Some techniques

Question 4.3

Tutorial 4: Macroeconomic dynamics, II

Forward-looking stability

Ben J. Heijdra

Department of Economics, Econometrics & Finance

University of Groningen

March 1 & 2, 2023

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 1 / 31

 Some techniques
Question 4.3

Outline

1 Some techniques

2 Question 4.3

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 2 / 31

 Some techniques
Question 4.3

Phase diagram analysis with two differential equations

[How to: Analyze differential equations graphically]

Suppose that we have a system of two first-order differential equations:

ẏ(t) = F (y(t), z(t), w0 , x0 )

ż(t) = G(y(t), z(t), w0 , x0 )

(1) Draw a diagram with y(t) on the vertical axis and z(t) on the
horizontal axis.
(2) Draw the isoclines.
The y-isocline depicts combinations of y(t) and z(t) for which
ẏ(t) = 0.
The slope can be determined by using the Implicit Function
Theorem. For example:
 
∂y(t) Fz (y(t), z(t), w0 , x0 )
=− .
∂z(t) ẏ(t)=0 Fy (y(t), z(t), w0 , x0 ))

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 3 / 31

 Some techniques
Question 4.3

Phase diagram analysis with two differential equations

(2) Draw the isoclines.
The z-isocline depicts combinations of y(t) and z(t) for which
ż(t) = 0.
The slope can be determined by using the Implicit Function
Theorem. For example:
 
∂y(t) Gz (y(t), z(t), w0 , x0 )
=− .
∂z(t) ż(t)=0 Gy (y(t), z(t), w0 , x0 )

(3) Mark the steady state, which is such that ẏ(t) = ż(t) = 0 (at the
intersection of the isoclines). Denote the steady-state values by y ∗
and z ∗ .
(4) Draw the arrows of motion.
Calculate either ∂ ẏ(t)/∂y(t) or ∂ ẏ(t)/∂z(t) (whichever is easier) and
analyze its sign. This determines whether y(t) is increasing or
decreasing over time for points off the y-isocline.
Calculate either ∂ ż(t)/∂y(t) or ∂ ż(t)/∂z(t) (whichever is easier) and
analyze its sign. This determines whether z(t) is increasing or
decreasing over time for points off the z-isocline.
Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 4 / 31
 Some techniques
Question 4.3

Phase diagram analysis with two differential equations

(5) Determine the type of stability exhibited by the system.

By looking at the arrows of motion:
If all arrows point towards the steady state then it is
backward-looking stable.
If all arrows point away from the steady state then it is
backward-looking unstable.
If some arrows point towards the steady state and others away from
it then it is saddle-point stable. In that case it is possible to draw the
saddle path (more on this below).
By analyzing the matrix of partial derivatives evaluated at the
steady-state point (y ∗ , z ∗ ):
 
Fy (y ∗ , z ∗ , w0 , x0 ) Fz (y ∗ , z ∗ , w0 , x0 )
∆= .
Gy (y , z , w0 , x0 ) Gz (y , z , w0 , x0 )
∗ ∗ ∗ ∗

Let λ1 and λ2 denote the eigenvalues of ∆, det(∆) the determinant

and tr(∆) the trace.

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 5 / 31

 Some techniques
Question 4.3

Phase diagram analysis with two differential equations

(5) Determine the type of stability exhibited by the system.

By analyzing the matrix of partial derivatives evaluated at the
steady-state point (y ∗ , z ∗ ):
 
Fy (y ∗ , z ∗ , w0 , x0 ) Fz (y ∗ , z ∗ , w0 , x0 )
∆= .
Gy (y , z , w0 , x0 ) Gz (y , z , w0 , x0 )
∗ ∗ ∗ ∗

Let λ1 and λ2 denote the eigenvalues of ∆, det(∆) the determinant

and tr(∆) the trace.
If det(∆) = λ1 λ2 > 0 then the eigenvalues have the same sign.
If tr(∆) = λ1 + λ2 > 0 then both are positive and the steady state is
backward-looking unstable.
If tr(∆) = λ1 + λ2 < 0 then both are negative and the steady state is
backward-looking stable.
If det(∆) = λ1 λ2 < 0 then the eigenvalues have opposite sign and
the steady state is saddle-point stable.

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 6 / 31

 Some techniques
Question 4.3

Phase diagram analysis with two differential equations

Stable Unstable

y(t) y(t)
. .
z(t) = 0 z(t) = 0

E0 E0
y* ! y* !

A A
y0 ! y0 !

. .
y(t) = 0 y(t) = 0

z0 z* z(t) z0 z* z(t)

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 7 / 31

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Question 4.3

Phase diagram analysis with two differential equations

Saddle-point stable

y(t)
.
B! z(t) = 0

!
A BN
y(0) !

C E0
!
y* !

