvalue, the algebraic multiplicity equals the geometric
multiplicity (i.e. if each eigenvalue is semisimple).
As is not, in general, diagonalizable, we use the Jordan canonical form.
5
For every matrix with distinct eigenvalues () =
1
, ,
s
, there
exists a nonsingular matrix Q such can be reduced to a matrix J by a
similarity transformation, i.e. Q
1
Q = J. The matrix J is of the following
form:
J = Q
1
Q =
_
_
_
_
_
J (
1
) 0 0
0 J (
2
) 0
.
.
.
.
.
.
.
.
.
.
.
.
0 0 J (
s
)
_
_
_
_
_
The Jordan segments J (
i
), i = 1, , s, consist of t
i
= dimN(
i
I)
Jordan blocks, J
j
(
i
), j = 1, , t
i
, such that each Jordan segment J (
i
)
has a block diagonal structure:
J (
i
) =
_
_
_
_
_
J
1
(
i
) 0 0
0 J
2
(
i
) 0
.
.
.
.
.
.
.
.
.
.
.
.
0 0 J
t
i
(
i
)
_
_
_
_
_
.
The Jordan blocks themselves are of the following form:
J
j
(
i
) =
_
_
_
_
_
_
_
i
1 0 0 0
0
i
1 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 0
i
1
0 0 0 0
i
_
_
_
_
_
_
_
=
i
I + N (3.11)
5
A detailed treatment of the Jordan canonical form can be found, for example, in Meyer
(2000).
where
N =
_
_
_
_
_
_
_
0 1 0 0 0
0 0 1 0 0
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
0 0 0 0 1
0 0 0 0 0
_
_
_
_
_
_
_
.
The square matrix N is a nilpotent matrix, i.e. N
k
= 0 if k is the dimension of
N. The dimension of the largest Jordan block in the Jordan segment J (
i
)
is called the index of the eigenvalue
i
, denoted by k
i
= index(
i
).
Given these preliminaries it is now a straightforward task to compute
t
= QJ
t
Q1 = Q diag (J
t
(
1
) , , J
t
(
s
)) Q
1
where the t-th power of a
Jordan segment J
t
(
i
) is just J
t
(
i
) = diag
_
J
t
1
(
i
) , , J
t
t
i
(
i
)
_
. The t-th
power of a Jordan block J
j
(
i
), j = 1, , t
i
, is given by the expression:
J
j
(
i
)
t
= (
i
+ N)
t
=
t
i
I +
_
t
1
_
t1
i
N +
_
t
2
_
t2
i
N
2
+ +
_
t
k 1
_
tk+1
i
N
k1
=
_
_
_
_
_
_
_
t
i
_
t
1
_
t1
i
_
t
2
_
t2
i

_
t
k1
_
tk+1
i
0
t
i
_
t
1
_
t1
i

_
t
k2
_
tk+2
i
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
_
t
1
_
t1
i
0 0 0
t
i
_
_
_
_
_
_
_
(3.12)
where N is the nilpotent matrix of size corresponding to the Jordan block.
3.1.2 Nonhomogeneous First Order System
Consider now the rst order nonhomogeneous system:
X
t
= X
t1
+ Z
t
(3.13)
As in the one-dimensional case the superposition principle also holds in the
multivariate case. Suppose that there exists two solution to the nonho-
mogeneous system (3.13), X
(1)
t
and X
(2)
t
. Then one can easily verify that
X
(1)
t
X
(2)
t
is a solution to the homogeneous system (3.5). Thus, the super-
position principle implies that X
(1)
t
X
(2)
t
=
t
c for some vector c.
Theorem 10. Every solution (X
t
) to the rst order nonhomogeneous system
(3.13) can be represented as the sum of the general solution to the homoge-
neous system (3.5), (X
(g)
t
), and a particular solution to the nonhomogeneous
system (3.13), (X
(p)
t
):
X
t
= X
(g)
t
+ X
(p)
t
=
t
c + X
(p)
t
. (3.14)
A particular solution can be found by iterating the dierence equation
backwards:
X
t
= X
t1
+ Z
t
X
t
= (X
t2
+ Z
t1
) + Z
t
=
2
X
t2
+ Z
t1
+ Z
t
. . .
X
t
=
t
X
0
+
t1
Z
1
+
t2
Z
2
+ + Z
t1
+ Z
t
=
t
X
0
+
t1
j=0
j
Z
tj
This suggests to take
X
(p)
t
=
t1
j=0
j
Z
tj
as a particular solution. So that the general solution to the nonhomogeneous
equation becomes
X
t
=
t
c +
t1
j=0
j
Z
tj
(3.15)
For the initial value problem X
0
= x
0
, c = x
0
. In the previous chapter we
have already seen that this backward looking solution is often not sensible,
particularly with rational expectations (see the equity price model and Ca-
gans hyperination model in 2.3.1). As we can decompose the system into
n unrelated rst order univariate dierence equations, the decision whether
to use the forward or the backward solution depends in each case on the
location of the eigenvalue (root of characteristic polynomial) with respect to
the unit circle. In general, we will have some eigenvalues smaller than one in
absolute value and some eigenvalues larger than one in absolute value. Thus,
we will have a mixture of backward and forward solutions. We will analyze
such situations in detail in section 3.2.
3.1.3 Stability Theory
In this section we are interested in the asymptotic behavior of X
t
as t .
In general a rst order, possibly nonlinear, system of dierence equations can
be written as
X
t+1
= f (X
t
, t) (3.16)
where f (x, t) is a function from R
n
N R
n
which is continuous in x. A
steady state or an equilibrium point of the system (3.16) is dened as follows.
Denition 8. A point X
R
n
is called a steady state or an equilibrium
point if
X
= f (X
, t) for all t 0
In the special case of nonhomogeneous linear system (3.13) with a con-
stant forcing variable Z
t
= Z, the steady state is dened through the equation
X
= X
+ Z. This equation has a unique solution if and only if I

n

is nonsingular. This is equivalent to the statement that the moduli of all
eigenvalues of are dierent from one. In this case the steady state is given
by X
= (I
n
)
1
Z.
6
In many situations it is useful to express the non-
homogeneous dierence equation as a homogenous system by rewriting the
variable X
t
as a deviation from steady state:
X
t+1
X
= (X
t
X
) . (3.17)
We repeat the denitions of stability.
7
.
Denition 9. An equilibrium point X
is called
stable if for all > 0 there exists a
> 0 such that

|X
0
X
| <
implies |X
t
X
| < t > 0. (3.18)

If X
is not stable its is called unstable.

The point X
is called attracting if there exists > 0 such that

|X
0
X
| < implies lim

t
X
t
= X
. (3.19)
If = , X
is called globally attracting.

The point X
is asymptotically stable or is an asymptotically stable

equilibrium point
8
if it is stable and attracting. If = , X
is called
globally asymptotically stable.
6
If I
n
is singular multiple steady steady states may exist or no steady states may
exist.
7
As we are dealing almost only with linear systems rened denitions of stability are
not necessary (see Elaydi (1999) and Agarwal (2000))
8
In economics this is sometimes called stable
In this denition |X| denotes some norm in R
n
, typically the Euclidian
norm. The induced matrix norm is denoted by |A|. (see appendix B). It
does not matter which norm is actually used because we are dealing with
norms in nite dimensional spaces only (vectors in R
n
, respectively matrices
in R
nn
). For these spaces all norms are equivalent.
The stability of equilibrium points is intimately related to the eigenval-
ues of , especially to the spectral radius of , (). Before proong the
corresponding theorem, consider the following lemma.
Lemma 5. The zero solution of the homogeneous system (3.5) is stable if
and only if there exists M > 0 such that
_
_
t
_
_
M for all t 0. (3.20)
Proof. Suppose that the inequality (3.20) is satised then |X
t
| M|X
0
|.
Thus, for > 0, let =

M
. Then |X
0
| < implies |X
t
| < so that the
zero point is stable. Conversely, suppose that the zero point is stable. Then
for all |X
0
| <
_
_
t
_
_
= sup
1
_
_
_
_
=
1
sup
X
0
_
_
t
X
0
_
_
= M
where the rst inequality is just the denition of the matrix norm correspond-
ing to the norm in R
n
. The second equality is a consequence of |X
0
| .
The inequality above follows from the assumption that the zero point is a
stable equilibrium.
Theorem 11. For the homogeneous system (3.5) the following statements
are true:
(i) The zero solution is stable if and only if () 1 and the eigenvalues
on the unit circle are semisimple.
(ii) The zero solution is asymptotically stable if and only if () < 1.
Proof. According to previous lemma 5 we have to prove that |
t
| M for
some M > 0. Using the Jordan canonical form = QJQ
1
this amounts to
|
t
| = |QJ
t
Q
1
| M. But this is equivalent to the existence of a

M > 0
such that |J
t
|

M. M may then be taken as M =

M
QQ
1
. Now the power

of J is given by powers of the Jordan blocks. The t-th power of a Jordan
block corresponding to the eigenvalue
i
is given according to equation (3.12)
by
J
j
(
i
)
t
= (
i
+ N)
t
=
t
i
I +
_
t
1
_
t1
i
N +
_
t
2
_
t2
i
N
2
+ +
_
t
k 1
_
tk+1
i
N
k1
=
_
_
_
_
_
_
_
t
i
_
t
1
_
t1
i
_
t
2
_
t2
i

_
t
k1
_
tk+1
i
0
t
i
_
t
1
_
t1
i

_
t
k2
_
tk+2
i
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
_
t
1
_
t1
i
0 0 0
t
i
_
_
_
_
_
_
_
.
The elements in this matrix become unbounded if [
i
[ > 1. They also become
unbounded if [
i
[ = 1 and J
j
(
i
) is not a 1 1 matrix. If, however, for all
eigenvalues with [
i
[ = 1 the largest Jordan blocks are 11, then the Jordan
segment corresponding to
i
with [
i
[ = 1, J (
i
), is just a diagonal matrix
with ones in the diagonal and is therefore obviously bounded. The Jordan
segments, J (
i
), corresponding to eigenvalues [
i
[ < 1, converge to zero, i.e.
lim
t
J (
i
)
t
= 0 because t
k
t
i
0 as t by lHopitals rule.
As in the case of one dimensional dierence equations (see Theorem 3),
a convenient way to analyze the stability of nonlinear system is by linear
approximation around the steady state. Denote the steady state by X
and
assume that f is continuously dierentiable with respect to x in an open
neighborhood of X
then the linearized version of the system (3.16) is given

by
Y
t+1
= X
t+1
X
=
t
Y
t
+g(Y
t
, t) =
t
(X
t
X
) +g((X
t
X
), t) (3.21)
where
t
and g((X
t
X
), t) denote the Jacobian matrix evaluated at the

steady state and the approximation error, respectively. Note that
t
and
g((X
t
X
), t) are independent of t if we have an autonomous system, i.e.

