ECON0702: Mathematical Methods in Economics

Yulei Luo

SEF of HKU

January 14, 2009

Luo, Y. (SEF of HKU) MME January 14, 2009 1 / 44

Comparative Statics and The Concept of Derivative

Comparative Statics is concerned with the comparison of dierent

equilibrium states that are associated with dierent sets of values of
parameters and exogenous variables.
When the value of some parameter or exogenous variable that is
associated with an initial equilibrium changes, we can get a new
equilibrium.
The question posted in the Comparative Statics analysis is: How
would the new equilibrium compare with the old one?
Note that in the CS analysis, we dont concern with the process of
adjustment of the variables; we merely compare the initial equilibrium
state with the nal equilibrium.

Luo, Y. (SEF of HKU) MME January 14, 2009 2 / 44

 (Continued.) The problem under consideration is essentially one of
nding a rate of change: the rate of change of the equilibrium value
of an endogenous variable with respect to the change in a particular
parameter or exogenous variable. Hence, the concept of derivative is
the key factor in comparative statics analysis.
We will study the rate of change of any variable y in response to a
change in another variable x:
y = f (x ). (1)
Note that in the CS analysis context, y represents the equilibrium
value of an endogenous variable, and x represents some parameter or
exogenous variable.
The dierence quotient. We use the symbol to denote the change
from one point, say x0 , to another point, say x1 . Thus x = x1 x0 .
When x changes from x0 to x0 + x, the value of the function
y = f (x ) changes from f (x0 ) to f (x0 + x ). The change in y per
unit of change in x can be expressed by the dierence quotient:
y f (x0 + x ) f (x0 )
= (2)
x x
Luo, Y. (SEF of HKU) MME January 14, 2009 3 / 44
Quick Review of Derivative, Dierentiation, and Partial
Dierentiation

The derivative of the function y = f (x ) is the limit of the dierence

quotient y
x exists as x ! 0. The derivative is denoted by

dy y
= y 0 = f 0 (x ) = lim (3)
dx x !0 x

Note that (1) a derivative is also a function; (2) it is also a measure

of some rate of change since it is merely a limit of the dierence
quotient; since x ! 0, the rate measured by the derivative is an
instantaneous rate of change; and (3) the concept of the slope of a
curve is merely the geometric counterpart of the concept of derivative.
Example: If y = 3x 2 4,
dy
= y 0 = 6x.
dx
Luo, Y. (SEF of HKU) MME January 14, 2009 4 / 44
 (Continued.) The concept of limit. For a given function q = g (v ), if,
as v ! N (it can be any number) from the left side (from values less
than N), q approaches a nite number L, we call L the left-side limit
of q. Similarly, we call L the right-side limit of q. The left-side limit
and right-side limit of q are denoted by limv !N q and limv !N + q,
respectively. The limit of q at N is said to exist if

lim q = lim + q = L (4)

v !N v !N

and is denoted by limv !N q = L. Note that L must be a nite

number.
The concept of continuity. A function q = g (v ) is said to be
continuous at N if limv !N q exists and limv !N g (v ) = g (N ). Thus
continuity involves the following requirements: (1) the point N must
be in the domain of the function; (2) limv !N g (v ) exists; and (3)
limv !N g (v ) = g (N ).

Luo, Y. (SEF of HKU) MME January 14, 2009 5 / 44

 (Continued.) The concept of dierentiability. By the denition of the
derivative of a function y = f (x ), at x0 , we know that f 0 (x0 ) exists if
y
and only if the limit of the dierence quotient x exists at x = x0
as x ! 0, that is,
y
f 0 ( x0 ) = lim
x !0 x
f (x0 + x ) f (x0 )
= lim (Dierentiation condition).
x !0 x
dy
Dierentiation is the process of obtaining the derivative dx . Note that
the function y = f (x ) is continuous at x0 if and only if

lim f (x ) = f (x0 ) (Continuity condition).

x !x 0

Luo, Y. (SEF of HKU) MME January 14, 2009 6 / 44

 (Continued.) Continuity and dierentiability are very closely related
to each other. Continuity of a function is a necessary condition for its
dierentiability, but this condition is not su cient. Consider example:
f (x ) = jx j, which is clearly continuous at x = 0, but is not
dierentiable at x = 0.
Continuity rules out the presence of a gap, whereas dierentiability
rules out sharpness as well. Therefore, dierentiability calls for
smoothness of the function as well as its continuity. Most of the
specic functions used in economics are dierentiable everywhere.