!
CN
SP

.
y(t) = 0

z0 z* z(t)

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 8 / 31

 Some techniques
Question 4.3

Analysis of a shock
[How to: Analyze a saddle-point stable model in continuous time]

A shock to one of the exogenous variables of the model results in a shift

of the isoclines and a change in the dynamics of the system.
Notation:
tA denotes the date at which the shock is announced
tI denotes the date at which the shock is implemented
tE denotes the date at which the shock ends
Shocks differ in two respects:
(1) The duration of the shock
Permanent shock (tE → ∞)
Temporary shock (tE < ∞)
(2) The ‘grace period’ afforded to the agents
Unanticipated shock (tI = tA )
Anticipated shock (tI > tA )

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 9 / 31

 Some techniques
Question 4.3

Analysis of a shock

Dynamics of the system:

tA ≤ t < tI : ‘old’ dynamics
tI ≤ t < tE : ‘new’ dynamics
t ≥ tE : ‘old’ dynamics
Intuitive solution method:
There can never be a discrete change (jump) in the predetermined
variable.
There can only be a discrete change in the jumping variable at the
time the news about the shock arrives (tA ).
If the shock is permanent then at the time it occurs (tI ) the system
has to be on the ‘new’ saddle path.
If the shock is temporary then at the time it ends (tE ) the system
has to be on the ‘old’ saddle path.

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 10 / 31

 Some techniques
Question 4.3

IS-LM model with sticky prices

The economy is described by the following equations:

y = −σRL + g, σ > 0 (1)

m − p = −λRS + γy + α, λ > 0, γ>0 (2)
ṗ = φ(y − ȳ), φ>0 (3)
ṘL
RS = RL − (4)
RL
Here m is the logarithm of the money supply, g is the logarithm of (an
indicator for) budgetary policy, p is the logarithm of the price level, y (ȳ)
is the logarithm of the (natural) output level. RL is the yield on
long-term bonds (“perpetuities”), and RS is the short-term interest rate.
The system can be reduced to two differential equations:

ṗ = φ[−σRL + g − ȳ]
ṘL [λ + γσ]RL − γg + (m − p) − α
=
RL λ
Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 11 / 31
 Some techniques
Question 4.3

Part (a)

(a) Provide a brief interpretation for these equations.

Equation (1) is the IS curve. Investment is assumed to depend

negatively on the long-term interest rate.
Equation (2) is the LM curve. Money demand depends negatively on
the short-term interest rate, and positively on output.
Equation (3) is the Phillips curve, relating the price change to the
output gap.
Equation (4) is the expression for the efficient term structure of
interest rates. The instantaneous yields on perpetuities and on
short-run instruments are equalized. There are no unexploited
arbitrage opportunities and perfect foresight is assumed.

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 12 / 31

 Some techniques
Question 4.3

Part (b), Phase diagram

(b) Demonstrate the effect of an unanticipated and permanent increase

in the natural output level (ȳ) on actual output, the long-term and
short-term interest rates, the price level, and the real money supply.
Show the effects in a diagram with time on the horizontal axis, and
use tA as the indicator for the time at which the shock in announced
(“announcement time”).

The phase diagram is obtained in the following five steps.

(1) Price p is sticky, long-term rate RL is allowed to jump.
(2) Draw a diagram with p on the horizontal and RL on the vertical axis.
(3) Isoclines:
g − ȳ
ṗ = 0 ⇔ RL =
σ
γg − (m − p) + α
ṘL = 0 ⇔ RL =
λ + γσ

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 13 / 31

 Some techniques
Question 4.3

Part (b), Phase diagram

The phase diagram is obtained in the following five steps
(4) Steady-state values:

∗ g − ȳ λ λ + γσ
RL = , p∗ = g− ȳ + m − α
σ σ σ
(5) Arrows of motion:

∂ ṗ ∂ ṘL RL
= −φσ < 0, =− <0
∂RL ∂p λ
(6) The matrix of partial derivatives is given by:
!
0 −φσ
∆= RL∗
λ+γσ ∗
− λ λ
RL

such that:
φσRL ∗
|∆| = −<0
λ
Hence the system is saddle-point stable.

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 14 / 31

 Some techniques
Question 4.3

Part (b), Phase diagram

RL ṘL = 0

∗
RL ṗ = 0

p∗ p

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 15 / 31

 Some techniques
Question 4.3

Part (b), Transitional dynamics

The steady state values and transitional paths for y and RS can be
deduced.
y = −σRL + g (M1)
γ[−σRL + g] + α − (m − p)
RS = (M2)
λ
ṗ = φ(y − ȳ) (M3)
ṘL
RS = RL − (M4)
RL

Consider the long run with ṗ = ṘL = 0:

From (M3) it follows that y ∗ = ȳ.
From (M4) it follows that RS∗ = RL ∗
= [g − ȳ]/σ.
Consider the transition:
From (M3) it follows that y ≷ ȳ if ṗ ≷ 0.
From (M4) it follows that RS ≷ RL if ṘL ≶ 0.
The impact effect of a shock will follow from (M1) and (M2).