if f does not depend on t. This would be the case if the forcing variable Z
t
is constant. In addition, the assumption on the dierentiability of f implies
that for any > 0 there exists a > 0 such that |g(Y, t)| |Y | whenever
|Y | .
to follow
3.1.4 Two-dimensional Systems
Many theoretical economic models can be reduced to two-dimensional sys-
tem, we devote this section to the analysis of such systems. In case the
system is of dimension 2 a necessary and sucient condition for asymptotic
stability is given in the following theorem.
Theorem 12. The homogeneous two-dimensional system has an asymptoti-
cally stable solution if and only if
[tr()[ < 1 + det < 2. (3.22)
Proof. The characteristic polynomial, T(), of a 2 2 matrix is T() =
2
tr() + det . The roots of this quadratic polynomial are thus
1,2
=
tr()
tr
2
()4 det
2
. Suppose that the zero point is asymptotically stable then
[
1,2
[ < 1. But, in the case of real roots, this equivalent to the following two
inequalities:
2 tr() <
_
tr
2
() 4 det < 2 tr()
2 tr() <
_
tr
2
() 4 det < 2 tr()..
Squaring the second inequality in the rst line and simplifying gives: tr() <
1 +det . Squaring the rst inequality in the second line gives 1 det <
tr(). Combining both results gives the rst part of the stability condition
(3.22). The second part follows from the observation that det =
1
2
and
the assumption that [
1,2
[ < 1. If the roots are complex, the are conjugate
complex, so that the second part of the stability (3.22) results from det =
2
= [
1
[ [
2
[ < 1. The rst part follows from tr
2
() 4 det < 0 which
is equivalent to 0 < tr
2
() < 4 det . This can be used to show that
4 (1 + det tr()) > 4 + tr
2
() 4tr() = (2 tr())
2
> 0.
which is the required inequality.
Conversely, if the stability condition (3.22) is satised and if the roots are
real, we have
1 <
2 +
_
tr
2
() 4 det
2
<
1
=
tr() +
_
tr
2
() 4 det
2
<
tr() +
_
tr
2
() + 4 4tr()
2
=
tr() +
_
(2 tr())
2
2
< 1.
Similarly, for
2
. If the roots are complex, they are conjugate complex and we
have [
1
[
2
= [
2
[
2
=
1
2
=
tr
2
()tr
2
()+4 det
4
= det < 1. This completes
the proof.
Phase Diagrams of Two-Dimensional Systems
An additional advantage of two-dimensional systems are that their qualitative
properties can be easily analyzed by a phase diagram. Consider for this
purpose the homogenous rst order system (3.5) written as a two equation
system:
9
X
t+1
=
_
X
1,t+1
X
2,t+1
_
= X
t
=
_
11

12
21

22
__
X
1,t
X
2,t
_
; (3.23)
or equivalently as
X
1,t+1
=
11
X
1,t
+
12
X
2,t
(3.24)
X
2,t+1
=
21
X
1,t
+
22
X
2,t
. (3.25)
It is clear that (0, 0)
is a equilibrium for this system. In order to understand

the dynamics of the system, we can draw two lines in a (X
1
, X
2
)-diagram.
The rst line is given by all points such that the rst variable does not change,
i.e. where X
1,t+1
= X
1,t
. From equation (3.24), these points are represented
by a line with equation (
11
1)X
1,t
+
12
X
2,t
= 0. Similarly, the points
where the second variable does not change is, from equation (3.25), the line
with equation
21
X
1,t
+(
22
1)X
2,t
= 0. These two lines divide the RR-
plane into four regions I, II, III, and IV as in gure 3.1. In this example both
lines have positive slopes.
The dynamics of the system in each of the four regions can be gured
out from the signs of the coecients as follows. Suppose we start at a point
on the X
1,t+1
X
1,t
= (
11
1)X
1,t
+
12
X
2,t
= 0 schedule then we know
that the rst variable does not change. Now increase X
2,t
a little bit. This
moves us into region I or IV. If
12
is positive, this implies that X
1,t+1

X
1,t
> 0 so that the rst variable increases. Thus, we know that above the
X
1,t+1
X
1,t
= 0 line, X
1,t
increases and that below this line X
1,t
decreases.
We can indicate this result in gure 3.1 by arrows from left to right in regions
I and IV and arrows from right to left in regions II and III. If
12
is negative,
we obtain, of course, the opposite result. Similarly, consider the schedule
X
2,t+1
X
2,t
=
21
X
1,t
+ (
22
1)X
2,t
= 0 where the second variable does
not change. Consider now an increase in X
1,t
. This moves us into region III
or IV. If the coecient
21
is positive, this implies that X
2,t+1
X
2,t
> 0 so
that the second variable must increase. As before we can infer that below the
X
2,t+1
X
2,t
= 0 line X
2,t
increases whereas above this line X
2,t
decreases.
We can again indicate this behavior by arrows: upward arrows in regions
III and IV and downward arrows in regions I and II. If the sign of
21
is
negative, the opposite result is obtained. This type of analysis gives us a
9
We may also interpret the systems as written in deviations from steady state.
X
2 t
X
1 t
region I region II
region IV
region III
steady
state
schedule: X - X = 0
1 , t+1 1 t
schedule:
X - X = 0
2 , t+1 2 t
Figure 3.1: Example of a Phase Diagram
phase diagram as in gure 3.1. This diagram shows us the dynamics of the
system starting in every possible point. In this example, the arrows indicate
that wherever we are, we will move closer to the steady state. But this
corresponds exactly to the denition of an asymptotically stable equilibrium
point (see denition 3.18). Thus, we conclude from this diagram that the
steady state is an asymptotically stable equilibrium point.
Of course the situation depicted in gure 3.1 is not the only possible one.
In order to analyze all possible situation which can arise in a two-dimensional
system, we make a variable transformation using the Jordan canonical form of
. If has the Jordan canonical form = QJQ
1
then we make the variable
transformation Y
t
= Q
1
X
t
. This results in a new rst order homogenous
dierence equation system:
Y
t+1
= Q
1
X
t+1
= Q
1
X
t
= Q
1
QQ
1
X
t
= JY
t
(3.26)
where J has one of the following three forms:
J =
_
1
0
0
2
_
distinct or repeated semisimple eigenvalues
J =
_
1
0
_
repeated eigenvalue with one independent eigenvector
J =
_
1
0
0
2
_
complex eigenvalues:
1,2
=
Note that the steady state is not aected by this variable transformation. It
is still the point (0, 0)
. Let us treat these three cases separately.

case 1: distinct or repeated semisimple eigenvalues The variable trans-
formation has eectively decoupled the two-dimensional system into
two separate homogenous rst order dierence equations with solu-
tions: Y
1,t
=
t
1
y
1,0
and Y
2,t
=
t
2
y
2,0
where y
1,0
and y
2,0
are given initial
values. From the previous discussion we know that the steady state is
asymptotically stable if and only if both eigenvalues are smaller than
one in absolute value. Such a situation is plotted in gure 3.2. The
arrows indicate that for every starting point the system will converge
towards the equilibrium point. As an example we have plotted four
trajectories starting at the points (1, 1), (1, 1), (1, 1), and(1, 1),
respectively.
Figure 3.3 displays a situation where the equilibrium point is unstable.
Indeed both eigenvalues are larger than one and the trajectories quickly
1 0.8 0.6 0.4 0.2 0 0.2 0.4 0.6 0.8 1
1
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
0.8
1
Y
1,t
Y
2
,
t
steady
state
Figure 3.2: Asymptotically Stable Steady State (
1
= 0.8,
2
= 0.5)
diverge in the directions indicated by the arrows. In the gure, we have
plotted again four trajectories with the same starting values as in the
previous example.
Figure 3.4 shows an interesting conguration which is often encoun-
tered in economic models, especially in those which involve rational
expectations. We have one eigenvalue smaller than one in absolute
value and one eigenvalue larger than one absolute value. This congu-
ration of the eigenvalues leads to a saddle point equilibrium. Although
the steady state is unstable, as almost all trajectories diverge, there are
some initial values for which the system converges to the steady state.
In gure 3.4 all trajectories starting on the y-axis converge to the steady
state. Thus, given an initial value y
20
for Y
2,t
, the requirement that the
solution must be bounded uniquely determines an initial condition for
Y
1,t
too, which in this reduced setting is just Y
1,0
= y
10
= 0. As this
case attracted much attention, we have devoted section 3.2 entirely to
this and similar issues.
When there are multiple eigenvalues with two independent eigenvec-
tors, can again be reduced by a similarity transformation to a di-
agonal matrix. The trajectories are then straight lines leading to the
origin if the eigenvalue is smaller than one as in gure 3.5, and straight
lines leading away from the origin if the eigenvalue is larger than one
6 4 2 0 2 4 6
1000
500
0
500
1000
Y
1,t
Y
2
,
t
steady
state
Figure 3.3: Unstable Steady State (
1
= 1.2,
2
= 2)
6 4 2 0 2 4 6
1
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
0.8
1
Y
1,t
Y
2
,
t
steady
state
Figure 3.4: Saddle Steady State (
1
= 1.2,
2
= 0.8)
1 0.8 0.6 0.4 0.2 0 0.2 0.4 0.6 0.8 1
1
0.8
0.6
0.4
0.2
0
0.2
0.4
0.6
0.8
1
Y
1,t
Y
2
,
t
steady
state
Figure 3.5: Repeated Roots with Asymptotically Stable Steady State (
1
=
2
= 0.8)
in absolute terms.
When one eigenvalue equals one whereas the second eigenvalue is smaller
than one in absolute value, we arrive at a degenerate situation. Whereas
Y
1,t
remains at its starting value y
10
, Y
2,t
converges to zero so that the
system converges to (y
10
, 0)
as is exemplied by gure 3.6. Only when

y
10
= 0 will there be a convergence to the steady state (0, 0). However,
(0, 0) is not the only steady state because the denition of an eigen-
value implies that A I is singular. Thus, there exists X
,= 0 such
that X
= X
.
In case that the rst eigenvalue equals minus one, there is no conver-
gence as Y
1,t
will oscillate between y
10
and y
10
.
case 2: repeated eigenvalues with one independent eigenvector In this
case can no longer be reduced to a diagonal matrix by a similarity
transformation. As J is no longer a diagonal matrix, the locus of all
points where Y
1,t
does not change is no longer the x-axis, but is given
by the line with equation ( 1)Y
1,t
+ Y
2,t
= 0. Figure 3.7 displays
this case with an eigenvalue of 0.8 which implies an asymptotically sta-
ble steady state. Note that, given our four starting points, the system
moves rst away from the equilibrium point until it hits the schedule
1.5 1 0.5 0 0.5 1 1.5
1.5
1
0.5
0
0.5
1
1.5
Y
1,t
Y
2
,
t
steady
state
Figure 3.6: Degenerate Steady State (
1
= 1,
2
= 0.8)
where Y
1,t
does not change, then it changes direction and runs into the
steady state.
case 3: complex eigenvalues If the two conjugate complex eigenvalues
are
1,2
= then is similar to the matrix
_

