BLOCK 6 ECONOMIC DYNAMICS Unit 20 Difference Equations: Theory and Economic Applications Unit 21‘ Differential Equations 225ignou THE PEOPLE’S UNIVERSITY ©)UNIT 20 DIFFERENCE EQUATIONS: THEORY AND ECONOMIC APPLICATIONS Structure 20.0 Objectives 20.1 Introduction 20.2 Difference Equations in Economics 20.3 Solving First Order Difference Equations 20.3.1 Behaviour of Solutions of First Order Equations 20.4 Economic Applications of First Order Equations 20.4.1 Harrod Domar One-Sector Model 20.4.2 The Cobweb Model 20.4.3 The Amortisation Problem 20.5 Solving Second Order Difference Equations 20.5.1, Homogeneous Equations 20.5.2 Behaviour of Solutions of Homogeneous Equations 20.5.3. Stability 20.5.4 Non-Homogeneous Equations 20.6 Economic Applications of Second Order Equations 20.7 Let Us Sum Up 20.8 Key Words 20.9 Answers/Hints to Check Your Progress Exercises 20.10 Exercises 20.0 OBJECTIVES After going through this unit, you should be able to: ‘+ explain the first order difference equations; © apply the first order difference equations in relevant problems; ‘© discuss the second order difference equations; and ‘* solve problems related to second order equations 20.1 INTRODUCTIO) A difference equation is used to solve the values of an unknown funetion y(x) for discrete values of x. We obtain a function y(x) such that it satisfies the equation for all values of x. This unit explains the difference equations and presents their economic applications. The unit will take you through the solving of first order difference equations and second order difference equations with wide range of examples. The difference equations and differential equations are analogous with the only difference that the former applies when the variables take only discrete values, whereas the latter applies when variables are continuous. 227228 20.2 DIFFERENCE EQUATIONS IN ECONOMICS To get an idea how difference equations may come up in economics consider the case where it is known that the national income y of a particular country has been growing at a constant rate g over (say) a ten-year period starting from some base year, The rate of growth of y at any period t may be represented as (2524). Note that this is the expression that gives the rate of growth of y at a particular it point in time. In contrast, you have seen the expression when y was » treated as a continuous variable. Treating y as discrete, we find the numerator as the increment of income in current period (period t) over the level attained in the immediately preceding period (period t-1). The ratio of this to the income y.1 of the preceding period gives the current rate of growth. Since we have said that rates of growth of income, g, is constant (i.e., independent of t) over ten year’s interval, it ean be written as: 12,3, 4, 24 10 or, y= (1 +g) yea, t= 1, 2, ..., 10 (20.1) Equation (1) relates the values of the variable y at two distinct periods t and (t-1). It is an example of a difference equation. There is a one-period lag in the values of the relevant variable (y; and yi) ‘Therefore, it is an example of a first order difference equation. The order of a difference equation is determined by the maximum number of periods lagged, Some examples of difference equations are given below with the orders noted. yea By a= 0 order 1 yi a(yer— yee) + 10 order 2 log yi+9—yer7 (ya) + 6ye= 0 order 9 18 yus— y= 2'- 5 order 4 Yoeg + Day = Ops + order 4 Consider a difference equation of the following form: ym aryert ayer t unt anyon tb where a1, a2, ..., ay and b are constants. This is called an n‘™ order linear constant coefficient difference equation (assuming a9# 0, otherwise the order will be less than n). Itis linear because the dependent variable y is not raised to any power and there are no product terms, constant coefficients because a1, .... dy are constants and do not change with t This equation will be homogencous if b = 0. If b # 0, then it is non- homogenous. In this unit, we shall work only with difference equations of this special type of orders one and two (n= 1, 2).20.3 SOLVING FIRST ORDER DIFFERENCE Difference Equations: Theory EQUATIONS ‘and Economic Applications In solving a difference equation, we find a time path y(0) from a given initial condition. As pointed out above, a first order difference equation takes the form 3H = L(Y.) forall We can solve such an equation by successive calculation, also called recursive method, taking the initial value of y (say yo) as given. Thus, yi =F (L,yo) yo F (2, yi) = £2, £U, yo) and so on, Note that given any value yo, there exists a unique solution path y., yo However, resorting to calculation of the solution through such a method does not tell us much about the properties of the solution, We should have a general formula, which exists if the form of fis simple. Let us start with a first-order linear difference equation with constant coefficient. It takes the form 1, =4y,. +8, for t= 1, ...00, and where a and b are constants. When the recursive method is used, you will see a pattern as follows: ¥,= ay, + Da", (20.2) a and such an equation has a unique solution path. To check that we get the unique solution from the above formulation, verify that it satisfies the original equation. Since we have mY ay, +b = for, +da"s, ) +b, sa'yy+ Yan, =) so that the solution obtained is correct. Taking equation (20.2), we can examine the special