Luo, Y. (SEF of HKU) MME January 14, 2009 7 / 44

Rules of Dierentiation

The central problem of comparative-static analysis, that of nding a

rate of change, can be identied with the problem of nding the
derivative of some function f (x ), provided only a small change in x is
being considered.
Constant function rule: for y = f (x ) = c, where c is a constant, then

dy
= f 0 (x ) = 0.
dx
Power function rule: if y = f (x ) = x where 2 ( , ) is any real
number, then
dy
= x 1 .
dx
Power function rule generalized: if y = f (x ) = cx , then

dy 1
= cx .
dx

Luo, Y. (SEF of HKU) MME January 14, 2009 8 / 44

 (continued. For two or more functions of the same variable)
Sum-dierence rule:
d d d
[f (x ) g (x )] = f (x ) g (x ) = f 0 (x ) + g 0 (x ) ,
dx dx dx
which can easily extend to more functions
" #
n n n
d d

dx i =1
fi ( x ) =
dx
fi ( x ) = fi 0 ( x ) .
i =1 i =1

Product rule:
d d d
[f (x ) g (x )] = f (x ) g (x ) + g (x ) f (x )
dx dx dx
= f (x ) g 0 (x ) + g (x ) f 0 (x )

Quotient rule:

d f (x ) f 0 (x ) g (x ) g 0 (x ) f (x )
= .
dx g (x ) g 2 (x )

Luo, Y. (SEF of HKU) MME January 14, 2009 9 / 44

Marginal-revenue Function and Average-revenue Function
Suppose that the average-revenue function (AR) is specied by
AR = 15 Q,then the total revenue function (TR) is
TR = AR Q = 15Q Q2, (5)
which means that the marginal revenue (MR) function is given by
d (TR )
MR = = 15 2Q. (6)
dQ
In general, if AR = f (Q ) , then
TR = f (Q ) Q and MR = f (Q ) + f 0 (Q ) Q,
which means that MR AR = f 0 (Q ) Q.
PQ
Note that since AR = TR Q = Q = P, we can view AR as the inverse
demand function for the product of the rm. If the market is perfect
competition, that is, the rm takes the price as given, then
P = f (Q ) =constant, which means that f 0 (Q ) = 0 and thus
MR = AR.
Luo, Y. (SEF of HKU) MME January 14, 2009 10 / 44
Marginal-cost Function and Average-cost Function

Suppose that a total cost function is

C = C (Q ) , (7)

the average cost (AC) function and the marginal cost (MC) function
are given by
C (Q )
AC = and MC = C 0 (Q ) .
Q
The rate of change of AC with respect to Q is
2 3 2 3
8 8
>0 < MC > AC
6 7
d 6 C (Q ) 7 6
1 6 0 C (Q ) 7 <
7
= 4C (Q ) = =0 i MC = AC
dQ 4 Q 5 Q | {z } Q 5 : :
| {z } MC
| {z } <0 MC < AC
AC AC

Luo, Y. (SEF of HKU) MME January 14, 2009 11 / 44

Rules of Dierentiation Involving Functions of Dierent
Variables
Consider cases where there are two or more dierentiable functions,
each of which has a distinct independent variables,
Chain rule: If we have a function z = f (y ), where y is in turn a
function of another variable x, say, y = g (x ), then the derivative of z
with respect to x gives by
dz dz dy
= = f 0 (y ) g 0 (x ) . (8)
dx dy dx
Intuition: Given a x, there must result a corresponding y via the
function y = g (x ), but this y will in turn being about a z via the
function z = f (y ).
Example: Suppose that total revenue TR = f (Q ) , where output Q
is a function of labor input L, Q = g (L) . By the chain rule, the
marginal revenue of labor is
dTR dTR dQ
MRL = = = f 0 (Q ) g 0 (L) . (9)
dL dQ dL
Luo, Y. (SEF of HKU) MME January 14, 2009 12 / 44
 Inverse function rule: If the function y = f (x ) represents a
one-to-one mapping, i.e., if the function is such that a dierent value
of x will always yield a dierent value of y , then function f will have
an inverse function
x = f 1 (y ) , (10)
note that here the symbol f 1 doesnt mean the reciprocal of the
function f (x ).
For monotonic functions, the corresponding inverse functions exist.
Generally speaking, if an inverse function exists, the original and the
inverse functions must be both monotonic. For inverse functions, the
rule of dierentiation is
dx 1
= dy . (11)
dy
dx

