EC400: Mathematical Methods for Macroeconomics Fall 2023

Dynamic Systems
Dmitry Mukhin
d.mukhin@lse.ac.uk

One of the most common ways to solve dynamic models in macroeconomics is to use ap-
proximations. This “perturbation” method allows to solve analytically models with two vari-
ables and is the way large-scale models are solved numerically (e.g. by the software “Dynare”).
Moreover, it allows to plot phase diagrams and impulse response functions to illustrate dy-
namic properties of the models. In general, this approach consists of several steps:

1. Use the sequential or recursive methods to derive the optimality conditions.

2. Combine the optimality conditions with the resource constraints into a system of dy-
namic equations F (Xt+1 , Xt ) = 0, where Xt is the vector of endogenous variables.

3. Choose a point of approximation and linearize the system around that point to obtain
a system of linear equations f (xt+1 , xt ) = 0, where xt corresponds to deviations from
the point of approximation.

4. Solve the dynamic system using the Blanchard-Kahn method, the method of undeter-
mined coefficients, etc.

The two other lectures discuss the first step, while most of this lecture will focus on how to
solve systems of dynamic equations. We start with the simplest examples and move gradually
towards more complex systems.

Linear equations Consider a first-order (one lag) deterministic difference equation:

xt+1 = λxt ,

where parameter λ ∈ R and initial value x0 ∈ R are some constants. Solving this equation
means finding the values of xt in every period t. This can be easily done by iterating the
equation backward:
xt = λxt−1 = λ2 xt−2 = · · · = λt x0 .

This simple example shows that dynamics of xt depends crucially on the value of λ:

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 1. Convergence:

(a) if |λ| < 1, the system converges to zero xt → 0,

(b) if |λ| > 1, the system diverges from zero xt → ∞.

2. Monotonicity:

(a) if λ > 0, the dynamics is monotonic,

(b) if λ < 0, the dynamics is oscillating.

The steady state (SS) of the system is a point x̄ such that if we start from it, we stay there
forever, i.e. if xt = x̄, then xt+j = x̄ for ∀j > 0. It follows that the steady state can be found
by solving equation x̄ = λx̄ and depends again on the value of λ.

3. Steady state:

(a) if λ 6= 1, the system has a unique steady state x̄ = 0,

(b) if λ = 1, the system has a continuum of steady states x̄ ∈ R.

The steady state is stable if xt → x̄ as t → ∞. Thus, steady state x̄ = 0 is stable iff |λ| < 1.
How can on solve a higher-order linear equation? For example, consider a second-order
difference equation
xt+1 = λ1 xt + λ2 xt−1 .

It turns out, one can reduce the order of the system by increasing its dimensionality:
! !
xt λ1 λ2
zt+1 = Azt , where zt ≡ and A ≡ .
xt−1 1 0

Thus, solving a high-order equation is isomorphic to solving a system of first-order equations

— the problem we discuss next.

Linear systems Suppose next that there are two variables (e.g. consumption and savings)
and two linear dynamics equations:
!
x1t
xt+1 = Axt , where xt ≡
x2t

and A is a 2 × 2 matrix. Again, the steady state of the system can be found from x̄ = Ax̄. It
follows that there is a unique steady state equal x̄ = 0 if |A − I| =
6 0 and continuum of steady
states otherwise. Given initial values x0 , one can iterate the system backward and obtain

xt = A t x0 .

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Thus, solving the dynamic system boils down to finding At . The latter can be easily calculated
when A is a diagonal matrix
!t !
a11 0 at11 0
=
0 a22 0 at22

and the system is uncoupled, i.e. the dynamics of each variable can be analyzed separately
from the other one. This is, however, rarely the case in macro models, and finding At is more
complicated in general case. To make progress, we use the results from linear algebra that
effectively transform an arbitrary A into an (almost) diagonal matrix.
We focus here on the simplest case when the eigenvalues of matrix A are real λ1 , λ2 ∈ R
and different λ1 6= λ2 .1 In this case, there exist a diagonal matrix Λ and a matrix Q such that
!
λ1 0
A = QΛQ−1 , Λ= and Q = (ν 1 ν 2 ),
0 λ2

where ν 1 and ν 2 are the eigenvectors corresponding to eigenvalues λ1 and λ2 . Using this
decomposition, it is easy to solve for At :
!
λt1 0
At = QΛQ−1 × QΛQ−1 × · · · × QΛQ−1 = QΛΛ . . . ΛQ−1 = QΛt Q−1 = Q Q−1 .
0 λt2
!
1 0.5
To illustrate this approach, consider an example with A = and follow these steps:
1 1.5

1. Find eigenvalues:

1−λ 0.5
|A − λI| = = (1 − λ)(1.5 − λ) − 1 · 0.5 = λ2 − 2.5λ + 1 = 0
1 1.5 − λ

The roots of this equation are λ1 = 2 and λ2 = 0.5.