case of by = b for all k= 1 We have yaa +b Sa! 229Economie Dynamics 230 Making use of the result of geometric series summation, the term }'a'" may be expanded as 1 +a +a? +... + ato give l+ata’+ ta (-a"y(1=a), if_a+ 1. Thus, we have yee aly + (1 -alV(1-a) ifarl For any given value y., the unique solution of the difference equation Y= ayrr tb, where a #1, is = alls —bi(1 —a)) + BIC a), A) Equilibrium or Stationary Value For a given value yo, the value of y: changes with ¢. But there may be some value of yo for which y, does not change. Such a solution exists if bil a) and y; is constant, equal to b/(1 -a) We call y* the equi rium value of y and rewrite the solution as aye- "+" Example 20.1: Solve y,,,=ay, +f, (20.3) ve where a. and B are constants. Look for a stationary or equilibrium value of yover time which can be repeated for any t consistently satisfying the above equation, Maybe you consider Fas an equilibrium value of y; such that Y=ay+p A 1-6 To understand the above example, we need to remember the dynamic multiplier. Let us consider the Keynesian model ay it B (20.4)By using the above relation we can write (20.4) as Difference Equations: Theory . and Eeonomie Yuan +B ‘Applications Afan equilibrium income ¥ is found, the solution can be written as Y=oa¥+f - A Bt l-a l-a@ Note that —— is the Keynesian multiplier. =a It is important to remember that we have solved equation (20.3) for the stationary level of y: ie., 7. There is no guarantee that the actual path of y converges toy. In case y, approaches j, then (», If these values of y, and y,,, hold, we can write BNP (20.5) Since y, andy satisfy (20.3), we have Yin = ay, +B and y=aytp Thus, a(y,-3) From (20.5), BV of 8. = OF, Bas = Yea OF, 8, = a8, (6) (20.6) Since Spy = 8, B= 88. 8) = 485 Substituting backward, = ag, =08 Gers = Gea = OG we get eee 231232 B= OB, or g,=a'g, for t=0, 1,2. Thus, any difference equation of the form y, =«y,., has a solution y, =a'y,, where y is the value of y at some chosen initial point. B) General Solution Suppose we intend to solve the equation Yan $Y, =e. (20.7) Its general solution will be consisting of particular solution (y,) and complementary function (y,), ie.y,=y,+y,. In this approach, the y, component represents the inter-temporal equilibrium level of y while that of y gives the deviations if the time path from that equilibrium. ‘The solution is called general solution due to the presence of an arbitrary constant, In order to get a definite solution, we need an initial condition. Let us work with complementary function, From (7), we get its reduced from as Joa tay, =0 (20.8) It is scen above that y, =a'y, is a solution to the difference equation. In that case we have y,,, =a'"'y, as well. We modify this and rewrite AB’ and y,., = AB ¥ Substitution of these into (20.8) gives b'"' + ab! =0 or, Ab’ (b+a)=0 or,(b+a)=0 or,b=-a ‘We must have b=—a in the trial solution such that the complementary solution can be written as y, = Ab’ = A(-a) Particular solution needs to be recast such that it is in agreement with the general solution. Consider the simplest value of y. If y, has an equilibrium value k such that it remains constant over time, we have y,= as well as y,, =k. Substitution of these values to the trial solution gives k+a,=e or, k= Ta Since the value, k, satisfies the equation, the particular solution can be written as y, k= for a#0 I¥aIn 1, however, the particular solution is not defined and some other se a solution of (20.7) must be searched for. Substituting k into (20.7), we get k(t+1)+ak, =e. or, k= Cand y,=C,. The general solution can now be written in one of the following forms: or, y= A(~a)' +6, =AtC, ifa= Notice that the solution above still remains indeterminate. This is due to the presence of arbitrary constant A. We have to take the help of initial condition (y, = y,) for eliminating it. Thus, taking t=0, we have c A+ lta or,A=y,-—£ einer The definite solution therefore, becomes. ( cy) Cc = —¢ fe #-l 2 -eies Be ory, =y,+C, fora=-l 20.3.1 Behaviour of Solutions of First Order Equations jion for the relevant variable The solution of a difference equation gives an expres as an explicit fnction of time. In other words, a time path of the variable is obtained. To investigate the nature of this time path of a solution of the first order ‘equation, we write the solution for a # 1 The behaviour of the solution path depends on the value of a. Let us look into the various possibilities. i) If al <1 there will be Convergence _y, converges to y* and the solution is stable. There are two subcases: 0.1 there will be Divergence a> 1 Explosion a <1 Explosive oscillation ‘To understand these features see Fig.20.1 Difference Equations: Theory and Economic Applications 233Econom Dynamics 234 a as — — Le a B , me : ae (200 Fig 20-1: Time paths of different values of “a* a a ‘J — nl oe ¢ oto Le ot ad ali tt In short, |al> 1 time path explodes (diverges) la|<1 time path converges a> 0 time path non-oscillating a <0 time path oscillating. Thus, the condition for stability is. |a|-<1 The different cases are shown in Fig. 20.1 ime paths of different values of “a”20.4 ECONOMIC APPLICATIONS OF FIRST ORDER EQUATIONS We consider three applications of the type of equations discussed in the previous section. The first is an analysis of one sector Harrod-Domar model while the second is of price dynamics. The last one deals with the amortisation problem of hire purchase of consumer durables. 