Examples: Suppose that y = x5 + x, y 0 = 5x 4 + 1 and

dx 1
= 4 .
dy 5x + 1

Luo, Y. (SEF of HKU) MME January 14, 2009 13 / 44

Partial Dierentiation
In CD analysis, several parameters appear in a model, so that the
equilibrium value of each endogenous variable may be a function of more
than one parameter.
Partial derivatives: Consider a function y = f (x1 , x2 , , xn ),where
the variables xi are all independent of one another, so that each can
vary by itself without aecting the others. If the variable xi changes
xi while the other variables remain xed, there will be a
corresponding change in y , y :
y f (x1 , , xi + xi , , xn ) f (x1 , , xi , , xn )
= .
xi x
The partial derivative of y with respect to xi is dened as
y y
= fi = lim
xi xi !0 xi

Techniques of partial dierentiation: PD diers from the previously

discussed dierentiation primarily in that we must hold the other
independent variables constant while allowing one variable to vary.
Luo, Y. (SEF of HKU) MME 2 January
2 14, 2009 14 / 44
Applications to Comparative-Static Analysis
How the equilibrium value of an endogenous variable will change when
there is a change in any exogenous variables or parameter?
The Single Market Model. The model setup is

Qd = a bP and Qs = c + dP

where a, b, c, and d are all positive. Qd = Qs implies that

a+c ad bc
P = and Q = ,
b+d b+d
which means
P 1 P (a + c )
= > 0, = < 0,
a b+d b (b + d )2
P 1 P (a + c )
= > 0, = < 0.
c b+d d (b + d )2

Luo, Y. (SEF of HKU) MME January 14, 2009 15 / 44

The National Income Model
The model setup is
Y = C + I0 + G0 (12)
C = + (Y T ) where > 0, 0 < < 1. (13)
T = + Y where > 0, 0 < < 1, (14)
where the rst equation in this system gives the equilibrium condition
for national income, while the second and third equations show how
C and T are determined in the model. > 0 means that
consumption is positive even if disposable income is 0; is a positive
fraction because it represents the marginal propensity to consume;
is positive because even if Y is zero the government will still have a
positive revenue; is an income tax rate that cannot exceed 100%.
Combining the three equations gives
+ I0 + G0
Y = . (15)
1 +
Luo, Y. (SEF of HKU) MME January 14, 2009 16 / 44
(continued.) From the equilibrium income (15), we can obtain the
following comparative-static derivatives that imply the eects of
government policy:

Y 1
= >0 (16)
G0 1 +
Y
= <0 (17)
1 +
Y ( + I0 + G0 ) Y
= 2
= <0 (18)
(1 + ) (1 + )2

Implications: (16) gives us the government-expenditure multiplier,

which is positive since < 1 and > 1. (17) is the nonincome-tax
multiplier because it measures the eect of a change in on the
equilibrium income. (18) measures the eect of a change in the
income tax rate on equilibrium income.

Luo, Y. (SEF of HKU) MME January 14, 2009 17 / 44

Note on Jacobian Determinants
Partial derivative is useful in CS analysis, but it also tests whether
functional (linear or nonlinear) dependence among a set of n
functions in n variables. This is related to the notion of Jacobian
determinants. Consider the two functions
y1 = 2x1 + 3x2 and y2 = 4x12 + 12x1 x2 + 9x22 ,
all the four partial derivatives are
y1 y1 y2 y2
= 2, = 3, = 8x1 + 12x2 , = 12x1 + 18x2 ,
x1 x2 x1 x2
which can be arranged into a square matrix which is called a Jacobian
matrix J
" #
y1 y1
2 3
J = y x1 x2 = (19)
x
2 y2
x
8x1 + 12x2 12x1 + 18x2
1 2

and its determinant is known as a Jacobian determinant, jJ j .