_
= [[
_
cos sin
sin cos
_
.
where [[ =
_
2
+
2
and = tan
1
_
_
. Figure 3.8 shows the dy-
namics in the case of eigenvalues inside the unit circle. One can clearly
discern the oscillatory behavior and the convergence to the steady state.
Figure 3.9 displays a situation with an unstable steady state where all
trajectories move away from the steady state. Finally gure 3.10 dis-
plays a degenerate case where the eigenvalues are on the unit circle. In
such a situation the system moves around its steady in a circle. The
starting values (0.25, 0.25), (0.5, 0.5), (1, 1), and (1.5, 1.5).
2.5 2 1.5 1 0.5 0 0.5 1 1.5 2 2.5
1
0.5
0
0.5
1
Y
1,t
Y
2
,
t
steady
state
schedule:
Y
1,t+1
Y
1,t
= 0
Figure 3.7: Repeated eigenvalues one independent eigenvector ( = 0.8)
1 0.5 0 0.5 1
1
0.5
0
0.5
1
Y
1,t
Y
2
,
t
schedule:
Y
2,t+1
Y
2,t
= 0
schedule:
Y
1,t+1
Y
1,t
= 0
Figure 3.8: Complex eigenvalues with Stable Steady State(
1,2
= 0.7746
0.2)
8 6 4 2 0 2 4 6 8
8
6
4
2
0
2
4
6
8
Y
1,t
Y
2
,
t
Figure 3.9: Complex eigenvalues with Unstable Steady State(
1,2
= 10.5)
3 2 1 0 1 2 3
3
2
1
0
1
2
3
Y
1,t
Y
2
,
t
Figure 3.10: Complex eigenvalues on the Unit Circle (
1,2
= cos (/4)
sin (/4))
3.1.5 Linearized Systems
3.2 First Order System of Dierence Equa-
tions under Rational Expectations
In this section we discuss the general boundary value problem which has been
treated exhaustively by Blanchard and Kahn ? for linear stochastic dierence
equations (see 5). As the stochastic setting delivers similar conclusions with
respect to uniqueness, we adapt there exposition to the deterministic case.
We now are in a position to study the general case:
X
t
= X
t1
+ Z
t
. (3.27)
In addition we have k initial values with 0 < k n:
10
x
0
= RX
0
(3.28)
where R is a (k n)-matrix of rank k. Moreover we assume that (Z) is
bounded. This assumption justies to restrict the solution space to the space
of bounded sequences, thereby generating restrictions in addition to those
given by initial values.
The application of the superposition principle gives the general solution
of the dierence equation (3.27) as the sum of the general solution of the
homogeneous equation X
(g)
t
and a particular solution of the nonhomogeneous
equation X
(p)
t
:
X
t
= X
(g)
t
+ X
(p)
t
= Q
t
Q
1
c + X
(p)
t
For simplicity, we assume that that is a diagonal matrix containing the
eigenvalues on its diagonal. The columns of Q consists the corresponding
eigenvectors. c is a vector of constants to be determined. The second line
follows from section 3.1.1. The challenge is the determination of the partic-
ular solution. Dene the number of eigenvalues smaller than one by n
1
and
the number of eigenvalues larger than one by n
2
. As we exclude eigenvalues
on the unit circle, we have n = n
1
+ n
2
. Assume that the eigenvalues are
ordered in terms of their modulus, then dene the matrices
1
and
2
as
follows:
1
=
_
diag(
1
, . . . ,
n
1
) 0
0 0
_
and
2
=
_
0 0
0 diag(
n
1
+1
, . . . ,
n
)
_
10
The case k = 0 can be treated in a similar manner (See the example in section 3.3.3).
3.2. FIRST ORDER SYSTEM UNDER RATIONAL EXPECTATIONS 79
Thus,
1
is a diagonal (n n)-matrix with the rst n
1
diagonal elements
being the n
1
eigenvalues smaller than one. The remaining diagonal elements
are zero. The denition of
2
is similar, but with respect to the eigenvalues
larger than one.
11
With this notation, we propose the following particular
solution:
X
(p)
t
=
j=0
Q
j
1
Q
1
Z
tj

j=1
Q
j
2
Q
1
Z
t+j
(3.29)
The reader is invited to verify that this is indeed a solution to equation 3.27.
The solution proposed in equation (3.29) has the property that variables
corresponding to eigenvalues smaller than one are iterated backwards whereas
those corresponding to eigenvalues larger than are iterated forwards. This
ensures that (X
(p)
) remains bounded whenever (Z) is. The general solution
therefore is of the form
X
t
= Q
t
1
Q
1
c + Q
t
2
Q
1
c +
j=0
Q
j
1
Q
1
Z
tj

j=1
Q
j
2
Q
1
Z
t+j
. (3.30)
The nal step now consists in nding the constant c. There are two type
of restrictions: the rst one are the initial values given by equation (3.28); the
second one are the requirement that we are only interested in non-exploding
solutions. Whereas the rst type delivers k restrictions because rank(R) =
k, the second type delivers n
2
restrictions. Thus, c must be determined
according to the following equation system:
initial values: Rc = x
0
RX
(p)
0
no explosive solutions: Q
(2)
c = Q
(21)
c
1
+ Q
(22)
c
2
= 0 (3.31)
where Q
1
=
_
Q
(11)
Q
(12)
Q
(21)
Q
(22)
_
, Q
(2)
=
_
Q
(21)
.
.
. Q
(22)
_
and c = (c
1
, c
2
)
and
where the partitioning of Q
1
and c conforms to the partitioning of the
eigenvalues. Depending on whether the number of independent restrictions
is greater, smaller or equal to n, several situations arise.
Proposition 1. The nonhomogeneous dierence equation (3.27) with initial
values given by (3.28) has a unique nonexplosive solution if and only if
rank
_
R
Q
(2)
_
= n. (3.32)
The solution is given by equation (3.30) with c uniquely determined from (3.31).
11
If n
1
or n
2
equal zeros then the corresponding matrices
1
and
2
are taken to be
zero.
A necessary condition is that k = rank(R) = n
1
: the number of eigenval-
ues smaller than one, n
1
, must be equal to the number of independent initial
conditions, k = rank(R).
In many instances the values of the rst k variables at given time, say
time zero, are given. This is the case when there are exactly k predetermined
variables in the system. The initial values then x the rst k values of c:
c
1
= x
10
X
(p)
10
where x
10
and X
(p)
10
denote the rst k values of x
0
and X
(p)
0
.
Corollary 1. If R = (I
k
, 0
k(nk)
) with k = rank(R) = n
1
, the necessary
and sucient condition (3.32) reduces to Q
(22)
is invertible. Given that c
1
is
xed by the initial conditions, c
2
= (Q
(22)
)
1
Q
(21)
c
1
.
If k = rank(R) > n
1
then there are too many restrictions and there is no
nonexplosive solution. We may, however, soften the boundedness condition
and accept explosive solutions in this situation.
If k = rank(R) < n
1
there are not enough initial conditions so that it
is not possible to pin down c uniquely. We thus have an innite amount
solutions and we call such a situation indeterminate. The multiplicity of
equilibria indeterminacy oers the possibility of sun spot equilibria.
12
Sun
spot equilibria have been introduced by Cass and Shell Cass and Shell (1983),
Azariadis Azariadis (1981), and Azariadia and Guesnerie Azariadis and Gues-
nerie (1986) (see also Azariadis Azariadis (1993) and Farmer Farmer (1993)).
We will study the idea of sun spot equilibria by looking at a particular ex-
ample (see section 3.3.4).
12
Sun spot equilibria explore the idea that extraneous beliefs about the state of nature
inuence economic activity. The disturbing feature of sun spot equilibria is that economic
activity may change across states although nothing fundamental has changed.
3.3. EXAMPLES 81
3.3 Examples
3.3.1 Exchange Rate Overshooting
A classic example for a system with one predetermined and one so-called
jump-variable is the exchange rate overshooting model by Dornbusch (Dorn-
busch (1976)).
13
The model describes the behavior of the price level and the
exchange rate in a small open economy. It consists of an IS equation, a price
adjustment equation, and a LM equation. In addition, the uncovered interest
rate parity (UIP) is assumed together with rational expectations:
y
d
t
= (e
t
+ p
p
t
) (r
t
p
t+1
+ p
t
), (IS)
p
t+1
p
t
= (y
d
t
y), (price adjustment)
mp
t
= y r
t
, (LM)
r
t
= r
+ e
t+1
e
t
, (UIP)
where the parameters , , , , and are all positive. The variables are
all expressed in logarithms. The IS-equation represents the dependence of
aggregate demand y
d
t
on the relative price of foreign to home goods and on
the real interest rate. A devaluation of the exchange rate
14
, an increase in the
foreign price level, p
, or a decrease in the domestic price level p

t
all leads to an
increase in aggregate demand. On the other hand, an increase in the domestic
nominal interest rate, r
t
, or a decrease in the expected ination rate, p
t+1
p
t
,
lead to a reduction in aggregate demand. A crucial feature of the Dornbusch
model is that prices are sticky and adjust only slowly. In particular, the price
adjustment p
t+1
p
t
is proportional to the deviation of aggregate demand
from potential output y. If aggregate demand is higher than potential output,
prices increase whereas, if aggregate demand is below potential output, prices
decrease. In particular, the price level is treated as predetermined variable
whose value is xed in the current period. The LM-equation represents
the equilibrium on the money market. The demand for real balances, m
p
t
, depends positively on potential output
15
and negatively on the domestic
nominal interest rate. The model is closed by assuming that the uncovered
interest parity holds where r
denotes the foreign nominal interest rate. In

contrast to the price level, the exchange rate is not predetermined. It can
13
Rogo (Rogo (2002)) provides an appraisal of this inuential paper.
14
The exchange rate e
t
is quoted as the price of a unit of foreign currency in terms of
the domestic currency. An increase in e
t
therefore corresponds to a devaluation of the
home currency.
15
This represents a simplication because money demand should depend on aggregate
demand, y
d
t
, and not on potential output, y. However, we adopt this simplied version for
expositional purposes.
immediately adjust within the current period to any shock that may occur.
For simplicity, the exogenous variables y, m, r
, and p
are assumed to remain

constant.
This system can be reduced to a two-dimensional system in the exchange
rate and the price level:
e
t+1
e
t
=
1
(y + p
t
m) r
(3.33)
p
t+1
p
t
=