20.4.1 Harrod-Domar One -Sector Model ‘An economy produces one good Q with capital K through a production function Q = bK:, where b = constant productivity of capital. Accumulation of capital between t and t+1 is given by I Keer — Ky, where I, = investment in period t Saving S:= sQ where s is the saving output ratio Equilibrium level of income is determined at the equality of saving and investment. So, Sah or, SQ: = Kr - K.. Since Q: = bK,, we have sbK, = Ki-1— Kr or, Kei = (1 + sb)Ky, a homogeneous first order linear difference equation. Therefore, solution to this equation is given by K=(1 + sb)'Ko. Since b is productivity of capital in the model, we write ; = capital output ratio =v (say). Now Ki (142) Koana Uv) yt s -(i+8 | & Kv) Remember that * = warranted rate of growth and constituted by two basic v parameters s and v. We can find out the output growth rate given s and v. 20.4.2 The Cobweb Model The essential feature of this model is that production or supply responds to price with a one-period lag. This type of lagged supply response is often observed for agricultural products. We assume: i) The market demand and supply functions are linear and do not change over time, ii) demand in any period t responds to price prevailing in the same period , but supply in t depends on price that prevailed in the last period, Difference Equations: Theory and Economic Applications 235Economie Dynamics 236 (t= 1) and iii) the market is competitive in the sense that the price that prevails in each period is the price that equates demand and supply. Thus, the model can be set out as consisting of the following equations: Di=a-bPsab>0 Si=a—B Pra, B>0,a 0 The time path of P; will always be oscillatory. Let us denote the constant iw by P*. +B Then .) (2) 1, Price diverges. 1h BY (2 = | Price oscillates uniformly. hb) ) (4 <1 Price converges to P*. wb) Only in the last case (P, approaches P* as t increases), that is the system is stable. ( \ Thus, the condition for stability is (4)< 1. Since graphically (5 Jis the slope \b) ) (1 of the supply curve and | ‘| is the slope of the demand curve in absolute value, \ the stability condition states that the slope of the supply curve must be steeper than the absolute value of the slope of the demand curve.a-a b+B At this point, we pause to note the significance of the value «This is the constant value of price that is a solution of the equation (20.9). To check, substitute P; = P,-1 = P* (a constant) in (20.9). p(B )p. ane Cb b a-a or, PY = b+B ‘Thus, P: = ip a solution of (20.9). This type of constant solution is called Stationary solution, The price P” may be called the equilibrium price because it equates demand and supply and stays unchanged over time. Example 20.2: We want to investigate the behaviour of price in a market with the demand and supply functions Dr, = 86 -0.8 Py Si== 1040.2 Prat Assuming market clearing in each period (D, = S:) we have (0.8) P= 0.2 P.-1- 96 or, Py = (-0.25)P\_1 + 120 The solution is 120 \(0.25) + 2 +0.25 1+0.25 i Po [Ro \ = (Po- 96) (-0.25)' + 96 Since |-0.25|= 0.25 < 1, the time path of P is oscillating but converges. The market is stable and with the passage of time price approaches the equilibrium value 96. 20.4.3 The Amortisation Problem We are all familiar with the practice of hire purchase or purchase by instalments of consumer durables like refrigerators, cars or T.V, sets. The buyer pays a part of the price at the time of purchase (the down payment) and pays the rest in monthly or annual instalments over a specified period. Because the payments are spread over a period, an interest cost is included in the value of instalments. Amortisation is the term associated with this method of repaying an initial debt plus interest charges by a series of payments of equal magnitude at equal intervals. Denote the value of the article purchased by V and the down payment by P. Then the initial debt of the buyer is Do = V—P. The contract states that the debt, Do is to be paid off over T periods. The rate of interest is r (expressed in percentages as 100%). The question we are interested in is: how is the magnitude of periodic instalment to be determined? Difference Equations: Theory and Economic Applications 237Economie Dynamics 238 Let us denote the value of the instalment (still unknown) by B. This value stays constant over time, The outstanding debt D, at the end of the period t obeys the equation D=(1+)D1-B (20.11) This simply says that to find the outstanding debt at the end of the t" period you take the debt outstanding at the end of the previous ((t— 1)*) period Dy-1, add the interest charge on it, r Dy-1, but subtract the payment B made in that period. Given the initial debt of Do the solution of (20.11) is p= [0,12 \asn+ 2 (20.12) \ r} r The value of B is to be selected so that the debt disappears at the end of period T, that is, Dy = 0. From (20.12) we get B / (po, +2 a ++ ==0 vir} r rD, 1-d+n* or, B= Thus, we have the exact relationship between the magnitude of the periodic payment and the rate of interest, the magnitude of the initial debt and the time horizon of the contract. The expression: (ee) Lor is referred to as the amortisation factor and value of this factor has been extensively tabulated for different values of r and . Check Your Progress 1 1) What is a difference equation? Distinguish