Luo, Y. (SEF of HKU) MME January 14, 2009 18 / 44
(continued.)
More generally, if we have n dierentiable functions in n variables,
y1 = f 1 (x1 , xn ) , ,
n
yn = f (x1 , xn ) ,
we can then derive a total of n2 partial derivatives. The Jacobian
determinant is
y1 y1
(y1 yn ) x1 xn
jJ j = = (20)
(x1 xn ) yn yn
x1 xn

Theorem: jJ j will be identically zero for all values of x1 , , xn if and

only if the n functions are functionally (linearly or nonlinearly)
dependent. E.g., for the above case,
J = 2 (12x1 + 18x2 ) 3 (8x1 + 12x2 ) = 0 for any x1 and x2 , which
then means that the two functions are dependent (y2 is just y1
squared: they are functionally nonlinearly dependent). Note that test
of linear dependence of a linear equation system is a special
application of the Jacobian criterion of functional dependence.
Luo, Y. (SEF of HKU) MME January 14, 2009 19 / 44
Comparative Static Analysis of General-functions
The study of partial derivatives allows us to handle the simple type of
CS problem, in which the equilibrium solution of the model can be
explicitly stated in the reduced-form. Note that the denition of PD
requires that the absence of any functional relationship among the
independent variables. As applied to CS, this means that parameters
or exogenous variables must be mutually independent.
However, in some cases, there is no explicit reduced-form solution due
to the inclusion of general functions in a model. In such a case, we
have to nd the CS derivatives directly from the originally given
equations. For example,
Y = C + I0 + G0 (Equilibrium condition) (21)
C = C (Y , T0 ) (T0 : Exogenous taxes), (22)
which can be reduced to a single equation Y = C (Y , T0 ) + I0 + G0
to be solved for Y . No explicit solution is available due to the general
function C .Must nd the CS derivatives directly from this equation.
Luo, Y. (SEF of HKU) MME January 14, 2009 20 / 44
 (continued.) Suppose that an equilibrium Y does exist. Then under
certain conditions (will discuss later), we may take Y to be a
dierentiable function of the exogenous variables:
Y = Y (I0 , G0 , T0 ) (23)
even though we are unable to determine the explicit form of this
function.
Furthermore, in some neighborhood of the equilibrium value, we have
Y = C (Y , T0 ) + I0 + G0 , (24)
which is called equilibrium condition because Y is replaced by its
equilibrium value Y .
Since Y is a function of T0 , the two arguments in the C function are
not independent. Specically, in this case T0 aects C not only
directly, but also indirectly via Y . Consequently, PD is no longer
appropriate for our purposes. We must resort to total dierentiation
and total derivatives, which can be used to measure the rate of
change in which the arguments are not independent.
Luo, Y. (SEF of HKU) MME January 14, 2009 21 / 44
 The symbol, dy dx , for the derivative of the function y = f (x ) , has
been regarded as a single entity. It can also be interpret as a ratio of
two quantities, dy and dx, which are called the dierentials of x and
y , respectively. The process of nding the dierential dy from a given
function y = f (x ) is called dierentiation:
dy = f 0 (x ) dx.
Economic application (Point elasticity of the demand function). Given
a demand function Q = f (P ) , the point elasticity of demand is
dened as
dQ/Q dQ/dP marginal function
d = = = , (25)
dP/P Q/P average function
8
< > 1 : the demand is elastic
jd j = 1 : the demand is of unit elastic .
:
< 1 : the demand is inelastic
Example: Given the demand function Q = 100 2P,
P 1 when P = 25
d = = .
50 P 1.5 when P = 30
Luo, Y. (SEF of HKU) MME January 14, 2009 22 / 44
Total Dierentials
The concept of dierentials can be extended to a function of two or
more independent variables. Consider a saving function
S = S (Y , i ) ,where S is savings, Y is national income, and i is the
interest rate. The total change in S is then approximated by the
dierential
S S
dS = dY + di = SY dY + Si di. (26)
Y i
dS is called the total dierential of the saving function (the process of
nding such a total dierential is called total dierentiation) and is
the sum of the approximate changes from both sources. SY and Si
play the role of converters that serve to convert the changes dY and
di, respectively, into a corresponding change dS.
Note that
S dS
= , (27)
Y dY i constant
which means that the partial derivative can also be interpreted as the
ratio of two dierentials dS and dY given that i is held constant.
Luo, Y. (SEF of HKU) MME January 14, 2009 23 / 44
 For a general function with n independent variables,
y = f (x1 , xn ) , the total dierential of this function is
n
f f
dy = dx1 + + dxn = fi dxi (28)
x1 xn i =1