1
_
(e
t
+ p
p
t
) y

(y m + p
t
)
_
(3.34)
The rst equation was obtained by combining the LM-equation with the
UIP. The second equation was obtained by inserting the IS-equation into
the price adjustment equation, replacing the nominal interest rate using the
LM-equation and then solving for p
t+1
p
t
.
The steady state of this system is obtained by setting e
t
= e
ss
and p
t
= p
ss
for all t and solving for this two variables:
p
ss
= r
+ my (3.35)
e
ss
= p
ss
p
+
1
(y + r
) (3.36)
In the steady state, UIP and the price adjustment imply r
t
= r
and y
d
t
= y.
The system can be further reduced by writing it in terms of deviations from
steady state:
_
e
t+1
e
ss
p
t+1
p
ss
_
=
_
_
1
1
1
1
( +

)
1
_
_
_
e
t
e
ss
p
t
p
ss
_
=
_
e
t
e
ss
p
t
p
ss
_
(3.37)
The dynamic behavior of the system (3.37) depends on the eigenvalues of .
Denote the characteristic polynomial of by T() and the two corresponding
eigenvalues by
1
and
2
, then
T() = (
1
)(
2
) =
2
tr() + det
Without additional assumptions on the parameters, it is impossible to obtain
further insights into the qualitative behavior of the system. We suppose that
the price adjustment is suciently slow. Specically, we assume that
0 < < 1 and <
4
(2 + 1/)( + 2)
,
3.3. EXAMPLES 83
we obtain:
tr =
1
+
2
= 2

1
_
+

_
< 2
det =
1
2
= 1

1
_
+

_
< 1
= (tr)
2
4 det =
_

1
_
+

_
_
2
+
4
(1 )
> 0
T(1) = (1
1
)(1
2
) =

(1 )
< 0
T(1) = (1 +
1
)(1 +
2
) = 4

1
_
2
_
+

_
+

_
> 0
where denotes the discriminant of the quadratic equation. The above
inequalities have the following implications for the two eigenvalues:
> 0 implies that the eigenvalues are real;
T(1) < 0 implies that they lie on opposite sides of 1;
tr < 2 implies that the sum of the eigenvalues is less than 2;
T(1) > 0 nally implies that one eigenvalue, say
1
, is larger than 1
whereas the second eigenvalue,
2
, lies between 1 and 1.
Because the eigenvalues are distinct, we can diagonalize as = QQ
1
where is a diagonal matrix with
1
and
2
on its diagonal. The column of
the matrix Q consist of the eigenvectors of . Multiplying the system (3.37)
by Q
1
, obtain the transformed system:
_
e
t+1
p
t+1
_
= Q
1
_
e
t+1
e
ss
p
t+1
p
ss
_
= Q
1
QQ
1
_
e
t
e
ss
p
t
p
ss
_
=
_
1
0
0
2
__
e
t
p
t
_
(3.38)
Through this change of variables we have obtained a decoupled system: the
original two-dimensional systems is decomposed into two one-dimensional
homogenous dierence equations. These two equations have the general so-
lution:
e
t
= c
1
t
1
p
t
= c
2
t
2
where c
1
and c
2
are two constants yet to be determined. Transforming the
solution of the decoupled systems back into the original variables yields:
e
t
= e
ss
+ c
1
q
11
t
1
+ c
2
q
12
t
2
(3.39)
p
t
= p
ss
+ c
1
q
21
t
1
+ c
2
q
22
t
2
(3.40)
where Q = (q
ij
)
i,j=1,2
. Because
1
> 1 this represents an unstable system.
As time evolves the unstable eigenvalue will eventually dominate. In order to
avoid this explosive behavior, we set c
1
equal to zero. The second constant
c
2
can be determined from the boundary condition associated with the pre-
determined variable, in our case the price level. Suppose the system starts
in period zero and we are given a value p
0
for the price level in this period,
then according to equation (3.40) c
2
=
(p
0
p
ss
)
q
22
, provided q
22
,= 0. Combining
all these elements with the equations (3.39) and (3.40) leads to the equation
for the saddle path:
e
t
= e
ss
+
q
12
q
22
(p
t
p
ss
) (3.41)
It can be shown that that
q
12
q
22
< 0 so that the saddle path is downward
sloping.
16
The Dornbusch is most easily analyzed in terms of a phase diagram rep-
resenting the price level and the exchange rate as in gure 3.11. The graph
consists of two schedules: p
t+1
p
t
= 0 and e
t+1
e
t
= 0. Their intersection
determines the steady state denoted by S. These two schedules correspond to
the equations (3.36) and (3.35). The e
t+1
e
t
= 0 schedule does not depend
on the exchange rate is therefore horizontal intersecting the price axis at p
ss
.
Above this schedule the exchange rate depreciates whereas below this sched-
ule the exchange appreciates, according to equation (3.37). This is indicated
by arrows pointing to the right, respectively to the left. The p
t+1
p
t
= 0
schedule is upward sloping. To its left, prices are decreasing whereas to its
right prices are decreasing, according to equation (3.37). The two schedules
divide the e-p-quadrant into four regions: I, II, III, and IV. In each region
the movement of e and p is indicated by arrows. In the Dornbusch model the
price level is sticky and considered to be a predetermined variable. Suppose
that in period 0 its level is given by p
0
. The exchange rate in this period is
not given, but endogenous and has to be determined by the model. Suppose
16
This can be established by investigating the dening equations for the eigenvector
corresponding to the second eigenvalue. They are given by (
11
2
)q
12
+
12
q
22
= 0 and
21
q
12
+ (
22

2
)q
22
= 0. Because (
11

2
) > 0 and
12
> 0, q
12
and q
22
must be of
opposite sign. The same conclusion is reached using the second equation. This reasoning
also shows that q
22
,= 0. Suppose that q
22
= 0 then q
12
must also be zero because
(
11
2
) > 0. But this contradicts the assumption that (q
12
, q
22
)
is an eigenvector.
3.3. EXAMPLES 85
I
IV
III
II
saddle path
saddle path
e
p
p
0
schedule:
p - p = 0
t+1 t
schedule:
e - e = 0
t+1 t
S
A B
p
ss
e
ss
Figure 3.11: Dornbuschs Overshooting Model
that the exchange rate in period 0 is at a level corresponding to point A.
This point is the left of the p
t+1
p
t
= 0 schedule and above the e
t+1
e
t
= 0
schedule and therefore in region I. This implies that price level has to fall
and the exchange rate to increase. The path of e and p will continue in this
direction until they hit the e
t+1
e
t
= 0 schedule. At this time the system
enters region IV and the direction is changed: both the price level and the
exchange rate decrease. They will so forever. We are therefore on an unstable
path. Consider now an exchange rate in period 0 corresponding to point B.
Like A, this point is also in region I so that the exchange rate increases and
the price level decreases. However, in contrast to the previous case, the path
starting in B will hit the p
t+1
p
t
= 0 schedule and move into region II. In
this region, both the price level and the exchange rate increase forever. Again
this cannot be a stable path. Thus, there must an exchange rate smaller than
the one corresponding to point B, but higher than the one corresponding to
point A, which sets the system on a path leading to the steady steady. This
is exactly the exchange rate which corresponds to the saddle path given by
equation (3.41). In this way the exchange rate in period 0 is pinned down
uniquely by the requirement that the path of (e
t
, p
t
)
converges.
The phase diagram is also very convenient in analyzing the eects of
saddle path
saddle path
e
p
p
ss
e
ss
e
0
p
ss
e
ss
schedule:
p - p = 0
t+1 t
schedule:
e - e = 0
t+1 t
S
new
new
new
old
old
Figure 3.12: Unanticipated Increase in Money Supply Dornbuschs Over-
shooting Model
changes in the exogenous variables. Consider, for example, an unanticipated
permanent increase in money supply. This moves, according to equation
(3.35), the e
t+1
e
t
= 0 schedule up and, according to (3.36), the p
t+1
p
t
= 0
to the left as shown in gure 3.12. The steady state therefore jumps from S
old
to S
new
and the new saddle path goes through S
new
. Suppose that the price
level was initial at p
ss
old
. As the price level cannot react to the new situation it
will remain initially at the old steady state level. The exchange rate, however,
can adapt immediately and jumps to e
0
such that the system is on the new
saddle path. As this value lies typically above the new steady level, we say
that the exchange rate overshoots. The reason for this excess depreciation
of the exchange rate is the stickiness of the price level. In the short-run,
the exchange rate carries all the burden of the adjustment. As time evolves
the system moves along its saddle path to its new steady state. During this
transition the price level increases and the exchange rate appreciates. Thus,
the immediate reaction of the economy is a depreciation of the exchange rate
coupled with an expected appreciation.
3.3. EXAMPLES 87
3.3.2 Optimal Growth Model
In contrast to the previously discussed Solow model (see section 2.3.1), the
optimal growth model seeks to determine the saving-consumption decision
optimally.
17
Consider for this purpose a planer who seeks the optimize the
discounted utility stream from per capita consumption (c
t
). If C
t
and L
t
denote aggregate consumption and aggregate labor input in period t then per
capita consumption is given by c
t
= C
t
/L
t
. As before labor input increases
at the exogenously given rate > 0, i.e. L
t+1
= (1 + )L
t
. The planner is
assumed to maximize the following Bentham type objective function:
V (c
0
, c
1
, ) =
t=0
t
L
t
U(c
t
)
= L
0
t=0
((1 + ))
t
U(c
t
), 0 < (1 + ) < 1. (3.42)
The constant is called the subjective discount rate. The period utility func-
tion U : R
+
R is continuously dierentiable, increasing, strictly concave,
and, in order to avoid corner solutions, fullls lim
c0
U
(c) = .
18
The rest of the specication is exactly the same as for the Solow model
(see section 2.3.1): Output is produced according to a neoclassical aggregate
production satisfying the Inada conditions. Recognizing that investment in
period t, I
t
equals I
t
= K
t+1
(1 )K
t
the national accounting identity
becomes:
C
t
+ I
t
= C
t
+ K
t+1
(1 )K
t
= F(K
t
, L
t
)
or in per capita terms
c
t
+ (1 + )k
t+1
(1 )k
t
= f(k
t
)
respectively,
c
t
+ (1 + )k
t+1
= f(k
t
) + (1 )k
t
= g(k
t
). (3.43)
17
The optimal growth model originates in the work of Ramsey Ramsey (1928). It has
been widely analyzed and stands at the heart of the Real Business Cycle approach. An
extensive treatment of this model together with additional references can be found in
Stokey and Lucas Jr. (1989).
18
Instead of a Bentham type objective function one could also work with the conventional
one: V (c
0
, c
1
, ) =
t=0