it from a differential equation, 2) Discuss the nature of the following time paths, i) y= HL ii) y,=5(-4) 3 Ox-Fe1 GH =3[-7) 433) Suppose you find the following the path of y. Difference Equations: Theory y= Aa’ + B; A<0,B>0. and Economic ‘Applications Draw the different cases of the behaviour of yt for different values of a 4) Solve the following equations: 20.5 SOLVING SECOND ORDER DIFFERENCE EQUATIONS A general second order difference equation which we have already mentioned at the beginning outset of this unit takes the form yor =L(G Yo Yo) Just as in the case of first-order difference equation, a second-order difference equation will have a unique solution and can be derived by succes (recursive) calculation, We will show that given y, and y, there exists a uniquely determined value of y; for all £2 2. Note that for a second-order equation we need two starting values, yo and yi, in place of one taken in the first order counterpart. ive 20.5 Homogeneous Equations Consider the following second-order constant coefficient difference equation +ay,,, ty, =0 (20.13) We need to find two solutions of the equation above. Ifwe make a guess that the solution takes the form u;= m! In order for u;to be a solution, we must have m'(m? + am + b)=0 239240 or, ifm #0, m+ am+b=0, This is called the characteristic (or auxiliary) equation of the difference equation and its solutions are —(1/2)a 2N((1/4)a? -5). 20.5.2 Behaviour of Solutions of Homogeneous Equations Looking at the component \((1/4)a? —b), we distinguish three cases: i) Distinct real roots If a? > 4b, the characteristic equation has distinct real roots, and the general solution of the homogeneous equation is Am‘, + Bm, where m,and m, are the two roots. ii) Repeated real root If a= 4b, then the characteristic equation has a single root, and the general solution of the homogeneous equation is (A+ Bom, where m =—(1/2)a is the root, iii) Complex roots If a'< 4b, then the characteristic equation has complex roots, and the general solution of the homogeneous equation is Ar cos(01* 0), where A and @ are constants, ‘Vb, and cos @ = -a/(2Vb), or, alternatively, Cir’cos(8) + Cor'sin(81), where C)= A cos @ and C2 (cos x)(cos y) (sin x)(sin y). —A sin @ (using the formula that cos(xty) = When the characteristic equation has complex root, the solution oseillates. Ar‘is the amplitude (which depends on the initial conditions) at time f, and ris growth factor. 0/27 is the frequency of the oscillations and « is the phase (which depends on the initial conditions), If Ir] <1 then the oscillations are damped; if |r| > 1 then the oscillations are explosive.20.5.3 Stability We say that a system of difference equations is stable if its long-run behaviour is not sensitive to the initial conditions. Consider the second-order equation Vena Deas +BY, Write the general solution as yim Aus + Brit it, where 4 and B are determined by the initial conditions. This solution is stable if the first two terms approach 0 as ¢ —»20, for all values of A and B. In this case, for any initial conditions, the solution of the equation approaches the particular solution u*. If the first two terms approach zero for all A and B, then u; and v; must approach zero, You can take A= 1 and B= 0 to see that u; approaches zero. On the other hand, take A = 0 and B= | to see that vy, approaches 0. A necessary and sufficient condition for this to be so, is that the moduli ie, the absolute value of the roots of the characteristic equation be both less than 1. Note that the modulus of a complex number a+ Bi is +V(a? + B?), which is the absolute value of number if the number is real. rl wre two cases: + If the characteristic equation has complex roots then the modulus of each root is Vb (the roots are otf, where & = —a/2 and B= \(b— (1/4)a’)). So, for stability we need 6 <1 + If the characteristic equation has real roots then the modulus of each root is its absolute value, So, for stability we need the absolute values of each root to be Tess than 1, or |-a/2 + V(a/4 -6)| <1 and |-a/2 —V(a*/4 -B)| <1 20.5.4 Non-Homogencous Equations To find the general solution of the original equation yea + ayer + Byer we need to find one of its solutions. Suppose that b + 0. The form of a solution depends on c:. Suppose that c= ¢ forall r. Then y; = Cis a solution if C= cl(1 +a + b) and if 1+atbe0; if | +a +b =0 then try y,= Cr; if that does not yield a solution, we have to try y= CP, Difference Equations: Theory and Economic Applications 241Economie Dynamics 242 20.6 ECONOMIC APPLICATIONS OF SECOND ORDER NON-HOMOGENEOUS EQUATIONS Now we discuss an economic example of a second order non-homogeneous equation, This is Samuelson’s model of interaction between the multiplier and the accelerator. Consider the following macro-economic equations: C= Co+ ei, 00 YeCth The symbols Y, C, I stand for national income, consumption and investment respectively. The first equation is the consumption function with a one-period lag; the second is the investment function of the accelerator type. Co + Ioare the levels of autonomous consumption and investment, The marginal propensity to consume ¢ and the accelerator coefficient v are assumed to be constant. The third equation is the condition of macro balance. The three equations together generate the following difference equation in Y Yi-e(1 +v) Yiu tev¥i2= Co +o -- (20.15) ‘The characteristic equation for the homogeneous part is m’-c(1 +v)m+cv=0 The roots are mi,m2= ; (cl + v4 Je? + v9)? —4ev) (20.16) Both m; and m2 are positive because from the theory of quadratic equations we know my + me = e(1 + v) > 0 and mim, = ev > 0. Since e(1 + vy) — ev # 1, the ott Particular solution is “1 -c Three types of solution are possible depending on the values of ¢ and v. 1) (1 + v)P> dev or, o(1+v)> 4y, the roots are real and distinet. Here, ; Ai, Az# 0 and constants 2) o(1+v)* = 4y, the roots are real and equal with value fou +y). In this case ? +1, year Ay CY) fo 2 Ive 3) e(1+v)*<4y, the roots are complex. From (20.16) we see that the roots are of the form (a + ib) withDifference Equations: Theory and Economic Applications because, 6% + v)* — 4e0=y/F (dev= e714 )")= ide e814) = i fdev—c?