in which each term on the right side indicates the amount of change
in y resulting from an innitesimal change in one of the independent
variable.
As in the case of one variable, the n partial derivatives can be written
as
f xi
yxi = where i = 1, , n.
xi f

Luo, Y. (SEF of HKU) MME January 14, 2009 24 / 44

Rules of Dierentials

Rule 1: for any constant c,

dc = 0

Rule 2:
1
d (cu ) = cu du
Rule 3:
d (u v ) = du dv
Rule 4:
d (uv ) = udv + vdu (29)
Rule 5:
u vdu udv
d =
v v2

Luo, Y. (SEF of HKU) MME January 14, 2009 25 / 44

Total Derivatives
Consider any function y = f (x, w ) where x = g (w ) ,unlike partial
derivative, a total derivative doesnt require that the argument x
remains constant as w varies. w can aect y via two channels: (1)
indirectly, via g and then f , and (2) directly, via f . Whereas the
partial derivative fw is adequate for expressing the direct eect alone,
a total derivative is needed to express both eects jointly.
To get the total derivative, we rst get the total dierentials
dy = fx dx + fw dw and then divide both sides by dw :
dy dx y dx y
= fx + fw = + .
dw dw x dw w
For a more general function y = f (x1 , x2 , w ) with x1 = g (w ) and
x2 = h (w ) , the total derivative of y is
dy f dx1 f dx2 f
= + + .
dw x1 dw x2 dw w
Luo, Y. (SEF of HKU) MME January 14, 2009 26 / 44
Application to an economic growth model

Let the production function is

Q = Q (K , L, t ) (30)

where K is the capital input, L is the labor input, and t is the time
which indicates that the production function can shift over time due
to technological changes. Since capital and labor can also change
over time, we have

K = K (t ) and L = L(t ).

Thus the rate of output with respect to time t can be written as

dQ Q dK Q dL Q
= + + .
dt K dt L dt t

Luo, Y. (SEF of HKU) MME January 14, 2009 27 / 44

Derivatives of Implicit Functions

A function y = f (x1 , xn ) is called an explicit function because the

variable y is explicitly expressed as a function of x1 , xn . But in
many cases, the relationship between y and x1 , xn is given by

F (y , x1 , xn ) = 0, (31)

which may also be dened as implicit function y = f (x1 , xn ) .Note

that an explicit function can always be transformed into an equation
F (y , x1 , xn ) = y f (x1 , xn ) = 0. The reverse transformation
is not always possible.
Hence, we have to impose a certain condition under which a given
equation F (y , x1 , xn ) = 0 does indeed dene an implicit function
y = f (x1 , xn ). Such a result is called implicit-function theorem.

Luo, Y. (SEF of HKU) MME January 14, 2009 28 / 44

Theorem
(implicit-function theorem) Given F (y , x1 , , xn ) = 0, if (a) the function
F has continuous partial derivatives Fy , Fx1 , , Fxn , and if (b) at a point
(y0 , x1,0 , , xn,0 ) satisfying F (y0 , x1,0 , , xn,0 ) = 0 and Fy is nonzero,
then there exists an n-dimensional neighborhood of (x1,0 , , xn,0 ), N, in
which y is an implicitly dened function of x1 , , xn , in the form of for all
points in N. Moreover, the implicit function f is continuous, and has
continuous partial derivatives f1 , , fn .