t
U(c
t
) with 0 < < 1. This modication will, however, not
change the qualitative implications of the model.
The rst oder condition for the optimum is given by the Euler-equation,
sometimes also called the Keynes-Ramsey rule:
U
(c
t
) = g
(k
t+1
)U
(c
t+1
) (3.44)
Thus, the Euler-equation equates the marginal rate of transformation, 1/g
(k
t+1
),
to the marginal rate of substitution, U
(c
t+1
)/U
(c
t
).
The equation system consisting of the transition equation (3.43) and the
Euler-equation (3.44) constitutes a nonlinear dierence equation system. The
analysis of this system proceeds in the usual manner. First, we compute
the steady state(s). Then we linearize the system around the steady state.
This gives a linear homogeneous dierence equation in terms of deviations
from steady state. We nd the solution of this dierence equation using
the superposition principle. Finally, we select, if possible, one solution using
initial conditions and boundedness arguments.
The steady state (k
, c
) is found by setting c
= c
t
= c
t+1
and k
= k
t
=
k
t+1
in equations (3.43) and (3.44). This results in the nonlinear equation
system:
k = 0 : c
= f(k
) ( + )k
(3.45)
c = 0 : g
(k
) = (f
(k
) + 1 ) = 1. (3.46)
The c = 0 equation is independent of c and of the shape of the utility
function U. This equation therefore determines k
. The rst equation viewed

as a function c of k has an inverted U-shape in the (k, c)-plane as can be
deducted from the following reasoning:
k = 0 implies c = 0. The derivative dc/dk = f
(k) ( + ) evaluated
at k = 0 is strictly positive because of the Inada conditions.
The function reaches a maximum at k
determined by dc/dk = f
(k
)
( + ) = 0. Because (1 + ) < 1 by assumption, k
< k
. k
is
called the modied golden rule capital stock. It is larger than the op-
timal capital stock because of discounting.
For k > k
the k = 0 schedule declines monotonically and crosses

the x-axis at k
max
. This is the maximal value of capital sustainable in
the long-run. It is achieved when the consumption is reduced to zero.
Thus, k
max
is determined from the equation f(k
max
) = ( + )k
max
.
The shape of both schedules is plotted in gure 3.13 as the blue lines. They
cross at point E which corresponds to the unique nonzero steady state of the
system. The equations (3.43) and (3.44) constitute a two-dimensional system
3.3. EXAMPLES 89
k
c
0 k
**
k
max
k
*
k
0
c
0
c
*
Dk=0
Dc=0
Saddlepath
E
Figure 3.13: Phase diagram of the optimal growth model
of nonlinear dierence equations of order one or, after inserting g(k
t
) (1 +
)k
t+1
for c
t
and g(k
t+1
) (1 + )k
t+2
for c
t+1
, a single nonlinear dierence
equation of order two. We therefore need two boundary condition to pin
down a solution uniquely. One condition is given by the initial value of the
per capita capital stock k
0
> 0.
In order to study the dynamics of the system in detail, rewrite the Euler
equation (3.44) as
U
(c
t+1
) U
(c
t
) = [1 g
(k
t+1
)]U
(c
t+1
). (3.47)
From this equation we can deduce that c
t+1
c
t
when k
t+1
< k
and vice
versa. Thus, to left of the (c = 0)-schedule consumption rises whereas to
the right consumption falls. Similarly, the transition equation (3.43) implies
that k
t+1
k
t
when c
t
is lower than the corresponding c
implied by the
(k = 0)-schedule. Thus, the two schedules divide the nonnegative orthant
of the (k, c)-plane in four regions. The dynamics in these four regions is
indicated in gure 3.13 by orthogonal arrows. In the region to the left of
the (c = 0)-schedule and above the (k = 0)-schedule, i.e. the north-
west region, consumption would increase whereas the capital intensity would
decrease. This dynamics would continue until the c-axis is hit. When this
happens, the economy has no capital left and therefore produces nothing but
consumes a positive amount. Such a situation is clearly infeasible. Paths with
this property have therefore to be excluded. Starting at k
0
, there is, however,
one path, the saddle path, were the forces which leads to explosive paths,
respectively infeasible paths, just osets each other and lead the economy
the steady state. This is the red line in gure 3.13.
The algebraic analysis requires the linearization of the nonlinear equation
system (3.43) and (3.44). This leads to:
_
1 + 0
U
(c
)g
(k
) U
(c
)
__
k
t+1
k
c
t+1
c
_
=
_
1
1
0 U
(c
)
__
k
t
k
c
t
c
_
where we used the fact that g
(k
) = 1. Given that > 0 and U
(c
) < 0,
the matrix on the left hand side is invertible. This then leads to the following
linear rst order homogenous system:
_
k
t+1
k
c
t+1
c
_
=
1
1 +
_

1
1
R
1
A
(c
)g
(k
) R
1
A
(c
)g
(k
) + (1 +)
__
k
t
k
c
t
c
_
=
_
k
t
k
c
t
c
_
(3.48)
where R
A
(c
) equals U
(c
)/U
(c
) > 0, the absolute risk aversion coe-

cient evaluated at the steady state.
19
As discussed in section 3.1.3 and 3.1.4,
the dynamics of the system is determined by the eigenvalues of . Denote
the characteristic polynomial of by T() and the corresponding eigenvalues
by
1
and
2
, then we have
T() = (
1
)(
2
) =
2
tr() + det
with
tr =
1
+
2
= 1 + [(1 + )]
1
R
1
A
(c
)g
(k
)/(1 + ) > 2
det =
1
2
=
1
(1 + )
> 1
= (tr)
2
4 det = [1 ((1 + ))
1
]
2
+
R
1
A
(c
)g
(k
)
1 +
_
R
1
A
(c
)g
(k
)
1 +
2
2
(1 + )
_
> 0
T(1) = 1 tr + det =
R
1
A
(c
)g
(k
)
1 +
< 0
19
This concept is intimately related to the intertemporal elasticity of substitution in
this context. In particular, for the U(c) =
c
1
1
1
the coecient of relative risk aversion
R
R
= c R
A
= is just the inverse of the intertemporal elasticity of substitution.
3.3. EXAMPLES 91
where denotes the discriminant of the quadratic equation and where we
used the fact that g
< 0. The above inequalities have the following impli-

cations for the two eigenvalues:
> 0 implies that the eigenvalues are real and distinct;
tr > 2 implies that at least one eigenvalue is greater than 1;
T(1) < 0 then implies that they lie on opposite sides of 1;
T(0) = det > 1 nally implies that one eigenvalue, say
1
, is larger
than 1 whereas the second eigenvalue,
2
, lies between 0 and 1.
Because the eigenvalues are distinct, we can diagonalize as = QQ
1
where is a diagonal matrix with
1
and
2
on its diagonal. We take
1
> 1 >
2
> 0. The column of the matrix Q = (q
ij
) consist of the
eigenvectors of . Thus, the solution can be written as
k
t
k
= c
1
q
11
t
1
+ c
2
q
12
t
2
(3.49)
c
t
c
= c
1
q
21
t
1
+ c
2
q
22
t
2
. (3.50)
Because
1
> 1 this represents an unstable system. As time evolves the
unstable eigenvalue will eventually dominate. In order to avoid this explosive
behavior, we set c
1
equal to zero. The second constant c
2
can be determined
from the boundary condition associated with the predetermined variable.
Suppose the system starts in period zero and we are given a value k
0
for the
capital intensity in this period, then according to equation (3.49) c
2
=
(k
0
k
)
q
12
,
provided q
12
,= 0. Combining all these elements with the equations (3.49)
and (3.50) leads to the equation for the saddle path:
c
t
= c
+
q
22
q
12
(k
t
k
) (3.51)
It can be shown that that
q
22
q
12
> 0 so that the saddle path is upward sloping
as shown by the red line in gure 3.13.
20
20
This can be veried by looking at the dening equations for the eigenvector corre-
sponding to the second eigenvalue. They are given by (
11

2
)q
12
+
12
q
22
= 0 and
21
q
12
+ (
22

2
)q
22
= 0. Because (
11

2
) > 0 and
12
< 0, q
12
and q
22
must have
the same sign. The same conclusion is reached using the second equation. This argument
also shows that q
12
,= 0.
3.3.3 The New Keynesian Model
In this section we study a simple version of the New Keynesian macroeco-
nomic model as it has become popular recently. A detailed description of the
model and its microfoundations can be found in Woodford (2003) and Gal
(2008b). Here we follow the exposition by Gal (2008a). The model consists
of the following three equations:
y
t
= y
t+1
(i
t
t+1
), (IS-equation)
t
=
t+1
+ y
t
+ u
t
, (forward-looking Phillips-curve)
i
t
=
t
, (Taylor-rule)
where y
t
,
t
, and i
t
denote income, ination and the nominal interest rate, all
measured as deviations from the steady state. u
t
is an exogenous cost-push
shock. Furthermore, we assume that > 0, > 0, and 0 < < 1. In
addition, we take an aggresive central bank, i.e. > 1.
This system can solved be for (y
t+1
,
t+1
)
by inserting the Taylor-rule

and Phillips-curve into the IS-equation:
X
t+1
=
_
t+1
y
t+1
_
=
1
_
1
( 1)/ + /
__
t
y
t
_
+
_
u
t
/
u
t
/()
_
= X
t
+ Z
t+1
(3.52)
Denote the characteristic polynomial of by T() and the corresponding
eigenvalues by
1
and
2
, then we have
T() = (
1
)(
2
) =
2
tr() + det
with
tr =
1
+
2
= 1 +
1
> 2
det =
1
2
=
1
> 1
= (tr)
2
4 det =
_
1
1
_
2
+