(1+v)* = 2ib The modulus of the roots = Va? +8 = Sev The solution is Y. = (vev 2 (Ar cos(t@ + Ao sin (t8)) + ath { 4ev-c2 +)? | e(l+y) where 0= tan” In this case, we have a cyclical time path of national income Y. If Vev < 1, then Cth, (ev Jt will tend to zero as t increases and Y; will approach the value Thus, the condition for stability (damped oscillations in Y) is Vev <1, that is, the product of the marginal propensity to consume and the accelerator coefficient should be less than unity. Check Your Progress 2 1) Solve the following difference equations and determine whether the solution paths are convergent or divergent, oscillating or not. 8) Yr t 3yn = (T/A) y= 9. b) Yoo 2¥n+2y.= 1 ©) Yor — You + (LADY, = 2, ) Yor + 2m + Y= 9-2 ©) Yer — By ty, = 3-Se+ sin((1/2)n0). 243244 2) a) Find the roots of the equation y= ay.) + byi2 b) Examine when the roots are ‘) real, unequal ii) real, equal iii) complex ©) What is the auxiliary or the characteristic equation of the equation above? What are the final forms of general solution of the equation in each c¢ 2 3) Find the solutions of the equations: a) yi + 4yr-2=0, y=12, I] att=0, | respectively. b) y= 2y-2- fy2,y=0, Lat t=0, | respectively 20.7 LET US SUM UP The present unit took up ‘time’ as a discrete independent variable and examined , we considered the the tool of simple difference equations. In the prot solutions of first order and second order linear difference equations covering homogeneous and non-homogeneous cases. To see the applications of these equations to economic problems, the time path of adjustment of macro-economic variable — national income — in the case of the simple Keynesian multiplier model and Samuelson’s multiplier-accelerator interaction model were discussed. We also examined the time path of adjustment of the price variable and looked into the conditions of dynamic stability of the different systems — i.e., whether over time, the economic variables — price or national income — converge to a stable equilibrium. Finally, the conditions when the systems become dynamically explosive — ice, the variables move further and further away from the equilibrium value -were examined,20.8 KEY WORDS Amortisation Cobweb Model : Constant Coefficient: Difference Equation Difference Equation Homogeneous : Difference Equation Linear Difference Equation Non-homogencous Difference Equation Order of a Difference Equation It is the term associated with the method of repaying an initial debt plus interest charges by a series of payments of equal magnitude at equal intervals It is a model where production or supply responds to price with a one-period lag. This model is often used to analyse the demand-supply mechanism for markets of agricultural commodities. A difference equation has constant coefficient if the coefficients ai’s associated with the y values are constant and do not change over time. A difference equation is an equation involving the values of an unknown function y(x) for different values of x. The independent variable time, in problems of economic dynamics, takes only discrete values. The form of the equation is, y: = aiyui + sayin + sas} anont * b Where ai, a2, ....5 dy and b are constants, is an example of an n-th order linear, constant coef ‘ent, difference equation. A difference equation is homogeneous if the constant term b is zero. A difference equation is linear if (i) the dependent variable y is not raised to any power, and (ii) there are no product terms. A difference equation is nonhomogeneous if the constant term, b, is non-zero. Tis determined by the maximum number of periods lagged. Equatio Difference Theory and Economic Applications 245Economie Dynamics 246 20.9 ANSWERS/HINTS TO CHECK YOUR PROGRESS EXERCISES Check Your Progress 1 1) See Section 20.1 2) Non-oscillatory; divergent 3) Oscillatory; convergent Fig, 20.1 shows the time path for a> 0, Draw the corresponding figures for aco, 4) i) y,=-8| l ) +9 i) -2fz! ) +4 Dy=8l3 : ii) y, la Check Your Progress 2 -7) +a(Z | +4. Non convergent oscillations, (x), sin| = |r J+1.. Non convergent o 4 (1 4 4i{5 | +8, Convergent, non-oscillating, 2mv1=(m+lP=0, which has a double root of -1. So, the general solution of the homogeneous equation is ,+C,t)(-1)'. A particular solution is obtained by inserting d) The characteristic equation ism’ = A2', which yields A= 1. So, the general solution of the inhomogeneous equation is_y, =(C, + C,t)(-1)' +24 e) By using the method of undetermined coefficients the constants 4, B, and C : (x 2) in the particular solution wu’ = AS + Boos| 5 t+ Csin| z |, we obtain (2) A= 1/4, B= 3/10, and C= 1/10. So the general solution to the equation is la (3 (n\))¢ (nr) \ y=, sor s(t)s cos 5} + wlS on aP 0 10 (2 2) a) See Section 20.5 and answer. b) Note that in the text yi = ay:1 + by. ©) Here you have a slightly changed equation, 3) a) y=a[neo(2).t if =)Difference = 2 ) ) ‘Equations: Theor Applications where @ = tan! (4) 3) 20.10 EXERCISES QI. Investigate the behaviour of price in a market, ie., the stability of a system with demand and supply functions: a) Di= 86 -0.8 Pr S1=-10+ 0.8 Ps b) i= 86-0.8 Pr Ans. Note that for the Cobweb model D.