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 16 / 31

 Some techniques
Question 4.3

Part (b), Unanticipated and permanent increase in ȳ

RL ṘL = 0

E0
(ṗ = 0)0
E1
(ṗ = 0)1

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 17 / 31

 Some techniques
Question 4.3

Part (b), Unanticipated and permanent increase in ȳ

RL p
∗
RL,0 p∗0

∗
RL,1 p∗1

tA = tI t tA = tI t

RS y
∗
RS,0 ȳ1

∗
RS,1 ȳ0

tA = tI t tA = tI t

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 18 / 31

 Some techniques
Question 4.3

Part (c)

(c) Now redo part b for the case in which the shock is announced (i.e.
becomes known to the public) before it actually takes place. The
time at which the shock actually occurs (the “implementation time”)
is tI , so we assume that tA < tI .

Figure out the effect in the phase diagram

Translate into Impulse-Response functions

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 19 / 31

 Some techniques
Question 4.3

Part (c), Anticipated and permanent increase in ȳ

RL ṘL = 0

E0
(ṗ = 0)0
E1
(ṗ = 0)1

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 20 / 31

 Some techniques
Question 4.3

Part (c), Anticipated and permanent increase in ȳ

RL p

RL,0
∗
p∗0

RL,1
∗
p∗1

tA tI t tA tI t

RS y

RS,0
∗
ȳ1

RS,1
∗
ȳ0

tA tI t tA tI t

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 21 / 31

 Some techniques
Question 4.3

Part (d)

(d) Show that an unanticipated and permanent budgetary expansion

(rise in g) leads to an immediate increase in the long-term interest
rate. Show what happens (at impact, during transition, and in the
long run) to output, the price level, and the short-term interest rate.
Illustrate your answers in an impulse-response diagram.

Figure out the effect in the phase diagram

Translate into Impulse-Response functions

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 22 / 31

 Some techniques
Question 4.3

Part (d), Unanticipated and permanent increase in g

RL (ṘL = 0)1 (ṘL = 0)0

E1
(ṗ = 0)1

(ṗ = 0)0
E0

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 Some techniques
Question 4.3

Part (d), Unanticipated and permanent increase in g

RL p
∗
RL,1 p∗1

∗
RL,0 p∗0

tA = tI t tA = tI t

RS y
∗
RS,1

ȳ

∗
RS,0

tA = tI t tA = tI t

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 Some techniques
Question 4.3

Part (e)

(e) Show that an anticipated and permanent budgetary expansion (a

future increase in g) will cause a recession at first and will only
stimulate the economy further into the future. Show what happens
(at impact, during transition, and in the long run) to output, the
price level, and the short-term interest rate. Illustrate your answers
in an impulse-response diagram.

Figure out the effect in the phase diagram

Translate into Impulse-Response functions

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 25 / 31

 Some techniques
Question 4.3

Part (e), Anticipated and permanent increase in g

RL (ṘL = 0)1 (ṘL = 0)0

E1
(ṗ = 0)1

(ṗ = 0)0
E0

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 Some techniques
Question 4.3

Part (e), Anticipated and permanent increase in g

RL p
∗
RL,1 p∗1

∗
RL,0 p∗0

tA tI t tA tI t

RS y
∗
RS,1

ȳ

∗
RS,0

tA tI t tA tI t

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Question 4.3

Part (f)

(f) What happens to the long-term interest rate if the anticipated

budgetary expansion (studied in the previous subquestion) does not
take place? (At implementation time, tI , the government announces
that it will keep g unchanged). Illustrate your answers in an
impulse-response diagram.

Figure out the effect in the phase diagram

Translate into Impulse-Response functions

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 28 / 31

 Some techniques
Question 4.3

Part (f), Anticipated but abolished increase in g

RL (ṘL = 0)1 (ṘL = 0)0

(ṗ = 0)1

(ṗ = 0)0
E0

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 Some techniques
Question 4.3

Part (f), Anticipated but abolished increase in g

RL p
∗
RL,1 p∗1

∗
RL,0 p∗0

tA tI = tE t tA tI = tE t

RS y
∗
RS,1

ȳ

∗
RS,0

tA tI = tE t tA tI = tE t

Intermediate Macroeconomics EBB842B05, 2022–2023 Tutorial 4: Macroeconomic dynamics, II 30 / 31

 Some techniques
Question 4.3

Part (g), Real interest rate affects the IS curve

(g) Assume that the real (rather than the nominal) long-term interest
rate, rL ≡ RL − ṗ, features in equation (Q4.1). Assume furthermore
that 0 < σφ < 1. Study the (impact, transitional, and long-run)
effects of an unanticipated and permanent technology shock (an
increase in ȳ). Illustrate your answers in an impulse-response
diagram.

The IS curve is now:

y = −σ[RL − ṗ] + g

substitute (Q4.3) to get the QRF for y:

−σ[RL + φȳ] + g
y=
1 − σφ

The rest of the question is similar to what was done in part (b)

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