+ 2 +
2
4
_
T(1) = (1
1
)(1
2
) =

( 1) > 0 if > 1
where denotes the discriminant of the quadratic equation. Depending on
, the roots of T() may be complex. We therefore distinguish two cases.
First assume that is high such that < 0. In this case we have two complex
3.3. EXAMPLES 93
conjugate roots. Because det > 1, they are located outside the unit circle.
21
Alternatively assume that is small enough such that > 0. In this case
both eigenvalues are real. Using the assumption > 1, T(1) > 0. Thus,
both roots are either greater or smaller than one. They cannot be smaller
than one because tr > 2. Thus, in both cases we reach the conclusion
that the eigenvalues are outside the unit circle. As both variables are non-
predetermined, the boundedness condition (3.31), Qc = 0 which is equivalent
to c = 0, then determines the unique solution:
X
t
=
j=1
Q
_
j
1
0
0
j
2
_
Q
1
_
u
t1+j
/
u
t1+j
/()
_
where the columns of Q consist of the eigenvectors corresponding to
1
and
2
.
Suppose now that the central bank xes the path of the interest rate. The
interest rate then becomes an exogenous variable and the system changes to:
X
t+1
=
_
t+1
y
t+1
_
=
1
_
1
1/ + /
__
t
y
t
_
+
_
u
t
/
i
t
/ + u
t
/()
_
=

X
t
+ Z
t+1
(3.53)
where i
t
is the exogenous path of the interest rate. The trace, determinant,
and discriminant,

of the characteristic polynomial of

become:
tr
=
1
+
2
= 1 +
1
> 2
det

=
1
2
=
1
> 1
= (tr)
2
4 det =
_
1
1
_
2
+

+ 2 +
2
_
> 0
T(1) = (1
1
)(1
2
) =

< 0.
The discriminant is now unambiguously positive so that both eigenvalues are
real. Moreover, T(1) < 0 so that one eigenvalue is smaller than one and the
other bigger than one. Thus, the boundedness condition does not determine
a unique solution. Instead there is a continuum of solutions indexed by c
1
and we are faced with the case of indeterminacy. The implications of this
indeterminacy for monetary policy and possible remediations are discussed
in Gal Gal (2008a).
21
Another way to reach this conclusion is by observing that the real part of the roots is
tr
2
> 1.
3.3.4 Sun Spots
Chapter 4
Singular Systems of Dierence
Equations
95
96CHAPTER 4. SINGULAR SYSTEMS OF DIFFERENCE EQUATIONS
Chapter 5
Linear Stochastic Expectational
Dierence Equations
In the following we analyze linear stochastic expectational dierence equa-
tions in X
t
of the form:
1
E
t
X
t+1
=
0
X
t
+ Z
t
, t = 0, 1, 2 . . . (5.1)
where X
t
and Z
t
are real-valued n-dimensional stochastic processes de-
ned on some probability space (, T, P). The random variables X
t
and
Z
t
are measurable with respect to the -algebra T
t
= (X
s
, Z
s
) : s t.
This makes the sequence T
t
a ltration adapted to X
t
and Z
t
. In eco-
nomics T
t
is also called the information set. E
t
then denotes the conditional
expectation with respect to T
t
. As expectations are based on current and
past X
t
s and Z
t
s only and not extraneous variables, we have eliminated the
possibility of sunspot solutions.
Expectational dierence equations of the type (5.1) arise typically in the
context of rational expectations models. Starting with the seminal paper by
Blanchard and Kahn (1980), an extensive literature developed which analyzes
the existence and nature of its solutions. The most inuential papers, at least
for the present exposition, are Gourieroux et al. (1982), Klein (2000), Sims
(2001), among others. There is no loss generality involved by conning the
analysis to rst order equations as higher order equations can be reduced
to rst order ones by inating the dimension of the process (see Binder and
Peseran, 1994).
To make the problem tangible, we consider only a certain class of so-
lutions. In particular, we require that the exogenous input process Z
t
is
bounded in L
p
, p > 1.
1
This means that sup
t
|Z
t
|
p
< . This assumption
1
L
p
denotes the space of random variables such that |X|
p
=
__
|X|
p
dP
_
1/p
<
97
98 CHAPTER 5. STOCHASTIC DIFFERENCE EQUATION
implicitly restricts the solution processes to be bounded as well.
Assumption 1. We restrict the class of processes Z
t
to processes bounded
in L
p
, p > 1. Thus, sup
t
E|Z
t
|
p
< .
Remark 1. The class of stationary processes is the prime example of such
processes as the expected value and the variance remain constant. In many
applications, Z
t
is specied as an ARMA-process.
2
Throughout the analysis we follow King and Watson (1998) and assume
that
1
z +
0
is a regular pencil:
3
Assumption 2. There exists at least one z C such that det(
1
z+
0
) ,= 0.
Remark 2. If the linear pencil
1
z +
0
would not be regular, there would
exist a polynomial vector P in the forward operator FX
t
= E
t
X
t+1
such
P(F)Z
t
= 0 for arbitrary processes Z
t
. However, this cannot be the case.
Note also that the assumption allows either
1
or
0
or both to be singular.
In that it generalizes the common assumption
0
and
1
to be invertible.
As was already pointed out by Blanchard and Kahn (1980), the notion of
a predetermined variable or process is key for understanding the nature of the
solution.
4
Following Klein (p.1412, 2000), we have the following denition.
Denition 10. A stochastic process K
t
adapted to the ltration T
t
is a
predetermined process if
(i) The process of expectational errors
t
with
t+1
= K
t+1
E
t
K
t+1
is
an exogenous martingale dierence process;
(ii) k
0
T
0
is exogenously given.
This denition is more general than the one given in Blanchard and Kahn
(1980) who require that K
t+1
= E
t
K
t+1
.
Finally, note that the superposition principle still applies in this context.
For suppose that there exists two solutions X
1
t
and X
(2)
t
then X
1
t

X
2
t
satises the homogeneous stochastic expectational dierence equation
1
E
t
X
t+1
=
0
X
t
.
where inside the integral |.| is the Euclidian norm in R
n
. If p = 2, we obtain the square-
integrable random variables. In this case L
p
becomes a Hilbert space.
2
ARMA-processes are stationary processes which fulll a stochastic dierence equation
of the form Z
t
a
1
Z
t1
. . . a
p
Z
tp
= U
t
+b
1
U
t1
+. . . +b
q
U
tq
, a
p
b
q
,= 0, with U
t
being white noise.

3
See Gantmacher (1959) for an extensive discussion of matrix pencils.
4
Sims (2001) provides an alternative approach which does not rely on an a priori division
of the variables into predetermined and non-predetermined ones.
5.1. THE UNIVARIATE CASE 99
Thus, the general solution of equation (5.1) is
X
t
= X
(g)
t
+ X
(p)
t
where X
(g)
t
denotes the general solution to the homogeneous equation and
X
(p)
t
a particular solution.
5.1 The univariate case
Before going into the details of the multivariate case, we will lay out the
main principles by examining a simple univariate case, often termed the
Cagan model (Cagan, 1956). Thus, consider the simple univariate rst or-
der stochastic expectational dierence equation.
5
In this model, the current
value, X
t
, is determined by the expectation of its value tomorrow and some
exogenous bounded process Z
t
:
E
t
X
t+1
= X
t
+ Z
t
, ,= 0. (5.2)
The superposition principle implies that we can nd a solution in two steps.
First, nd the general solution to the homogeneous equation
E
t
X
t+1
= X
t
. (5.3)
Then, second, nd a particular solution to the nonhomogeneous equation.
Note that the equation (5.1) can be rewritten as a rst order autoregres-
sive scheme:
X
t+1
= E
t
X
t+1
+ (X
t+1
E
t
X
t+1
) = X
t
+ Z
t
+
t+1
(5.4)
where the expectational errors
t+1
= X
t+1
E
t
X
t+1
form a martingale
dierence sequence.
6
Although this process has no serial correlation, it is
not white noise because its variance may change over time.
5.1.1 Solution to the homogeneous equation
In order to nd the general solution to the homogeneous equation (5.3) note
that M
t
dened as M
t
=
t
X
t
is a martingale with respect to T
t
:
E
t
M
t+1
= E
t
t1
X
t+1
=
t1
E
t
X
t+1
=
t1
X
t
= M
t
.
5
Compare this discussion with the one in Section 2.3.1.
6
This is the representation preferred by Sims (2001).
This suggests that the general solution to the homogeneous equation is of
the form
X
(g)
t
=
t
M
t
(5.5)
where M
t
is any martingale dened with respect to T
t
. M
t
plays the
same role as the constant c in the deterministic case. Given Assumption 1,
we consider only solutions which are bounded in L
p
, p > 1 i.e. for which
sup
t
|X
(g)
t
|
p
< . By the Martingale Convergence Theorem (see Hall and
Heyde, 1980), there exists a random variable M L
p
such that M
t
=
E(M[T
t
) = E
t
M. Moreover, |M
t
M|
p
converges to zero for t .
As in the deterministic case, we can distinguish several cases depending
on the value of .
[[ > 1: An implication of the Martingale Convergence Theorem is that E|M
t
|
converges to E|M| < . Thus, for X
(g)
t
to remain bounded M
t
must
be equal to zero for all t and hence the general solution of the homo-
geneous equation vanishes.
= 1: The general solution is X
(g)
t
= M
t
which converges to M.
= 1: No convergent solution exists.
[[ < 1: In this case, the representation (5.4) implies that the solution fol-
lows an autoregressive process of order one. This representation admits
a causal representation with respect to the expectational errors. This
representation is given by X
t
=
t
X
0
+
t1
j=0
tj
and is bounded.
However, if X
t
is not predetermined, there is no starting value X
0
and we are faced with a situation of indeterminacy because any mar-
tingale dierence sequence dened with respect to T
t
would satisfy the
dierence equation.
5.1.2 Finding a particular solution
A particular solution can be found by iterating the dierence equation for-
ward in time and applying the law of iterated expectations. After k iterations
5.1. THE UNIVARIATE CASE 101
one obtains:
X
t
=
1
E
t
X
t+1
1
Z
t
=
1
E
t
_
1
E
t+1
X
t+2
1
Z
t+1
_
1
Z
t
=
2
E
t
X
t+2
1
Z
t
2
E
t
Z
t+1
= . . .
=
k1
E
t
X
t+k+1
1
k
j=0
j
E
t
Z
t+j
As we are looking for solutions which remain bounded, this suggests to take
X
t
=
1
j=0
j
E
t
Z
t+j
(5.6)
as a particular solution if [[ > 1. As Z
t
is bounded the expression (5.6)
qualies as a candidate for the particular solution when [[ > 1. Note that
X
t
will be bounded (stationary) for any bounded (stationary) process Z
t
.
If [[ < 1, the forward iteration may still make sense if E
t
|Z
t+j
| goes
to zero quick enough. Take as example the case where Z
t
follows an au-
toregressive process of order one, i.e. Z
t
= Z
t1
+ u
t
with u
t
WN(0,
2
)
and [[ < 1. This specication implies that E
t
Z
t+j
=
j
Z
t
. Thus, as long as
[
1
[ < 1, the forward solution will exist and will be bounded (stationary).
However, this will not be true for every [[ < 1.
In general, if [[ < 1, we may consider the equivalent representation (5.4)
instead. Iterating this equation backward, we obtain:
X
t
=
t
X
0
+
t1
j=0
j
(Z
tj
+
tj
).
This solution, however, makes only sense when X
t
is predetermined so that
X
0
is given.
5.1.3 Example: Cagans model of hyperination
Let us illustrate our ndings by taking up again Cagans model of hyperin-
ation with rational expectations (see section 2.3.1). This model leads to the
following dierence equation in the logged price level p
t
:
E
t
p
t+1
=
1
p
t
+
m
t
, < 0, (5.7)
where m
t
is now a stochastic process and where the expected price level is
replaced by the conditional expectation of the logged price level.
Given that < 0, the coecient of p
t
, = ( 1)/, is positive and
strictly greater than one. Therefore the only bounded (stationary) solution
to the homogeneous equation is X
(g)
t
= 0 and a particular solution can be
found by forward iteration. Thus the solution is:
p
t
=
1
1
j=0
_

