Giancarlo Gandolfo

Economic Dynamics
Study Edition

Fourth Edition

^ Springer
 Chapter 15

Second-order Differential
Equations in Economic Models

While second- and higher-order difference equations are frequently met in

economics, examples of the use of 'direct' second- or higher-order differential
equations are scarce. Let us first explain what we mean by 'direct'. As
we shall see in Chap. 18, a simultaneous system of differential equations
can always be transformed into a single differential equation of a certain
order. Thus a second- or higher-order differential equation can result from
the transformation of a system. By 'direct' we mean differential equations
that arise directly, and not as a transformation of a system, in economic
dynamics.
Now, in the context of period analysis, it is normally the case that lags
can be plausibly poured over the model: for example, in any macroeconomic
model built in discrete time one can introduce investment and consumption
functions with distribuíed lags. On the contrary, in the context of continuous-
time analysis it is more difficult to give an economic meaning to derivatives
of order higher than the first, and henee to introduce them 'directly' into an
economic model.

15.1 The second-order accelerator

We have already met the accelerator in the context of Samuelson's multiplier-
accelerator model in discrete time (see Sect. 6.1). A more general investment
function relates net fixed investment to the gap between the desired and the
actual capital stock, i.e.

K' = I = a(K* - K), (15.1)

where a > 0 denotes the speed of adjustment, and for simplicity we have
assumed no depreciation. Equation (15.1) is a partial adjustment equation
of the type illustrated in Sect. 12.4, and is called the capital stock adjustment

G. Gandolfo, Economic Dynamics, 223

© Springer-Verlag Berlín Heidelberg 2010
224 Chapter 15. Second-order Differential Equations in Economic Models

principie. This equation leaves the desired capital stock undetermined, and
can give rise to different investment functions according to the specification
of K*. The desired capital stock is presumably related to output (we neglect
financial factors), which should be expected output, but to keep the matter
simple it is often assumed that K* = kY, namely K* is proportional to
current output according to the capital/output ratio k, that can be taken as
fixed in the short run. Thus we have

K' ~ I = a(kY ~ K). (15.2)

Equation (15.2) is called the flexible accelerator, and has been introduced
by Goodwin (1951), although in a non-linear context. The simple accelerator
can be shown to be a particular case of the flexible accelerator when the
adjustment speed tends to infinity. In fact, in the case of a —> oo, we have
instantaneous adjustment (see Sect. 12.4), i.e. K = kY. Henee the capital
stock varies simultaneously with output, i.e., differentiating with respect to
time we get I = kY', that is the continuous-time formulation of the simple
accelerator.
The second-order accelerator represents a further development of the cap-
ital stock adjustment principie and of the flexible accelerator, and arises when
/ in Eq. (15.1) is interpreted not as the actual, but as the desired level of
investment, /*. Actual investment is then carried out according to a partial
adjustment equation of I toward /*, namely

I' = 0(1* - I ) = (3[a(K* - K ) - I ) . (15.3)

The idea underlying the second-order accelerator is that actual investment

expenditure is the result of a two-stage decisión process: in the first stage
entrepreneurs determine the gap between the actual and the desired capital
stock, that they would like to fill with a certain adjustment speed measured
by a; this gives rise to desired investment. In the second stage they carry out
investment, that however is not instantaneously equal to its desired level due
to production lags and other frictions, henee the partial adjustment equation
of I toward I*. The second-order accelerator was developed independently
by Gandolfo and Hillinger in the 1970's, and can be given a rigorous microe-
conomic foundation (for this aspect see Hillinger et al., 1992, where previous
studies are also examined).
Since I' ~ K", by rearranging terms in Eq. (15.3) we have

K" + Í5K' + a(3K = a¡3K\ (15.4)

Let us neglect for the moment the determinants of AT*, and consider it as a
generic function of time. Then Eq. (15.4) is a second-order non-homogeneous
equation in K. The characteristic equation of the homogeneous part is

A2 -(- 3\ -f- o¿¡3 — 0.

15.1. The second-order accelerator 225

Since the succession of signs of the coefficients is + + +, the movement will

be stable. As regards the nature of the roots, let us consider the discriminant
A = (32 — 4a(3, which will be positive, zero, or negative according as

0 = 4 a. (15.5)

Henee the model is capable of generating stable oscillations endogenously, i.e.

its ability to describe investment cycles is independent of the specification of
K*. Hillinger refers to the gradual, rather than immediate, adjustment of I
to I* as the 'inertia' of investment, and observes that 'as in physical systems,
inertia potentially leads to overshooting and eyelieal behaviour because K* =
K does not imply I = 0, so that a positive or negative rate of net investment
continúes and K again departs from its equilibrium level' (p. 168).
A particular solution to Eq. (15.4) can be found by applying the general
formula of variation of parameters, Eq. (14.36) in Chap. 14. This gives

m . K ¡ m f £ ! » , , + ,m I ( 1 M )

where K2(t) are the two components of the solution of the homoge-
neous equation, and W(t) is the Wronskian of that equation.
This treatment is valid only in so far as K* is independent of Y When
K* is related to Y, for example through the naive assumption K* = kY that
we have already used before, the structure of the homogeneous part changes
unless we are willing to assume that Y is wholly exogenous. In fact, in the
context of a simple model of income determination, Y is related to / through
the multiplier. If we build a very simple macroeconomic model by adding a
standard consumption function without any lag (the introduction of a partial
adjustment equation in the consumption function would increase the order
of the final equation), C = a + bY, 0 < b < 1, we obtain