2. Find eigenvectors and matrix Q:

! !
−1 0.5 1
A − λ1 I = ⇒ v1 =
1 −0.5 2
! !
0.5 0.5 1
A − λ2 I = ⇒ v2 =
1 1 −1
1
The complex and repeated eigenvalues appear routinely in macroeconomic problems and require special
treatment. This material, however, goes beyond the scope of this course and can be found in textbook “Discrete
Dynamical Systems” by O.Galor.

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 !
1 1
Thus, the matrix is given by Q = .
2 −1

3. Find matrix Q−1 : applying the formula

!−1 !
a b 1 d −b
=
c d ad − bc −c a

we get !
1 1 1
Q−1 = .
3 2 −1

4. Solve for xt :
! ! ! !
1 1 1 2t 0 1 1 x10
xt = QΛt Q−1 x0 =
3 2 −1 0 0.5t 2 −1 x20
!
1 2t (x10 + x20 ) + 0.5t (2x10 − x20 )
=
3 2t (2x10 + 2x20 ) + 0.5t (−2x10 + x20 )

Of course, one can only guarantee analytical solution for a system of 2 equations. If the number
of variables and equations exceeds 2, numerical methods can be used to solve the system.

Phase diagram The dynamics of two-dimensional systems can be illustrated with phase
diagrams. Although this also applies to non-linear systems, we focus here on the case of
linear dynamic equations. Drawing a phase diagram includes several steps and starts with
finding the iso-lines, i.e. the points where one of the variables does not change. To solve for
the iso-lines, it is sufficient to impose x1t+1 = x1t and x2t+1 = x2t . The intersection of the
two lines corresponds to the steady state of the model as both variables are stationary at that
point. Each iso-line also divides the space into an area where xit+1 > xit and an area where
xit+1 < xit . Putting arrows allows to see in which direction the system evolves starting from
any given point.
Further progress can be made using the following observation: the decomposition of ma-
trix A allows to switch from a dynamic system for xt to a dynamic system for yt ≡ Q−1 xt

xt+1 = Axt ⇔ xt+1 = QΛQ−1 xt ⇔ Q−1 xt+1 = ΛQ−1 xt ⇔ yt+1 = Λyt .

The important advantage of the dynamic system for yt is that it is decoupled and its transition
can be easily analyzed. Effectively, the idea is to go from the original basis to the one give
by the eigenvectors y0 = Q−1 x0 , then find the dynamics of yt , and finally to go back to the
original basis xt = Qyt .

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 Similarly to the case of one difference equation, the dynamics of the system depends on the
eigenvalues λ1 and λ2 . Each of them determines the dynamics of yit in the decoupled system.
The different combinations of paths for y1t and y2t give rise to different dynamics of xt around
the zero steady state:

1. If |λ1 | < 1 and |λ2 | < 1, then xt → 0, the system is stable and the origin is called a sink.

2. If |λ1 | > 1 and |λ2 | > 1, then xt → ∞, the system is unstable and the origin is a source.

3. If |λ1 | > 1 and |λ2 | < 1 (or vice versa), then the system is stable along one dimension
and unstable along the other and the origin is a saddle point.

