Tutorial 10

1. Find the solution of the following and determine whether the time paths are oscillatory
and convergent.
(a) yt+1 1/3yt = 6 (y0 = 1)
(b) yt+1 + 2yt = 9 (y0 = 4)
(c) yt+1 + 1/4yt = 5 (y0 = 2)
(d) yt+1 yt = 3 (y0 = 5)

Answer

(a) yt = -8(1/3)t + 9, non-oscillatory and convergent.

(b) yt = (-2)t + 3, oscillatory and divergent.

(c) yt = -2(-1/4)t + 4, oscillatory and convergent.

(d) yt = 5 + 3t, non-oscillatory and divergent.

2. In the Cobweb model:

Qdt = Qst
Qdt = Pt (, >0)
Qst = - + Pt-1 (, >0),

change the supply curve to: Qst = - + Pt*

where Pt* denoted the expected price for period t. Furthermore, suppose that sellers have the
adaptive type of expectation:

Pt* = Pt-1* + (Pt-1 - Pt-1*) (0 < 1)

where is an expectation adjustment coefficient.

(a) Give an economic interpretation to the last equation.

(b) What happens if takes the maximum value? Can we consider the Cobweb model as a
special case of the present model?
(c) Show that the new model can be represented by the first-order difference equation:

Pt+1 (1- /)Pt = ( + )/

[Hint: Solve the supply function for Pt* and then use the information that Qst = Qdt = Pt]

(d) Find the time path of price. Is this path necessarily oscillatory? Can it be oscillatory?
Under what conditions?
(e) Show that the time path pt, if oscillatory, will converge only if:
1 2/ < -/. As compared with the Cobweb solution: Pt = (P0-P*)(-/)t + P*, does the
new model have a wider or narrower range for the stability inducing values of -/?

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 Answer

(a) The interpretation is that if actual price Pt-1 exceeds (falls short of) the expected price P*t-1
then P*t-1 will be revised upward (downward) by a fraction of the discrepancy Pt-1 P*t-1, to
form the expected price for the next period, P*t. The adjustment process is essentially the same
as in (16.34), except that here time is discrete and the variable is price rather than the rate of
inflation.

(b) If = 1, then Pt = Pt-1 and the model reduces to the cobweb model. Thus the present model
includes the cobweb model as a special case.

(c) The supply function gives: P*t = (Qs,t + )/, which implies that P*t-1 = (Qs,t-1 + )/. But
since Qs,t = Qd,t = Pt, and similarly, Qs, t-1 = Pt-1, we have:

P*t = ( + Pt)/, and: P*t-1 = ( + Pt-1)/.

Substituting these into the adaptive expectations equation and simplifying and shifting the time
by one period, we obtain:

Pt+1 (1 /)Pt = ( + )/
Which is in the form of yt+1 + aYt = c, with a = -(1 /) -1, and c = ( + )/.

(d ) Since a -1, the solution is:

Pt = [P0 ( + )/( + )]( 1 /)t + ( + )/( + ), or:

Pt = (P0 P*)(1 /)t + P*

This time path is not necessarily oscillatory, but will be if: (1/) < 0, i.e., /( + ) < .

(e) If the price path is oscillatory and convergent, we must have: -1 < 1- / < 0, where
the 2nd inequality has to do with the presence of oscillation and the 1st with the question of
convergence.

Adding ( -1) and dividing by , we have: 1 - 2/ < -/ < 1- 1/.

Given that the path is oscillatory, convergence requires: 1 - 2/ < -/. If = 1 (cobweb
model), the stability inducing range for -/ is: -1 < -/ < 0. If 0 < < 1, however, the range
will become wider.

For example, with = , the range becomes: -3 < -/ < -1.

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3. Consider the following model:

Ct = a + bYdt-1
It = hYt-1 + I0 + I0
Tt = Ta + Yt
Ydt = Yt Tt + Ra
Yt = Ct + It + Gt
Where: C stands for consumption expenditure, Yd for disposable income, I for firm
investment, T for taxes, G for government expenditure and R for net transfers. I0 represents a
change in autonomous investment.

(a) Discuss the stability conditions and the nature of the time path of Y over time.

(b) Is this model more or less stable compared to a model without taxes?