Y
=c + I
= T^b{I + a) =
T^b{K' + a)
> (15 7)
'

which is the standard multiplier equation. With K* = kY, Eq. (15.4) be-
comes ^
K" + ¡ÍK' + al3K = apk—^— + aPk-?—,
l—o l—o
i.e.
K"+ 011- ———— | K' + apK = aBk—. (15.8)
y 1 — bJ l —o
A particular solution is easily found by letting K = K= constant, whence

K = k—^— = kYe, (15.9)

l —o
226 Chapter 15. Second-order Differential Equations in Economic Models

which is the capital stock corresponding to the static equilibrium valué of

output.
The characteristic equation of the homogeneous part is

A2 + /?—-7—7—-A + a/3 = 0. (15.10)

l —o
The model is no longer certainly stable: the crucial stability condition is
1 — b — ak > 0, namely
a<j, (15.11)
where s = 1—b. Thus the coefficient of adjustment of K to K* must be smaller
than the critical valué s/k. Empirical research carried out by Gandolfo et al.
(1990) shows a to be very low (the corresponding mean time-lag is of the
order of a few years) and such that the stability condition would certainly
be satisfied.
Oscillations require A < 0, i.e.

á<
(rrirs)'4"' <1512>
If the stability condition is satisfied, the fraction on the right-hand side turns
out to be greater than one, henee inequality (15.12) is more likely to be
satisfied than the analogous inequality (3 < 4a that we found in the case of
an exogenous K*.
It should be noted, in conclusión, that a feature of the second-order accel-
erator is that cycles can be generated solely in the investment sector, which
implies a minor role for consumption in causing business cycles. This result
contrasts with the standard multiplier-accelerator model of the business eyele
(see Chap. 6, Sect. 6.1), that gives an equally important role to consumption.

15.2 Exercises
1. Suppose that K* is related to expected output, and that expectations are
of the extrapolative type, from which
K* = k(Y + 7 ^ ' ) , 7 > 0.
Examine the behaviour of the solution to the second-order accelerator model.
Consider then the case of regressive expectations (7 < 0) and compare the
results in the two cases.

2. In the foreign exchange market non-speculators (commercial traders, etc.)

are permanently present, whose excess demand depends on the current ex-
change rate and on seasonal factors, represented by a periodic oscillation:
En(t) = (lo + aiSR(t) 4- Bcosujt, a 0 > 0, a\ < 0,0 < B < a0.
15.2. Exercises 227

where SR(t) denotes the current spot exchange rate (number of units of
domestic currency per unit of foreign currency). Henee in the absence of
other agents the exchange rate would follow the periodic path

SR(t) = coscut — —,
—ai ai
which is determined by the equilibrium condition En(t) = 0. Let us now
introduce speculators, who demand and supply foreign exchange in the ex-
pectation of a change in the exchange rate. Their excess demand for foreign
exchange is given by
Es(t) = m[ER(t) — SR(t)], m > 0,
where ER(t) denotes the expected spot exchange rate. The market equi-
librium condition is now En(t) + Es(t) = 0. To determine the path of the
exchange rate we need to know how expectations are formed. Let us assume
the following (admittedly ad hoc) process of expectation formation:
ER(t) = SR(t) + hSR'it) + b2SR"(t),
i.e., speculators base their expectations on the current rate of exchange, on
the direction in which it is moving, and on the acceleration of its movement.
The signs of 61,62 are left unspecified. In fact, the exercise consists of the
following problems:
(2.a) determine the signs of 6i, 62 so that the model is stable;
(2.b) show that the particular solution involves a periodic oscillation hav-
ing the same frequeney as the basic seasonal factors;
(2.c) is it possible to say that the particular solution has a smaller ampli-
tude than the one involved in the path of the exchange rate when speculators
are absent?

3. Suppose that the monetary authorities are also operating in the foreign
exchange market with the aim of stabilizing the exchange rate at the constant
valué a 0 / a i . Assume that the authorities' excess demand can be represented
by the following function:
«o
EG(t) = h SR{t) -
L V—ax

where /i, f2 are policy parameters.

(3.a) Prove that the stability conditions are always satisfied for a suitable
choice of /i, f2.
(3.b) Examine the influence of / i , / 2 on the particular solution;
(3.c) Find an explicit expression for the change in the authorities' foreign
exchange reserves over the interval 0 — T, where T is a given positive number
(Hint: the authorities excess demand for foreign exchange gives the instan-
taneous valué of the change in reserves. Henee J 0 r Ec(t)dt is the change over
the period considered. Given the solution for SR(t), etc.).
228 Chapter 15. Second-order Differential Equations in Economic Models

15.3 References
Gandolfo, G. and P.C. Padoan, 1990, The Italian Continuous Time Model:
Theory and Empirical Results, p. 97 and p. 107.
Goodwin, R.M., 1951, The Nonlinear Accelerator and the Persistence of
Business Cycles.
Hillinger, C. (ed.), 1992, Cyclical Growth in Market and Planned Economies,
Chap. 8.