Derivatives of implicit functions. Dierentiating F , we have dF = 0 :

Fy dy + F1 dx1 + + Fn dxn = 0. (32)

Luo, Y. (SEF of HKU) MME January 14, 2009 29 / 44

 (continued.) Suppose that only y and xi are allowed to vary, then we
have
Fy dy + Fi dxi = 0, (33)
which means that
dy y Fi
jother variables constant = = for any i. (34)
dxi xi Fy

For a simple case F (y , x ) = 0, the rule gives

dy Fx
= . (35)
dx Fy

Assume that the equation F (Q, K , L) = 0 implicitly denes a

production function Q = Q (K , L) . We can then get the marginal
product of capital and labor, MPK and MPL, as follows:
Q FK Q FL
MPK = = and MPL = = .
K FQ L FQ

Luo, Y. (SEF of HKU) MME January 14, 2009 30 / 44

Extension to the Simultaneous-equation Case
Consider a set of simultaneous equations,
F 1 (y1 , , yn ; x1 , , xm ) = 0 (36)

F n (y1 , , yn ; x1 , , xm ) = 0. (37)
Suppose that F 1 , , F n are dierentiable, we have
F 1 F 1 F 1 F 1
dy1 + + dyn = dx1 + + dxm
y1 yn x1 xm

F n F n F n F n
dy1 + + dyn = dx1 + + dxm ,
y1 yn x1 xm
or in matrix form
2 1
32 3 2 32 3
F F 1 F 1 F 1
dy1 dx1
6 y1 yn
74 5= 6 x1 xm
74 5
4 5 4 5
F n F n dyn F n F n dxm
y1 yn x1 xm
Luo, Y. (SEF of HKU) MME January 14, 2009 31 / 44
 If we want to obtain partial derivatives with respect to xi , let dxj = 0
for any j 6= i and we have the following equation:
2 32 3 2 3
F 1 F 1 F 1
dy1
6 y1 yn
74 5 = 6 xi 7
4 5 4 5 dxi =)
F n F n dy F n
y1 yn n x
2 1 1
32 3 2 i1 3
F F y1 F
xi
6 y1 yn
76 7 6 xi
7
4 54 5 = 4 5. (38)
F n F n yn F n
y1 yn xi xi
| {z }
J

Suppose that the Jacobian determinant is nonzero: jJ j 6= 0. Then by

the Cramer rule, we have

yj jJji j
= where i = 1, , m; j = 1. , n. (39)
xi jJ j

Luo, Y. (SEF of HKU) MME January 14, 2009 32 / 44

The National Income Model
The model setup is
F1 = Y (C + I0 + G0 ) = 0 (40)
2
F = C [ + (Y T )] = 0 (41)
3
F = T ( + Y ) = 0. (42)
F 1 F 1 F 1
Y C T 1 1 0
jJ j = F 2 F 2 F 2 = 1 =1 + .
Y C T
F 3 F 3 F 3 0 1
Y C T
Suppose all exog. variables and parameters are xed except G0 , then:
2 3 2 Y 3 2 3
1 1 0 G 0 1 1 1 0
4 6 7 Y
1 5 4 C G 0 5 = 4 0 5 =) = 0 1 /J
G0
0 1 T
G
0 0 0 1
0
1
= .
1 +
Luo, Y. (SEF of HKU) MME January 14, 2009 33 / 44
The Market Model (with general functions)
The model setup is
Qd = D (P, Y0 ) , Qs = S (P )
dS
where D D
P < 0, Y 0 > 0, dP > 0, Qd is a function not only of P but
also of Y0 , and both demand and supply functions have continuous
derivatives. The equilibrium condition Qd = Qs implies that
F (P , Y0 ) = D (P , Y0 ) S (P ) = 0. (43)
We assume that there does exist a static equilibrium (for otherwise
there would be no point in raising the equation of CS) and expect that
P = P (Y0 ) . (44)
Note that with the IF theorem, the satisfaction of the conditions of
the IF theorem will guarantee that every Y0 will yield a unique P in
the neighborhood around a point satisfying (43) that denes the
initial equilibrium. In that case, we can write the IF P = P (Y0 ).
Luo, Y. (SEF of HKU) MME January 14, 2009 34 / 44
 (continued.) A straightforward application of the IF theorem gives