1
_
j
E
t
m
t+j
. (5.8)
Suppose that the money supply follows an autoregressive process of order
one:
m
t
= am
t1
+
t
, [a[ < 1 and
t
IID(0,
2
).
The conditional expectation E
t
m
t+j
then equals a
j
m
t
. Inserting this into
equation (5.8) leads to
p
t
=
1
1
j=0
_

1
_
j
a
j
m
t
=
1
1 (1 a)
m
t
.
This shows that the relation between the price level and money supply de-
pends on the conduct of monetary policy, i.e. it depends on the autoregressive
coecient a. Thus whenever the monetary authority changes its rule, it af-
fects the relation between p
t
and m
t
. This cross-equation restriction is viewed
by Hansen and Sargent (1980) to be the hallmark of rational expectations.
It also illustrates that a simple regression of p
t
on m
t
can not be considered a
structural equation, i.e. cannot uncover the true structural coecients ( in
our case), and is therefore subject to the so-called Lucas-critique (see Lucas
(1976)).
A similar conclusion is reached if money supply follows a moving average
process of order one instead of an autoregressive process of order one:
m
t
=
t
+
t1
, [[ < 1 and
t
WN(0,
2
).
As [[ < 1, the process for m
t
is invertible and we can express
t
as
t
= m
t
m
t1
+
2
m
t2
. . .
This then leads to the follows conclusions:
m
t+1
=
t+1
+
t
=
t+1
+ (m
t
m
t1
+
2
m
t2
. . .)
E
t
m
t+1
= (m
t
m
t1
+
2
m
t2
. . .)
5.2. THE MULTIVARIATE CASE 103
and
E
t
m
t+2
= E
t
t+2
+ E
t
t+1
= 0.
The particular solution then becomes
p
t
=
1
1
m
t
+

( 1)(1 )
(m
t
m
t1
+
2
m
t2
. . .)
=
_
1 +

1
_
m
t
1
+

2
(1 )
2
m
t1

3
(1 )
2
m
t2
+ . . .
Subtracting from this equation the corresponding expression for p
t1
nally
gives:
p
t
+ p
t1
=
_
1 +

1
_
m
t
1
+
m
t1
1
This shows that p
t
follows an autoregressive moving average process of
order (1, 1), i.e. an ARMA(1,1) process, with respect to m
t
. The same
remarks as before also apply in this case. Note that the AR-polynomial of
p
t
and the MA-polynomial of m
t
coincide. This remains true for general
ARMA-specications for m
t
(Gourieroux et al., 1982).
5.2 The multivariate case
Following the bulk of the literature, we try to decouple the system into a
non-explosive and an explosive part. Suppose that there n
k
predetermined
variables assembled in X
(k)
t
then we can partition the vector X
t
as
X
t
=
_
X
(k)
t
X
(d)
t
_
.
The analysis proceeds by rst examining the case where
1
is invertible.
This is the specication investigated initially by Blanchard and Kahn (1980).
1
invertible
The invertibility of
1
implies that we can rewrite equation (5.1) as
E
t
X
t+1
= X
t
+

Z
t
, t = 0, 1, 2 . . .
where =
1
1

0
and

Z
t
=
1
1
Z
t
. Let us further assume that is diagonal-
izable with = QQ
1
, diagonal. As in the discussion of the deterministic
case in Section 3.2, we partition as
=
_
1
0
0
2
_
such that the eigenvalues in
1
are strictly inside the unit circle whereas those
in
2
are strictly outside the unit circle. We disregard the case of eigenvalues
on the unit circle.
We make the following assumption with respect to the dimension of
1
and
2
.
Assumption 3. The dimension of
1
is n
k
. Thus, there are exactly as many
eigenvalues inside the unit circle as there predetermined variables. Hence,
there are as many non-predetermined variables as there are eigenvalues out-
side the unit circle. This implies that X
(k)
t
= X
(1)
t
and X
(d)
t
= X
(2)
t
.
We will discuss later what happens if this condition is violated. Parti-
tioning Q and X
t
accordingly leads to
_
E
t
X
(1)
t+1
E
t
X
(2)
t+1
_
=
_
Q
11
Q
12
Q
21
Q
22
__
1
0
0
2
__
Q
(11)
Q
(12)
Q
(21)
Q
(22)
_
_
X
(1)
t
X
(2)
t
_
+
_
Z
(1)
t
Z
(2)
t
_
.
Multiplying this equation from the left by Q
1
leads to the decoupled system
_
E
t
Y
(1)
t+1
E
t
Y
(2)
t+1
_
=
_
1
0
0
2
_
_
Y
(1)
t
Y
(1)
t
_
+
_
Z
(1)
t
Z
(2)
t
_
where Q
1
X
t
= Y
t
and Q
1

Z
t
=

Z
t
, i.e.
Y
(1)
t
= Q
(11)
X
(1)
t
+ Q
(12)
X
(2)
t
Y
(2)
t
= Q
(21)
X
(1)
t
+ Q
(22)
X
(2)
t
Z
(1)
t
= Q
(11)

Z
(1)
t
+ Q
(12)

Z
(2)
t
Z
(2)
t
= Q
(21)

Z
(1)
t
+ Q
(22)

Z
(2)
t
.
Following the logic of the discussion in Section 5.1, the unique bounded
solution for Y
(2)
t
is
Y
(2)
t
=
1
2
j=0
j
2
E
t

Z
(2)
t+j
=
j=0
j
2
E
t
_
Q
(21)

Z
(1)
t+j
+ Q
(22)

Z
(2)
t+j
_
=
1
2
j=0
j
2
_
Q
(21)
Q
(22)
_
E
t

Z
t+j
. (5.9)
Turn next to the rst part of the decoupled equation. Note that the
predetermined variable X
(1)
t
satises the identity:
X
(1)
t+1
E
t
X
(1)
t+1
= Q
11
_
Y
(1)
t+1
E
t
Y
(1)
t+1
_
+ Q
12
_
Y
(2)
t+1
E
t
Y
(2)
t+1
_
=
t+1
.
Inserting this equation into the equation for Y
(1)
t+1
, we get
Y
(1)
t+1
= E
t
Y
(1)
t+1
+
_
Y
(1)
t+1
E
t
Y
(1)
t+1
_
=
1
Y
(1)
t
+

Z
t
(1)
+ Q
1
11

t+1
Q
1
11
Q
12
_
Y
(2)
t+1
E
t
Y
(2)
t+1
_
=
1
Y
(1)
t
+

Z
t
(1)
+ Q
1
11

t+1
Q
1
11
Q
12
t+1
(5.10)
where
t+1
= Y
(2)
t+1
E
t
Y
(2)
t+1
is an exogenous martingale dierence process.
Thus, equation (5.10) is a rst order autoregressive scheme with starting
value given by
Y
(1)
0
= Q
1
11
_
X
(k)
0
Q
12
Y
(2)
0
_
.
Equations (5.10) and (5.9) determine the solution for Y
t
. This step in the
derivation is only valid if Q
11
is invertible. Otherwise, we could not determine
the initial values of Y
(1)
t
from those of X
(1)
t
and there would a lack of initial
values for Y
t
.
7
Hence, Assumption 3 is not sucient for the uniqueness of
the solution. In addition, we need the following assumption.
Assumption 4. Q
11
is nonsingular.
Finally, the solution for Y
t
can be turned back into a solution for X
t
by
multiplying Y
t
by Q.
We can get further insights into the nature of the solution by assuming
that
Z
t
is a causal autoregressive process of order one:
Z
t+1
= A
Z
t
+ u
t+1
, u
t
WN(0,
2
) and |A| < 1
where u
t
is exogenous. This specication implies that E
t

Z
t+j
= A
j

Z
t
,
j = 1, 2, . . . Inserting this into equation (5.9) we nd that
Y
(2)
t
=
j=0
j
2
_
Q
(21)
Q
(22)
_
A
j

Z
t
= MZ
t
where M =
j=0

j
2
_
Q
(21)
Q
(22)
_
A
j
. The solution to Y
(1)
t
then can be
written as
Y
(1)
t+1
=
1
Y
(1)
t
+

Z
t
(1)
+ Q
1
11

t+1
Q
1
11
Q
12
Mu
t+1
.
Finally, the initial condition can be computed as
Y
(1)
0
= Q
1
11
_
X
(k)
0
Q
12
M