Blanchard-Kahn method So far, we have assumed that the initial values of the variables x0
are known and therefore, the dynamic path xt can be found by iterating the system backward.
In contrast, the agents in most macroeconomic models are forward-looking, i.e. their actions
today depend on what their expectations about the future. This can be easily seen in the
saving problem discussed in the previous lecture, where according to the Euler equation, the
optimal consumption today depends on agent’s expectations about consumption in the next
period u0 (Ct ) = βRu0 (Ct+1 ). In contrast to the accumulated wealth Bt , the initial value of
consumption is not given and has to be determined endogenously. In particular, suppose we
can reduce the saving problem to a system
!
bt
xt+1 = Axt , where xt = ,
ct

where bt and ct are some transformation of savings and consumption. Decomposing matrix
A we get a phase digram with multiple transition paths, each corresponding to some initial
values of b0 (given) and c0 (not known). Each of the paths satisfies both the budget constraint
and the Euler equation and hence, to choose c0 and the equilibrium trajectory we need to
use another optimality condition — the tranversality condition. In “well-behaved models”, the
latter usually implies that the optimal trajectory should eventually lead to the steady state. If
there is only one such trajectory, then the equilibrium is unique. If the the number of such
trajectories is greater than one, then there is indeterminacy and multiplicity of equilibria.
Finally, if there are no such trajectories, then the model has no solution.
The Blanchard-Kahn principle generalizes this insight. Partition variables into two classes:

1. state variables are predetermined at the beginning of a period by the previous history,
2. control variables are not predetermined and can be freely adjusted by the agents.

E.g. household wealth Bt is a state variable and the level of consumption Ct is a control
variable. Similarly, the capital stock of a firm Kt is a state variable, while the level of investment

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It is a control.2 Denote the number of control variables with m and the number of eigenvalues
greater than one (in absolute terms) |λi | > 1 with n. Then the Blanchard-Kahn principle says
that the system has (i) exactly one solution if n = m, (ii) multiple solutions if n < m, (iii) no
solution if n > m. ! !
bt 1 0.5
As an example consider again the case when xt = and A = . As
ct 1 1.5
shown above, the eigenvalues of the matrix are λ1 = 2 and λ2 = 0.5 and hence, n = m and
the model has a unique solution. To find it, consider the equation of the decoupled system that
corresponds to λ1 :
y1t+1 = λ1 y1t .

Iterating this equation forward we get

y1t = lim λ−j

1 y1t+j .
j→∞

Assume that the transversality condition requires convergence to the steady state. Then
limj→∞ y1t+j = 0 and y1t = 0. Another way to understand this condition is to notice that
if y1t 6= 0 in some period t, then y1t → ∞ and the system does not converge to zero. Given
yt = Q−1 xt , condition y1t = 0 implies bt + ct = 0. Thus, for any given initial value of b0 , we
can find the initial value of consumption c0 = −b0 and then iterate the system to solve for the
equilibrium path (bt , ct ), which corresponds to moving along saddle path y2t .

Linearization The equilibrium conditions in macroeconomic models are usually not linear
and there are no general mathematical tools that can be used to solve such systems. To make
progress, economists often focus on linear approximations to the equilibrium systems, which
can then be solved using the techniques discussed above. This approach includes:
1. Choosing a point of approximation. If the economy is stable, then it is reasonable to
assume that it spends most of the time in the neighbourhood of the steady state and
hence, the latter can be used as a point of approximation.
2. Linearizing the equilibrium conditions. Because the deviations in levels are sensitive to
denomination (pounds vs. pence) and hard to interpret, economists usually focus on
log-percent deviations from the steady state.

The following approach works in most cases:

Xt Xt
Xt = X̄ = X̄elog X̄ ≡ X̄ext ≈ X̄(1 + xt ),
X̄
2
However, the same macro variables can play the role of states or controls depending on a particular model.

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where xt is the log-deviation of Xt from the steady-state value X̄. A few useful properties:

Zt = Xta ⇒ zt = axt ,
Zt = Xt Yt ⇒ zt = xt + yt ,
X̄ Ȳ
Zt = Xt + Yt ⇒ zt = axt + (1 − a)yt , a ≡ =1− .
Z̄ Z̄

Example Consider again the savings model discussed in the previous lecture.3 To simplify
the analysis, assume the CRRA preferences, βR = 1, and any shocks to Yt are completely
unexpected. The equilibrium system includes the household budget constraint

Bt+1 = RBt + Yt − Ct ,

and the Euler equation

Ct−σ = Ct+1
−σ
.

Solving the model consists of several steps:

1. Choose the point of approximation: this model does not a have a unique steady state,
which complicates the first step. Instead, we are going to use the initial level of wealth
B̄ = B0 > 0. Substitute this value into the budget constraint to find the steady-state
value of consumption C̄ = (R − 1)B̄ + Ȳ . Define the exogenous ratio α ≡ ȲB̄ and note
C̄
that B̄ = R − 1 + α.