=a-bP Si= a+ BP a, B: Di=Seforall t A specification of the initial price Po allows us to solve the equation (py . It [5 ] > Oast oe, Pes P*, the equilibrium value, Lb) This is possible if and only if fe 1 ie, B or, the slope of the supply curve = the absolute slope of the demand curve. b) b=0.8,8=0.9 Hence —=1 or, B>b. 1 or, 4 function. Take, for example, the above solution, y = te with e= 0. Then ay dx or, dy = x?dx or, dy—x7dx=0 ‘Note that ‘0’ in the right side of this solution is due to a choice like c = 0, So we write dy—x7dx =e, (where c= constant) Generalising the above result, we ean write u(x, y) =e. So, du=usds + uydy =0 x8 Let us take a example: Ifu= —*—+ y, then du =-x2dx + dy =0 By solving the above equation we get 2 =x Sinceu= + y, 3 a and 4 =} ar oyTherefore, dx = m and dy - 2 From these we write the generalised form of elastin ‘ a» differential equation as P(x, y) dx + Q(x, y) dy = 0. 2 we ay If we can find a function g(x, y) such that P(x, y) = “Sand Q(x, y) = ex write [a y= Zax+ S ay = P(x, y) dx + Q(x, y) dy. Then g(x, y) = ¢ are integral curves of the above differential equation. This ck of differential equations is called exact differential equations, To determine if a differential equation is exact or not, we need to check whether, @P _@Q ay ar Example 21.2 : For xdx + ydy =0, set g= ForHy? ‘Then gx = xdx and gy = ydy. The solutions are x+y? =e, or circles. Example 21.3: From, (3x”+y”)dx + 2xydy = 0, we get P(x, y) = 3x*+y? QUx, y) = 2xy, so that Py=2y=Q«. The equation, therefore, is exact. Example 21.4: Solve the exact differential equation 2yxdy + y7dx = 0 In this equation P(x, y) = 2yx Qe y=y* Now F(, x) = [2yxdy + $(x) = y"x+ 600, Fay +9) As Qa we equate Q(x, y) = y? and aF +¢'(x) to get g'(x)=0 dx dx (x)= J # (ade = J Ode = k, which give the specific form of ¢'(x) So, Fly,x)=y*x+K The solution of the exact differential equation should then be F(y, x) = c. K being a constant can be merged with ¢, so that y°x = ¢, or yx = ex"! where e is arbitrary. 253254 A first order linear differential equation is general written as P(x)y = (x) (21.1) where P and Q are two functions of x, and that of y. P and Q may also be expressed in other forms as x? and e*. These may also be constants. Now, we will discuss homogenous differential equations. 21.3.1.1 Homogenous Case If P and Q are constant functions and if Q is identically equal to zero, equation ay (21.1) becomes + ay = 0 where a is some constant (21.2) ix Please note that the constant term ‘0° can be regarded as in the first degree in terms of y because Oy = 0. Equation (21.2) can be written as 1 dy (21.3) y de dy ; For solution, we write “” = cdx (with ¢ = —a) and integrate both the sides, such y that je =Jede. The left side of the above gives log y +e: for y #0, » Where as the right side becomes cxter Bringing together the result of the left and right sides, logy +1 = exter or, log y = cdx + ¢3 (combining ¢; and c2 of both sides) onebty= or, y= €7.€9=A ee where A= e* Putting back ¢ =a, we get y(x) = Ae where A is arbitrary -(21.4) To get rid of the arbitrary constant, set x = 0 in the equation y(x) = Ae, so that y)=Ae® =A. Thus, y(x) = y(0)e™ (21.5) In (21.4), A is an arbitrary constant. The solution, therefore, is a general solution. When a particular value is substituted for A, we derived the particular solution in (21.5). There are an infinite number of particular solutions, value of (0). However, y(0) is important since it can alone satisfy the initial condition.From the feature of giving a definite value to the arbitrary constant, we refer the result in (21.5) as the definite solution of the differential equation, 21,3.1.2 Non-Homogenous Case When we have a non-zero constant in place of the zero in equation (21.2) above, it is called a non-homogenous linear differential equation Thus, 2 + ay=6 +. 21.6) dx is a non-homogencous differential equation, The solution of this class of equations has two parts, (i) complementary function (ye) and (ii) particular integral (yp). Before we proceed to solve equation (21.6), it will be useful to point out that homogencous equation (21.2) is called a reduced equation of (21.6) and the non-homogenous equation (21.6) itself is categorised as the complete equation. Moreover, the complementary function (yc) is the general solution of the reduced equation, whereas the particular integral (yp) is one of the particular solutions of the complete equation. Solution to non-homogenous differential equation is seen as a sum of the complementary function and the particular integral. Thus, y(x) = ye * yp. We have noted above that yc is the general solution of the reduced equation. We take the general solution of the homogencous differential equation (21.4) above, which was Ae“. Thus, ye= Ae. Let us now consider particular integral. Recall that it is any particular