Z
0
_
.
Before turning to the general case several remarks are in order.
7
See Klein (2000, section 5.3.1) and King and Watson (2002) for details and examples.
Remark 3. The above derivation remains valid even the matrix is not
diagonalizable. In this case, we will have to work with the Jordan canonical
form instead (see Section 3.1.1).
Remark 4. The derivation excluded the possibility of roots on the unit circle.
1
singular
In many practical applications,
1
is not invertible so that the procedure just
outlined is not immediately applicable. This, for example, is the case when
a particular equation contains no expectations at all which translates into a
corresponding row of zeros in
1
. One way to deal with this problem is to
take a generalized inverse of
1
and proceed as explained above.
The most appropriate type of generalized inverse in the context of dier-
ence equations is the Drazin-inverse (see Campbell and Carl D. Meyer, 1979,
for a comprehensive exposition). This inverse can be obtained for any n n
matrix A in the following way. Denote by IndA the smallest nonnegative
integer k such that rankA
k
= rankA
k+1
. This number is called the index of
A. Then the following Theorem holds (see Theorem 7.2.1 in Campbell and
Carl D. Meyer, 1979).
Theorem 13. Let A be an n n matrix with Ind(A) = k > 0, then there
exists a nonsingular matrix P such that
A = P
_
C 0
0 N
_
P
1
where C is nonsingular and N is nilpotent of index k (i.e. N
k
= 0). The
Drazin-inverse A
D
is then given by
A
D
= P
_
C
1
0
0 0
_
P
1
.
With this Theorem in mind, we can now decouple the system in two
parts. The rst part will be similar to the case when
1
is invertible. The
second one will correspond to the singular part and will in some sense solve
out the expectations. Multiply for this purpose equation (5.1) from the left
by (z
1
+
0
)
1
where assumption 2 guarantees that the inverse exists for
some number z. Thus, we get
(z
1
+
0
)
1
1
E
t
X
t+1
= (z
1
+
0
)
1
0
X
t
1
E
t
X
t+1
= (z
1
+
0
)
1
(z
1
+
0
z
1
)X
t
1
E
t
X
t+1
= (I
n
z
1
)X
t
where

1
= (z
1
+
0
)
1
1
. The application of Theorem 13 to

1
then leads
to the decoupled system
_
C 0
0 N
_
E
t

X
t+1
=
_
I
n
z
_
C 0
0 N
__

X
t
where

X
t
denotes P
1
X
t
. This leads to the following two equations:
CE
t

X
(1)
t+1
= (I
n
1
zC)

X
(1)
t
NE
t

X
(2)
t+1
= (I
n
2
zN)

X
(2)
t
where

X
t
has been partitioned appropriately. As C is invertible, the rst
dierence equation can be treated as outlined above. By shifting the time
index, the second equation can be written as
NE
t

X
(2)
t+k
= (I
n
2
zN)

X
(2)
t+k1
.
Applying the law of iterated expectations and multiplying the equation from
the left by N
k1
gives
0 = N
k
E
t

X
(2)
t+k
= (I
n
2
zN)
2
N
k2
E
t

X
(2)
t+k2
= (I
n
2
zN)
3
N
k3
E
t

X
(2)
t+k3
= . . .
= (I
n
2
zN)
k
E
t

X
(2)
t
= (I
n
2
zN)
k

X
(2)
t
.
Because (I
n
2
zN)
k
is invertible, the only solution to the above equation is
X
(2)
t
= 0.
Chapter 6
Computer Algorithms for
Solving Linear Stochastic
Dierence Equations
109
110 CHAPTER 6. COMPUTER ALGORITHMS
Appendix A
Complex Numbers
As the simple quadratic equation x
2
+ 1 = 0 has no solution in the eld
of real numbers, R, it is necessary to envisage the larger eld of complex
numbers C. A complex number z is an ordered pair (a, b) of real numbers
where ordered means that we regard (a, b) and (b, a) as distinct if a ,= b. We
endow the set of complex numbers by an addition and a multiplication. Let
x = (a, b) and y = (c, d) be two complex numbers then, we have the following
denitions:
addition: x + y = (a, b) + (c, d) = (a + c, b + d)
multiplication: xy = (a, b)(c, d) = (ac bd, ad + bc).
These two operations will turn C into a eld where (0, 0) and (1, 0) play
the role of 0 and 1.
1
The real numbers R are embedded into C because we
identify any a R with (a, 0).
The number = (0, 1) is of special interest. It solves the equation x
2
+1 =
0, i.e.
2
= 1. The other solution being = (0, 1). Thus any complex
number (a, b) may be written as (a, b) = a + b where a, b are arbitrary real
numbers.
2
1
Substraction and division can be dened accordingly:
subtraction: (a, b) (c, d) = (a c, b d)
division: (a, b)/(c, d) =
(ac + bd, bc ad)
(c
2
+ d
2
)
c
2
+ d
2
,= 0
2
A more detailed introduction of complex numbers can be found in Rudin (1976) or
any other mathematics textbook.
111
112 APPENDIX A. COMPLEX NUMBERS
2 1 0 1 2
2
1
0
1
2
real part
i
m
a
g
i
n
a
r
y

p
a
r
t
Representation of complex numbers
z=aib
unit circle:
a
2
+ b
2
= 1
a
b
z=a+ib
r

1
i
i
1
b
Figure A.1: Representation of a complex number
An element z in this eld can be represented in two ways:
z = a + b Cartesian coordinates
= re
= r(cos + sin ) polar coordinates.

In the representation in Cartesian coordinates a = Re(z) = 1(z) is called
the real part whereas b = Im(z) = (z) is called the imaginary part of z.
A complex number z can be viewed as a point in the two-dimensional
Cartesian coordinate system with coordinates (a, b). This geometric inter-
pretation is represented in Figure A.1.
The absolute value or modulus of z, denoted by [z[, is given by r =
a
2
+ b
2
. Thus the absolute value is nothing but the distance of z viewed
as a point in the complex plane (the two-dimensional Cartesian coordinate
system) to the origin (see Figure A.1). denotes the angle to the positive real
axis (x-axis) measured in radians. It is denoted by = arg z. It holds that
tan =
b
a
. Finally, the conjugate of z, denoted by z, is dened by z = a b.
Setting r = 1 and = , gives the following famous formula:
e
+ 1 = (cos + sin ) + 1 = 1 + 1 = 0.
113
This formula relates the most famous numbers in mathematics.
From the denition of complex numbers in polar coordinates, we get
immediately the following implications:
cos =
e
+ e
2
=
a
r
,
sin =
e
2
=
b
r
.
Further implications are de Moivres formula and the Pythagoras theorem
(see Figure A.1):
de Moivres formula
_
re
_
n
= r
n
e
n
= r
n
(cos n + sin n)
Pythagoras theorem 1 = e
= (cos + sin )(cos sin )

= cos
2
+ sin
2
From Pythagoras theorem it follows that r

2
= a
2
+ b
2
. The representation
in polar coordinates allows to derive many trigonometric formulas.
Consider the polynomial (z) =
0
1
z
2
z
2
. . .
p
z
p
of order p 1
with
0
= 1.
3
The fundamental theorem of algebra then states that every
polynomial of order p 1 has exactly p roots in the eld of complex numbers.
Thus, the eld of complex numbers is algebraically complete. Denote these
roots by
1
, . . . ,
p
, allowing that some roots may appear several times. The
polynomial can then be factorized as follows:
(z) =
_
1
1
1
z
_ _
1
1
2
z
_
. . .
_
1
1
p
z
_
.
This expression is well-dened because the assumption of a nonzero constant
(
0
= 1 ,= 0) excludes the possibility of roots equal to zero. If we assume
that the coecients
j
, j = 0, . . . , p, are real numbers, the roots appear in
conjugate pairs. Thus if z = a + b, b ,= 0, is a root then z = a b is also a
root.
3
The notation with
j
z
j
instead of
j
z
j
was chosen to conform to the notation
of AR-models.
114 APPENDIX A. COMPLEX NUMBERS
Appendix B
Matrix Norm
Consider a vector x in R
n
and a matrix A R
nn
. If |x| is any vector norm
on R
n
then we may consider the induced matrix norm:
|A| = max
x=1
|Ax|.
Thus the induced matrix norm is the maximum amount a vector on the unit
sphere can be stretched. The matrix norm induced by the Euclidian vector
norm is given by:
|A| = max
x=1
|Ax| =
_
(A
A)
where (A
A) is the spectral radius of A
A, i.e. (A
A) = max[[ : is an eigenvalue of A
A.
Another convenient matrix norm is the Frobenius norm, sometimes also
called the Hilbert-Schmidt or the Schur norm. It is dened as follows:
|A|
2
=
n
i,j
[a
ij
[
2
= tr(A
A) =
n
i
where
i
are the eigenvalues of A
A. Thus the Frobenius norm stakes the

columns of A into a long n
2
-dimensional vector and takes its Euclidian norm.
The matrix norm has the following properties:
|A| 0 and |A| = 0 A = 0.
|A| = [[|A| for all R.
|A + B| |A| +|B| for all A, B R
nn
.
|AB| |A||B| for all A, B R
nn
.
The last property is called submultiplicativity.
Because all norms are equivalent, it does not really matter which one we
will use. For more details see Meyer (2000).
115
116 APPENDIX B. MATRIX NORM
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Dierence Equations for Economists

in the following way:

endowed with the metric induced by this norm is

). This leads to two steady states

. Figure 2.1 shows the two steady states and

> 0 such that

| < t > 0. (2.11)

is not stable, its is called unstable.

is called attracting if there exists > 0 such that

| < implies lim

is called globally attracting.

is asymptotically stable or is an asymptotically stable

. Due to the negative value of , the price

, A > 0, 0 < <

(k) > 0. These properties ensure that

) must be smaller than one for g to cross

is easily established by observing that (k

) and monotonically decreasing

< 1. Starting in period zero with an initial

). As 0 < < 1, the steady state k

be an equilibrium point of the nonlinear autonomous

is an asymptotically stable equilibrium point.

+ ), > 0, such that [f

(X)[ M < 1 for all

and is thus also in J because M < 1. By

is therefore a stable equilibrium point. In addition, X

is attractive because lim

)[ = 1 is not treated by this theorem. It involves a more

> 1, the stability condition is violated. One

must be a root to the characteristic equation (2.33). These

for some and some . Inserting into the above

can be found by solving the equation:

if and only if the characteristic equation has

is an asymptotically stable) if and only if max[

is an asymptotically stable (i.e. all

) if and only if the following three conditions are

is an asymptotically stable equilibrium point. Ac-

for equation (2.41) can be computed as follows:

, the characteristic equation becomes:

Writing this equation in extensive form leads to:

Equating terms gives:

. Inserting the solutions for

In this case the price p

. Thus, in this situation there is no need to

. Examples of normal matrices include

), skew symmetric matrices ( =

= I). More generally, is diagonalizable if and

+ Z. This equation has a unique solution if and only if I

> 0 such that

| < t > 0. (3.18)

is not stable its is called unstable.

is called attracting if there exists > 0 such that

| < implies lim

is called globally attracting.

is asymptotically stable or is an asymptotically stable

. Now the power

then the linearized version of the system (3.16) is given

), t) denote the Jacobian matrix evaluated at the

), t) are independent of t if we have an autonomous system, i.e.

is a equilibrium for this system. In order to understand

. Let us treat these three cases separately.

as is exemplied by gure 3.6. Only when

, or a decrease in the domestic price level p

denotes the foreign nominal interest rate. In