dP F /Y0 D/Y0
= = > 0, (45)
dY0 F /P D/P dS /dP
in which all derivatives are evaluated at the equilibrium point.
Economic (qualitative) implication: an increase (decrease) in the
income level will always result in an increase (decrease) in the
equilibrium price P . If we know the values of the derivatives at the
equilibrium, this formula gives a quantitative conclusion.
Furthermore, at the equilibrium, we have Q = S (P ) and apply the
chain rule gives
dQ dS dP
= > 0, (46)
dY0 dP dY0
|{z}
>0
which also means that the equilibrium quantity is positively related to
Y0 .

Luo, Y. (SEF of HKU) MME January 14, 2009 35 / 44

Simultaneous-equation Approach
The above analysis was carried out on the basis of a single equation.
dQ
We rst derived dP
dY 0 and then infer dY 0 . Now we shall show how both
can be determined simultaneously. As there are two endogenous
variables, we need accordingly set up a two-equation system. First, let
Q = Qd = Qs in the market model and rearranging gives
F 1 (P, Q; Y0 ) = D (P, Y0 ) Q=0 (47)
2
F (P, Q; Y0 ) = S (P ) Q = 0, (48)
which is in the form of (36), ,(37), with n = 2 and m = 1. First,
we check the conditions of the implicit-function theorem: (1) since
the demand and supply functions are both assumed to have
continuous derivatives, so must F 1 and F 2 ; (2) the
endogenous-variable Jacobian (the one involving P and Q ) indeed
turns out to be nonzero regardless of where is evaluated because
F 1 F 1 D
1 dS D
jJ j = P
F 2
Q
F 2
= P
dS = > 0. (49)
P Q dP 1 dP P
Luo, Y. (SEF of HKU) MME January 14, 2009 36 / 44
 (continued.) Hence, if an equilibrium solution exists, the
implicit-function theorem implies that

P = P (Y0 ) and Q = Q (Y0 )

even though we cannot solve for P and Q explicitly. These implicit

functions are known to have continuous derivatives. Furthermore,
(47) and (48) will have the status of a pair of identities in some
neighborhood of the equilibrium state, so we may also have

F 1 (P , Q ; Y0 ) = D (P , Y0 ) Q =0 (50)
2
F (P , Q ; Y0 ) = S (P ) Q = 0, (51)
dQ
from which, dPdY 0 and dY 0 can be found simultaneously by using the
implicit function rule (38) (Note that here we have two endogenous
variable and one exogenous variable):
" 1 1
#" # " 1
#
F F dP F
P Q dY 0 = Y 0 . (52)
F 2 F 2 dQ F 1
P Q dY 0 Y 0

Luo, Y. (SEF of HKU) MME January 14, 2009 37 / 44

 (continued.) More specically,
" #
D dP D
1 dY 0
P
dS dQ = Y 0 . (53)
dP 1 dY 0 0

By Cramer rule, we have

D dS D
dP dQ dP Y 0
= Y0 and = ,
dY0 jJ j dY0 jJ j
where all the derivatives of the demand and supply functions are to
be evaluated at the initial equilibrium. Note that the results here are
identical to those from solving the single equation.
Instead of directly applying for the implicit function rule, we can also
reach the same result by rst dierentiating totally (50) and (51) to
get a linear equation system in terms of dP and dQ :
D D dS
dP dQ = dY0 and dP dQ = 0.
P Y0 dP
Luo, Y. (SEF of HKU) MME January 14, 2009 38 / 44
Use of Total Derivatives

In both the single equation and the simultaneous equation approaches

illustrated above, we have taken the total dierentials of both sides of
an equation equation and then equated the two results to arrive at
the implicit function rule. However, it is possible to take and equate
the total derivatives of the two sides of the equilibrium equation with
respect to a particular exogenous variable or parameter.
For example, in the single equation approach,

D (P , Y0 ) S (P ) = 0

where P = P (Y0 ) . Taking total derivatives of this equation w.r.t.