solution of the complete equation. Perhaps the simplest possible type of solution we can think of is to take it being some constant (y = k). As we are taking y as a constant, we get 2 =0. Therefore, equation (21.6) becomes ay = b, or y= > where a #0. b In that case yp= ~ , and we get the general solution to the equation as a yoy Aes 2 we QUT) a See that the solution remains general, The presence of arbitrary constant A is responsible for it, In order to make it definite, we need to take an initial condition. Setting x = 0, y can be assigned the value y(0) and we get yo=a+e on A=yo)- 2 a Differential Equations 255Economie Dynamics 256 Putting this value in (7), the solution becomes, f. bY) na, b Y(x) = | »(0)- Je +2 -- (21.8) ea a which is the definite solution as long as a # 0. Example 21.5 : Solve the equation & +2y=6 with the initial condition x y(0) = 10. We have a=2 and b= 6. Hence, according to (21.8), the solution is y(x) =[10—3]e* +3=7e% +3 Solution: when a= 0 ir ® 4 ay=bhas a=0, then ax ay —=b w. (21.9) ae (21.9) Its general solution is found by integration, i.e., y(x) = bx + ¢ where ¢ = arbitrary constant, Complementary funetion: with a= 0 ye= Ae™ = Ae? =A (A= an arbitrary constant) 21.3.1.3 Particular Integral As a = 0, the constant solution y = k does not work and some non-constant solution needs to be tried. Take y = kx so that 2 = From the complete equation (21.9) above k=b. yp=bx General solution: y(x) = ye + yp = A + bx 21.3.1.4 Verification of the Solution ‘You can check the correct answer of your solution to a differential equation by taking its differentiation. Carry out the following two steps: 1) Test that the derivative of the time path is consistent with the given differential equation, 2) Test the definite solution to find that the solution satisfies the initial condition.Check Your Progress 1 1) Solve the equation a. 4y =0 with initial condition y(0) = | 2) Find ye, yp, the general solution and definite solution of the equation and check its validity for the following equation: B say =12490)=2 21.4 ECONOMIC APPLICATIONS In this section, we discuss the applications of first order linear differential equations to Economics. The general form of a first order linear differential equation (first order linear) Ds my=k (21.10) dx where m and k are constants. The formula for a general solution (assuming m ois yeaems & QLD, m where A is an arbitrary constant. It would be good for you to check that (21.11) indeed satisfies equation (1). The value of A can be fixed if an initial condition is given, For m= 0, k #0, the solution is y = kx + A where A is an arbitrary constant. Example 21.6 : Solve 4 —4y=20with y(0) = ik From the formula (21.11) a general solution is y= Act—5, Also, y(0) = A-5= 15. So, A=20. The solution then is y= 20.e% — 5, Differential Equations 257258 Application 1: The Harrod -Domar Analysis of Steady Growth Consider a macroeconomic model consisting of the following equations: SD =sY(H),00 dx sw =10) where Y, S, I stand for the rates of flow of national income, planned saving and planned investment at any point of time t. The first equation says that a constant fraction s of income is saved in each time period. The second equation represents the accelerator theory of investment in which induced investment is proportional to the rate of change of income (v is a constant of proportionality). There is no autonomous investment, For dynamic equilibrium, we need equality between saving and investment in each period. The three equations of the Harrod-Domar model, lead to a simple differential equation dY os doy y=0 (21.12) By formula (21.11), the general solution is Y= Ace Suppose it is known that Y = Yo at t= 0. Then A = Yo so that the equation becomes Y(t) = Yoo" (21.13) This solution gives the behaviour of national income over time in dynamic equilibrium. For any variable x that changes with time, its rate of growth at any point in time is defined to be (22) the rate of change of x divided by (as a x dt) proportion of) the value of x at that point of time. It is clear from equation (ar) (21.12) that in this model the rate of growth of national income the constant value “, In other words, national income grows at the constant rate © in dynamic equilibrium. It follows as a corollary from our discussion that if a variable x is changing at a constant rate g over time (growing if g > 0, decaying if g <0), then its time path is given by x = xo e® where xo is the value of x at initial or base period (1 = 0).Application 2: The Dynamics of Price in a Single Market Our next application is from micro economics. It will help us to understand the notion of stability of equilibrium Suppose the demand and supply functions for a particular commodity are given by D, =a-bPy S =c+bPya,b,c,d>0,a>c ‘The equilibrium price in this context has the property that it (i) clears the market in each period and (ii) does not change over time. Let us denote it by P". (Note that since it is constant through time there is no subscript). Writing P* for Py in the demand and supply equations and setting D, = S; we obtain the expression for the equilibrium price P= bed The restriction a> ¢ ensures that P” is positive. Now comes an important point. Knowledge of the equilibrium price tells us nothing about the behaviour of price out of equilibrium. In other words, although we know P* we do not know what. happens when in any period t the price P; is not equal to P”. Does price rise or fall or fluctuate in some unpredictable manner? ‘To answer questions of this type, we must introduce a dynamic adjustment rule for price. It seems natural and sensible to assume that price will tend to rise if demand exceeds supply and fall if demand falls short of supply and stay unchanged if demand and supply just balance in any period. This type of adjustment is incorporated in the analysis through a simple linear relationship. a _ 9 .