2. Log-linearize the equilibrium system: apply the formulae from above to the EE

C̄ −σ (1 − σct ) = C̄ −σ (1 − σct+1 )

and simplify to
ct = ct+1 .

Similarly, the budget constraint can be expressed as

B̄(1 + bt+1 ) = RB̄(1 + bt ) + Ȳ (1 + yt ) − C̄(1 + ct ),

which after simplification becomes

Ȳ C̄
bt+1 = Rbt + y t − ct ,
B̄ B̄
3
As shown below, this model is not stationary and therefore, local approximations might be not very accurate.
We use this model only for pedagogical reasons to show how it can be solved using different methods.

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 or equivalently,
bt+1 = Rbt + αyt − (R − 1 + α)ct ,

Thus, the linearized system is

! ! !
bt R −(R − 1 + α) α
xt+1 = Axt + Dyt , xt = , A= and D =
ct 0 1 0

3. Diagonalize matrix A:
|A − λI| = (R − λ)(1 − λ) = 0

The roots of this equation are λ1 = R > 1 and λ2 = 1. The corresponding eigenvectors
are given by
! !
0 −(R − 1 + α) 1
A − λ1 I = ⇒ v1 =
0 1−R 0
! !
R − 1 −(R − 1 + α) R−1+α
A − λ2 I = ⇒ v2 =
0 0 R−1
It follows that !
R 0
Λ= ,
0 1
!
1 R−1+α
Q= ,
0 R−1
!
1 R − 1 −(R − 1 + α)
Q−1 =
R−1 0 1
and !
α
Q−1 D = .
0

4. Find the saddle path: define zt ≡ Q−1 xt and consider the first equation of the system

zt+1 = Λzt + Q−1 Dyt

that corresponds to the eigenvalue greater than one:

∞
α 1 α X −j
z1t = − yt + z1t+1 = · · · = − R yt+j + lim R−j z1t+j
R R R j=0 j→∞

The last term is equal zero according to the transversality condition. Given that income

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 shocks are unexpected, we have yt+j = 0 for j > 0. It follows that z1t = − Rα yt and
substituting in the definition of zt we get

α
(R − 1)bt − (R − 1 + α)ct = − (R − 1)yt .
R

Thus, the saddle path is given by

R−1  α 
ct = bt + y t .
R−1+α R

5. Find the law of motion for the state variable: substitute the optimal consumption func-
tion into the budget constraint:

α
bt+1 = bt + yt .
R

Thus, the wealth of households bt follows a random walk with innovations Rα yt .

Continuous time Similar methods can be used to solve dynamic models in continuous-
time. The difference equations are replaced with the differential equations in this case. Given
this analogy, we only scetch the key ideas. Start again with a one-dimensional linear equation

ẋt = λxt ,

which can also be written as

dxt
= λdt.
xt
Integrating the latter expression, we get

xt
log = λt
x0

or equivalently,
xt = x0 eλt .

Indeed, taking a derivative with respect to time, we get the initial equation

dxt
= x0 λeλt = λxt ,
dt

confirming the solution. It is clear from this expression that xt → 0 if λ < 0 and xt → ∞ if
λ > 0. The steady state can be found from ẋt = 0 and is unique as long as λ 6= 0. Thus, the
threshold for λ of 0 plays the same role in continuous time as the threshold of ±1 in discrete
time. This analogy can be seen clearly if we rewrite the difference equation for an arbitrary

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period of time xt+∆ = Λxt = (1 + λ∆)xt and transform it as xt+∆∆−xt = λxt . Taking the limit
∆ → 0, we get the differential equation and the mapping λ = Λ − 1.
Consider next the system of linear differential equations

ẋt = Axt ,

where xt is a vector. If matrix A is diagonal, then the system is decoupled and each equation
can be solved independently. Otherwise, we can use the same decomposition A = QΛQ−1 to
transform the system into a decoupled system for y ≡ Q−1 xt :

ẏt = Λyt .

The Blanchard-Kahn principle still applies: to have a unique solution, the number of control
variables in a model has to be equal to the number of eigenvalues greater than one. The
continuous-time equations can also be linearized in the same way as the discrete-time analogs.

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