Y0 gives
D
D dP D S dP dP Y 0
+ = 0 =) = . (54)
P dY0 Y0 P dY0 dY0 S
P
D
P

Luo, Y. (SEF of HKU) MME January 14, 2009 39 / 44

Application to the IS-LM Model
Equilibrium in the IS-LM model is characterized by an income level
and interest rates that simultaneously determine equilibrium in both
the goods market and the money market. A goods market is
described by the following set of equations:
Y = C + I + G; (55)
C = C (Y T ) ; I = I (r ); (56)
T = T (Y ); G = G0 (57)
where Y is the level of GDP (gross domestic product) or total
income. C , I , G , and T are consumption, investment, government
spending, and taxes, respectively.
Note that (1) consumption is a strictly increasing function of
disposable income Y d = Y T , that is, the marginal propensity to
consume is
dC
= C 0 Y d 2 (0, 1) .
dY d
Luo, Y. (SEF of HKU) MME January 14, 2009 40 / 44
 (continued.) (2) Investment is a strictly decreasing function of the
interest rate
dI
= I 0 (r ) < 0. (58)
dr
(3) The government sector is described by two variables: government
spending (G ) and taxes (T ). G is assumed to be set exogenously,
whereas T is assumed to be an increasing function of income: the
dT
marginal tax rate dY = T 0 (Y ) 2 (0, 1) .
Slope of the IS curve. The IS equation can be written as

Y C Yd I (r ) G0 = 0, (59)

then take the total dierential with respect to Y and r gives

dY C0 Y d 1 T 0 (Y ) dY I 0 (r ) dr = 0
dr 1 C 0 Y d (1 T 0 (Y ))
=) slope of the IS curve = < 0.
dY I 0 (r )
dY d
where we use the fact that dY =1 T 0 (Y ) .
Luo, Y. (SEF of HKU) MME January 14, 2009 41 / 44
 (continued.) The money market can be described by the following
three equations

Money demand: M d = L (Y , r ) where LY > 0, Lr < (60)

0,
Money supply: M s = M0s (M0s is exogenously), (61)
s d
Equilibrium condition: M =M , (62)

which implies the LM equation (curve):

L (Y , r ) = M0s . (63)

Slope of the LM curve. Take the total dierential with respect to Y

and r gives
dr LY
LY dY + Lr dr = 0 =) slope of the LM: = .
dY Lr

Luo, Y. (SEF of HKU) MME January 14, 2009 42 / 44

Comparative static analysis (the eects of two exog.
variables on endo. variables)
The simultaneous macro equilibrium state of the goods and money
markets can be characterized by the IS-LM equations:

Y = C Y d + I (r ) + G0 (64)
L (Y , r ) = M0s . (65)
Taking the total deferential of the system gives

dY C0 Y d 1 T 0 (Y ) dY I 0 (r ) dr = dG0
LY dY + Lr dr = dM0s ,
which can be written in matrix form
1 C 0 Y d (1 T 0 (Y )) I 0 (r ) dY dG0
= .
LY Lr dr dM0s
| {z }
J

Luo, Y. (SEF of HKU) MME January 14, 2009 43 / 44

 (continued.) The Jacobian determinant jJ j is
h i
jJ j = 1 C 0 Y d 1 T 0 (Y ) Lr + I 0 (r ) LY < 0. (66)

Note that since jJ j 6= 0, this system satises the conditions of the

implicit function theorem and the implicit functions
Y = Y (G0 , M0s ) and r = r (G0 , M0s ) can be written even though
we are unable to solve for them explicitly.
To do comparative static analysis, rst we need to set dM0s = 0, and
divide both sides by dG0 :
" #
dY
1 C 0 Y d (1 T 0 (Y )) I 0 (r ) dG 0 1
dr = . (67)
LY Lr dG
0
0

Using Cramer rule gives

dY 1 I 0 (r ) Lr dr LY
= / jJ j = > 0 and = > 0.
dG0 0 Lr jJ j dG0 jJ j

Luo, Y. (SEF of HKU) MME January 14, 2009 44 / 44