-S), &0 (1.14) at Since dis a positive constant, this tells us that i) P= oorPrises if D> Ss: at it) ~ oor falls if < Sand at iii) 2 = 0 or P stays unchanged if D, = S; it ‘Substituting the demand and supply funetions we obtain the differential equation for price aP dt ab + d) P= Aa—c) Differential Equations 259Economie Dynamics 260 ‘This, being of the form (21.13), has the solution a-c bed PH Acar y Suppose it is known that P = Po at t= 0. Then from the above solution A=|P,-2=*]. But £—© =p’, the equilibrium price. So the solution can be b+d b+d written as P=(Po—P*) Aca? ot + pr «. (21.15) This completely describes the time path of price in the market characterised by the given demand and supply curves and the adjustment rule (21.14). Note that the time path (for any given initial price Ps) is determined by the demand and supply parameters (a, b, c, d) and the coefficient of adjustment @ The dependence of the solution on brings out clearly the importance of adjustment rules in dynamics. Now let us take up the question of stability, Suppose that the initial price Po is not the equilibrium price P’, that is (Po — P°) # 0. The system is stable if price tends to approach the equilibrium price P* as time passes, that is if Le P(t) =P” It is clear that since @ 0 and (b + d) > 0 the term e~*' ®" (and hence the first term of (21.15) will tend to zero as t tends to infinity, so that P will indeed converge to P* and we have a system that is dynamically stable. Check Your Progress 2 1) If the rate of change of y with respect to x is 2x and y = 4 when x find y as a function of x. 2) The rate of change of y with respect to x is (0.8x — 0.6x) and y = 0 and x =0. Find y as a function of x.21.5 LET US SUM UP You have seen that dynamics is essentially concemed with change and the effec of change on the behaviour of variables over time. Dynamic analysis considers the actual process of transition from the initial pre-change position to the final equilibrium, Hence, economic dynamics in continuous time always has the time period as an independent variable. In this unit, you have been introduced to differential equations as a tool of dynamic analysis, The use of indefinite integral and definite integral in solving the differential equations was discussed. 21.6 KEY WORDS Definite Integral : The definite integral of the function (x) over the interval (a, b) is expressed symbolically as | f(x)dx, read as “integral of f with respect to x from a to b The smaller number a is termed the lower limit and b, the upper limit of integration. Geometrically, this definite integral denotes the area under the curve representing f(x) between the points x = 0 and x = b. Note that the definite integral J @)is a number. Indefinite Integral: The indefinite integral is _ basically _ reverse differentiation. To differentiate means to find the rate of change (derivative) of a given function, Indefinite integration reverses the process and finds the unknown function whose rate of change (derivative) is given. Differential : Differential equations are equations involving the Equations derivatives (or differentials) of unknown functions. Solving a differential equation means finding a function that satisfies that equation. Economie Dynamics : Dynamics is essentially concemed with change and the effects of change on the behaviour of variables over time, Economic dynamics deals with economic variables like national income, price, etc. The task of dynamics is to consider the actual process of, transition from the initial pre-change position to the final equilibrium, Differential Equations 261Economie Dynamics 262 Order of a : Ibis the order of the highest derivative appearing in Differential the equation Equation Degree of a : It is the highest power to which the highest order Differential derivative is raised. Equation 21.7 ANSWERS/HINTS TO CHECK YOUR PROGRESS EXERCISES Check Your Progress 1 1) yx) = (0+ C= 2) y(x) = 43 Check Your Progress 2 or fa ory=x +e 2xdx = 2 xdx = Now y=4 when x= I so that 4=1 +core+3. 2 Da08r-0.6x7 or Je =f. 8x —0.6x? dx = [0.8xdx— [0.6x°de 0.8) xdv—0.6f x°dx 2 3 x x = 08-06% + ¥ 2 37° ory =0.4x7-0.2x° Now y=0 forx=0 = 0-0 y =0.4x?— 0.2x521.8 EXERCISES Differential Equations Qu. Ans. Q. Ans. Ans. 4. Ans. Solve the equation 2 =5y=-25with y(0) = 6 rc m 2! 5 = Ack +5 yaAe® + Now, y(0) = 6 => Ae? +5=60rA.1=1orA=1. y=e% +5, is the answer, Explain the dynamics of price adjustment process in a single market. What happens if 6< 0? See application 2 of Section 21.4. If 0< 0, the system cannot attain a stable equilibrium, i.., the system is unstable, You reason why. Solve the equation 4 +4y =0, with initial condition y(0) = 1. te y(x) = [1 - O]e* +e Find ye, yp, the general solution and definite solution of the equation and check its validity £* + 4y-=12; y(0)=1 yQx) = 43 263NOTES 264MPDD/IGNOU/P.O. 5.3K/September, 2023 ISBN : 978-93-5568-992-4