Answer
(a) Making the necessary substitutions we get the following first order difference equation:
Yt [(b - b + h)Yt-1 = a bTa + bRa + I0 + I0 + G0

The stability condition is: (b - b + h) < 1

(b) The model without taxes is less stable (stability condition: (b + h) <1); note that since b > 0,
the stability condition in part (a) is easier to satisfy.

4. Consider the following model with a government sector:

Yt = Ct + It + Gt

Ydt = Yt - xYt

Ct = c + d(Ydt-1)

Tt = xYt

WhereYd is disposable income, x is the tax rate, d is the marginal propensity to consume, T is
total tax collected and I and G are the investment and government expenditure, both
exogenous.

(a) Derive an equation for the time path of national income, Yt.
(b) Derive the general solution and discuss the stability conditions. Is this model with
government sector more or less stable compared to a model without government sector?
(c) Now assume that G is not exogenous, but takes the form: Gt = gYt-1. With 0 < g < 1. Assess
the effect on the stability of the model.

Answer

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(a) Substituting into the equilibrium condition and simplifying:
Yt = (c + I + G) + d(1-x)Yt-1
Or: Yt - d(1-x)Yt-1 = c + I + G
(b) The general solution is:
Yt = A[d(1-x)]t + (c + I + G )/[(1 d(1 x)]

The stability of the system requires that: d(1 x) be both positive and < 1. This is consistent
with the usual economic assumptions for such a model (i.e., we would expect both the marginal
propensity to consume and the tax rate to be positive and < 1.
This model (with government sector) will converge at a faster rate than the model without
government. That is, the smaller the d(1 x) term is, the faster the convergence process.

(c ) The term on which stability depends is now: [d(1 x) + g]. Now, when we have
convergence ([d(1 x) + g] < 1), the convergence is slower. If g is sufficiently large, there
could be instability/divergence.

5. For each of the following difference equations find on the basis of the characteristic roots
whether the time path involves oscillation or stepped fluctuation and whether it is
explosive.

(a) yt+2 yt+1 + 0.5yt = 2

(b) yt+2 4yt+1 + 4yt = 7
(c) yt+2 + 0.5yt+1 - 0.5yt = 5
(d) yt+2 - 2yt+1 + 3yt = 4

Answer

(a) Complex roots imply stepped fluctuation. Since the absolute value of the roots are:
r = a2 = 1/2 < 1, it is damped.

(b ) With repeated roots > 1, the path is non-oscillatory and explosive.

(c ) Distinct real roots; the dominant root is -1. Oscillation will eventually become
uniform.

(d ) The complex roots have r = 3. Explosive stepped fluctuation.

6. Consider a model of business cycle described below:

Consumption function: Ct = c0 + c1Yt-1
Desired capital stock: Kdt = kYt-1
Given that net investment is defined as:
It = Kt Kt-1

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 and that to keep their capital stock at the desired level investment undertaken by firms is given
by:
It = Kdt Kt-1
implies that investment changes over time according to the accelerator principle:
It = k(Yt-1- Yt-2)
In addition we have the equilibrium condition:
Yt = Ct + It + Gt

Assume the following parameters:

c0 = 0, c1 = 0.5, k = 1.1, and that initially the system is in equilibrium with government
spending, G=50 billion, National Income, Y= 100 billion, consumption, C= 50 billion and net
investment, I=0. Now suppose after 4 periods of equilibrium, G increases to 100 and remains at
that level thereafter.
(a) Derive an equation which, when solved, gives the time path of National Income (Y).

(b) Discuss the time path of National Income (Y) over time.

(c) Chose the parameters c1 and k such that the time path is monotonic and convergent.

Answer

(a) The equation is: Yt = c0 + (c1 + k)Yt-1 kYt-2 + Gt

(b) Initially the system is in equilibrium with G = 50, Y = 100, C = 50 and I = 0. In period
5 government spending increases to 100 and remains at this higher level. With the
given coefficients, this sets off a persistent cycle. This cycle is unstable and Y deviates
from $200 over time.
(c) For example, if we choose the parameters c1 = 0.9 and k = 0.1, there is monotonic
convergence. By analysing the roots of the characteristic equation, it can be shown that
stability requires k < 1.
.