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Log LineariIzation

1. Log-linearization is a method used to approximate nonlinear dynamic stochastic models with linear equations by taking a first-order Taylor approximation around the steady state. This yields equations that are linear in the log-deviations of the variables from their steady state values. 2. There are two main methods for deriving the log-linearized form of an equation: taking the derivative of the functions and substituting log-deviations, or simply substituting common approximations like Xt ≈ X(1+xt) directly into the original nonlinear equation. 3. Examples show how this process yields log-linearized versions of common macroeconomic relationships like the resource constraint, Euler equation, and propensity to consume

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73 views5 pages

Log LineariIzation

1. Log-linearization is a method used to approximate nonlinear dynamic stochastic models with linear equations by taking a first-order Taylor approximation around the steady state. This yields equations that are linear in the log-deviations of the variables from their steady state values. 2. There are two main methods for deriving the log-linearized form of an equation: taking the derivative of the functions and substituting log-deviations, or simply substituting common approximations like Xt ≈ X(1+xt) directly into the original nonlinear equation. 3. Examples show how this process yields log-linearized versions of common macroeconomic relationships like the resource constraint, Euler equation, and propensity to consume

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An introduction to log-linearizations

Fall 2000
One method to solve and analyze nonlinear dynamic stochastic models is to
approximate the nonlinear equations characterizing the equilibrium with loglinear ones. The strategy is to use a first order Taylor approximation around
the steady state to replace the equations with approximations, which are linear
in the log-deviations of the variables.
Let Xt be a strictly positive variable, X its steady state and
xt log Xt log X

(1)

the logarithmic deviation.


First notice that, for X small, log(1 + X) ' X, thus:
xt log(Xt ) log(X) = log(

Xt
) = log(1 + %change) ' %change.
X

The standard method

Suppose that we have an equation of the following form:


f (Xt , Yt ) = g(Zt ).

(2)

where Xt , Yt and Zt are strictly positive variables.


This equation is clearly also valid at the steady state:
f(X, Y ) = g(Z).

(3)

To find the log-linearized version of (2), rewrite the variables using the identity Xt = exp(log(Xt ))1 and then take logs on both sides:
log(f (elog(Xt ) , elog(Yt ) )) = log(g(elog(Zt ) )).

(4)

Now take a first order Taylor approximation around the steady state (log(X),
log(Y ), log(Z)). After some calculations, we can write the left hand side as
log(f (X, Y )) +

1 This

1
[f1 (X, Y )X(log(Xt ) log(X)) + f2 (X, Y )Y (log(Yt ) log(Y ))].
f (X, Y )
(5)

procedure allows us to obtain an equation in the log-deviations.

Similarly, the right hand side can be written as


log(g(Z)) +

1
[g0 (Z)Z(log(Zt ) log(Z))].
g(Z)

(6)

Equating (5) and (6), and using (3) and (1), yields the following log-linearized
equation:
[f1 (X, Y )Xxt + f2 (X, Y )Y yt ] ' [g0 (Z)Zzt ].

(7)

Notice that this is a linear equation in the deviations!


Generalizing, the log-linearization of an equation of the form
f (x1t , ..., xnt ) = g(yt1 , ..., ytn )
is:
n
m
X
X
fi (x1 , ..., xn )xi xit '
gj (y 1 , ..., y m )y j ytj .
i=1

j=1

A simpler method

However, in the large majority of cases, there is no need for explicit dierentiation of the function f and g. Instead, the log-linearized equation can usually
be obtained with a simpler method. Lets see.
Notice first that you can write
Xt = X(

Xt
) = Xelog(Xt /X) = Xext
X

Taking a first order Taylor approximation around the steady state yields
Xext

' Xe0 + Xe0 (xt 0)


' X(1 + xt )

By the same logic, you can write


Xt Yt

' X(1 + xt )Y (1 + yt )
' XY (1 + xt + yt + xt yt )

where xt yt ' 0, since xt and yt are numbers close to zero.


Second, notice that
f(Xt ) '
'
'
'

f(X) + f 0 (X)(Xt X)
f(X) + f 0 (X)X(Xt /X 1)
f(X) + f(X)(1 + xt 1)
f(X)(1 + xt )
2

(X) X
where fX
f (X) .
Now, the log-linearized equation can be obtained as follows. After having
multiplied out everything in the original equation, simply use the following
approximations:

2.1
2.1.1

Xt ' X(1 + xt )

(8)

Xt Yt ' XY (1 + xt + yt )

(9)

f (Xt ) ' f (X)(1 + xt )

(10)

Some examples
The economy resource constraint

Consider the economy resource constraint


Yt = Ct + It .
and rewrite it as
1=

It
Ct
+ .
Yt
Yt

Using (9) we obtain


1'

C
I
(1 + ct yt ) + (1 + it yt )
Y
Y

where it is the log-deviation of investment.


Since at the steady state
Y = C + I,
we can cancel out (some) constants and rearrange to obtain

yt '
2.1.2

C
I
ct + it .
Y
Y

The marginal propensity to consume out of wealth

Assume that the marginal propensity to consume out of wealth is governed by


the following first order dierence equation:
1
Rt+1

t
= 1 t .
t+1
3

Notice that at the steady state


R1 = 1 .
and
= 1 R1 .
Using (8) and (9) we can write the nonlinear dierence equation as
R1 (1 + ( 1)rt+1 + t t+1 ) ' 1 (1 R1 )(1 + t ).
Canceling out constants yields
R1 [( 1)rt+1 + t t+1 ] ' (1 R1 )t .
Rearranging, we obtain
R1 1
t ' ( 1)rt+1 + t t+1
R1
and, finally,
t ' R1 [(1 )rt+1 + t+1 ] .
2.1.3

The Euler equation

The consumption Euler equation is


1 = Rt+1 (Ct+1 /Ct ) .
Using (9) and (10) we can write it as
1 ' R(1 + rt+1 (ct+1 ct )).
Canceling out constants yields
0 ' rt+1 (ct+1 ct )
and, rearranging,
ct ' rt+1 + ct+1
where = 1/ is the intertemporal elasticity of substitution.

2.1.4

Multiplicative equations

If the equation to log-linearize contains only multiplicative terms, there is a


faster procedure. Suppose we have the following equation:
Xt Yt
=
Zt
where is a constant. To log-linearize divide first by the steady state variables:
Yt
t
(X

X )( Y )
= = 1.

( ZZt )

Now take logs:


log(

Xt
Yt
Zt
) + log( ) log( ) = log(1) = 0.
X
Y
Z

Using (1) we arrive then easily to the log-linearized equation:


xt + yt zt = 0.
Notice that in this case the log-linearized equation is not an approximation!

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