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Organization
Introduction
Basic Idea
Log-Linearization
Examples
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The solutions to many discrete time
dynamic economic problems take the
form of a system of non-linear
difference equations.
Many modern economic models are
hard to solve due to non-linearities.

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1. Introduction
One method to solve and analyze nonlinear
dynamic stochastic models is to approximate
the nonlinear equations characterizing the
equilibrium with log-linear ones.
The strategy is to use a first order Taylor
approximation around the steady state to
replace the equations with approximations,
which are linear in the log-deviations of the
variables.

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2. Basic Idea
Consider an arbitrary univariate function,
Taylors theorem tells us that this can be
expressed as a power series about a particular
point x, where x belongs to the set of possible
x values:
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Taylor Series
( ) f x
2
( ) ( )
( ) ( ) ( ) ( )
1! 2!
f x f x
f x f x x x x x
' ''
= + +
3
( )
( ) ...
3!
f x
x x
'''
+ +
For a function that is sufficiently smooth,
the higher order derivatives will be small,
and the function can be well approximated
(at least in the neighborhood of the point of
evaluation, x) linearly as:


For an arbitrary multivariate function,

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( ) ( ) ( )( ) f x f x f x x x
'
= +
( , ) ( , ) ( , )( ) ( , )( )
x y
f x y f x y f x y x x f x y y y = + +
One particularly easy and very common
approximation technique is that of log-
linearization.
First, take natural logs of the system of
non-linear difference equations.
Linearize (using Taylor series) the logged
difference equations about a particular
point (usually a steady state)

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3. Log-Linearization
Simplify until we have a system of
linear difference equations where the
variables of interest are percentage
deviations about a point (again, usually
a steady state).

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Cobb-Douglass production function:

Take logs


Do the first order Taylor series
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4. Examples
1
t t t t
y a k n
o o
=
ln ln ln (1 ) ln
t t t t
y a k n o o = + +
1 1
ln ( ) ln ( )
t t
y y y a a a
y a
+ = +
(1 )
ln ( ) (1 ) ln ( )
t t
k k k n n n
k n
o o
o o

+ + + +
Simplify as percentage deviations
Note that,


Therefore,



Using hat variables being percentage deviations
from steady state, we have

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1 1 (1 )
( ) ( ) ( ) ( )
t t t t
y y a a k k n n
y a k n
o o
= + +
ln ln ln (1 ) ln y a k n o o = + +

(1 ) y a k n o o = + +
Note that

Given the fact that
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then
log log
t t
z z z =
log( )
t
z
z
=
log(1 ) log(1 % )
t
z z
change
z

= + = +
%change =
In words, log-deviations can be interpreted as
percentage deviations from the steady state
log log
t t
z z z =
log(1 ) z z + =
z
for a small
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The economy resource constraint:

Take logs

Do the first order Taylor series


Simplify as percentage deviation


t t t
y c i = +
ln ln( )
t t t
y c i = +
1 1 1
ln ( ) ln( ) ( ) ( )
( ) ( )
t t t
y y y c i c c i i
y c i c i
+ = + + +
+ +

c i
y c i
y y
= +
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Capital accumulation equation:

Take logs

Do the first order Taylor series



Simplify as percentage deviation


1
(1 )
t t t
k i k o
+
= +
1
ln ln( (1 ) )
t t t
k i k o
+
= +
1
1
ln ( ) ln( (1 ) )
t
k k k i k
k
o
+
+ = +
1

(1 )
t t t
i
k i k
k
o
+
= +
1 1
( ) ( )
( (1 ) ) ( (1 ) )
t t
i i k k
i k i k
o
o o

+ +
+ +
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Consumption Euler equation:

Take logs

Do the first order Taylor series



Simplify as percentage deviation



1
( ) (1 )
t
t
t
c
r
c
o
|
+
= +
1
ln ln ln ln(1 )
t t t
c c r o o |
+
= + +
1
ln ( ) ln ( )
t t
c c c c c c
c c
o o
o o
+
+
1
ln ln(1 ) ( )
(1 )
t
r r r
r
| = + + +
+
1
1

t t t
c c r
o
+
=
with
( )
t t
r r r =
1
1
(1 ) r
=
+
and
Note that
Since interest rate (r) is already a percent, it is common
to leave it in absolute (as opposed to percentage)
deviations. Therefore,

We approximate the term

The equation says that the growth rate
of consumption is approximately proportional to the
deviation of the real interest rate from steady state
interpreted as the elasticity of inter-temporal
substitution of consumption


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( )
t t
r r r =
1
1
(1 ) r
=
+
( )
1

1
t t t
c c r o
+
=
1 o