Economics of Chaos

The Economics of Chaos or the Chaos of Economics
Author(s): David Kelsey

Source: Oxford Economic Papers, New Series, Vol. 40, No. 1 (Mar., 1988), pp. 1-31
Published by: Oxford University Press
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Oxford Economic Papers 40 (1988), 1-31
THE ECONOMICS
OF CHAOS OR
THE CHAOS OF ECONOMICS*
By DAVID KELSEY
Abstract
a simple account of non-linear dynamics, focussing on

cycles and chaos. There is a survey of economic models which involve
chaos. The case where a chaotic system is subject to exogenous random
shocks is discussed.
THIS PAPER gives
1. Introduction
Economics and weather forecastinghave a lot in common. When people
are not talking about the weather they talk about the economy. Both
weather forecasters and economic forecasters have a bad name with the
public. The similaritiesgo further:both are trying to predict the outcomes
of very large systems, the componentsof which mutuallyinteractin complex
ways. The output of both systemshas a seeminglyrandomappearance,even
though there are certain other regularities (e.g., weather is hotter in
summerthan winter, also there is higher employment).
In recent years some mathematicsknownpopularlyas the theory of chaos
has been studied. This deals with systems of equations which are able to
produce motions so complex that they appear completely random. It is
thought that chaos might be applied both within fluid mechanics(which is
the body of theoretical knowledge on which weather forecastingdepends)
and economic theory.
Anyone who has watchedthe flow of liquid will realize how complexfluid
motion can be. Suppose that water is flowing down a straightchannel with
smooth sides. The motion will break into a series of swirls which have a
somewhat random appearance. Despite the fact the initial conditions are
symmetricboth in space and time the flow will be symmetricin neither.
Such fluid flows are described as being turbulent.Turbulenceis caused by
viscosity or friction within the fluid. Viscosity introducesnon-linearterms
into the equations of motion which allow complex turbulentsolutions to be
possible. As an example, the presence of viscosity makes aeroplane flight
possible. In the absence of viscositypressureson the upper and lower sides
of the wing would be equal and hence there would be no uplift.
Because of the random character of turbulent motion it has been
suggestedthat the mathematicsof chaos can be applied in this area. Similar
* Financialsupportfrom the ESRC post-doctoralfellowshipscheme is gratefullyacknowledged. I would like to thank Colin Sparrowwhose excellent lectures greatly encouragedan
interestin this subject. I am also gratefulfor commentsfrom MargaretBray, David Canning,
ParthaDasgupta,Joy Read, Peter Read, Gene Savin, Peter Sinclairand two referees of this
journal.
(C Oxford University Press 1988

THE ECONOMICS OF CHAOS OR THE CHAOS OF ECONOMICS
argumentssuggest that it could be of use to economists. This paper aims to

give an introductionto the applicationsof chaos in economics.
The models in this paper are very simple. The reason for this is that a
detailed mathematicaltheory has only been constructedfor one-dimensional
dynamicalsystems. (That is there is only one dependent variable and the
system of equations is of the first order in that variable.) In higher
dimensionsthere is no general theory. There have been theories developed
of particularequations, two commonly studied examples are the Lorenz
equations (Sparrow (1982), Guckenheimer and Holmes (1983)) and the
Henon map (see Henon (1976)). Higher dimensionsystems have also been
studiedby means of computersimulations.These systemscan displayall the
kinds of behavior discussed in this paper and other forms of complex
behavioras well. Those systemsstudied to date have largelybeen motivated
by applicationsof dynamicsystems theory in the physicalsciences.
Thus economic models involving chaos are not always particularly
realistic.The reason is, as explainedabove, our researchis as yet in its early
stages. The simple models studied here are interesting for the following
reasons. Most importantis that they tell us the kinds of behavior, of which
an economic system is capable. Before this literature,it was largelyassumed
that in the long run, an economy would be in a stationarystate (or balanced
growth). Cycles were considered, but were under-emphasizedgiven the
considerable amount of empirical evidence to support the view that the
economy is cyclic. Aperiodic motion was essentially not considered.
Economic data is clearly aperiodic. This, however, was put down to the
superposition of random shocks onto an essentially stationary economic
system. Non-linearities in economic systems cannot be denied. Little
attention, however, was paid to them. Here we give an account of some
aspects of the behaviorof non-linearsystems.
2. Some results from non-lineardynamics
2.1. Linear and non-linear difference equations
The simplest differenceequation is linear and first order:

(2.1)
xt+l = axt
to which the solution is xt = x0at. This grows exponentiallyif laI> 1. When
O- a <1 the solution decays exponentially towards zero in a monotonic
fashion. Finallyif -1 < a - 0 the solution exponentiallydecays towardszero
in an oscillatorymanner.
If aI< 1, the system converges to a stationarystate. In the case where
a = -1 there is a 2-cycle, i.e., for all t, xt = Xt+2 xt+1. Thus the only cyclic
solution of (2.1) is a cycle of period 2, and this only occursfor a single value
of the parametera.
If on the other hand we consider difference equations, which are still

D. KELSEY
Xt+ll
XI
Xt
XI
X(
1/2
Xt
FIG. 1
first-order,but are non-linear then the behavior we find is very different.

Equation (2.2) like equation (2.1) is a first-orderdifferenceequation.
Xt+i=fr(xt)
where fr(x)=rx(1-x):
O -r e-4.
(2.2)
Equation(2.2) is often known as the logistic equation. While equation (2.2)

is also of the first order it is quadratic, and hence non-linear. Quadratic
behavioris the most simple kind of non-linearity.Hence one might expect
(2.2) to behave in a fairly simple manner as (2.1) does. In fact as we shall
see the solutions to (2.2) can be extremely complex. As shown in Fig. 1, fr
has the following properties: fr(O) = fr(l) = 0. fr has a unique maximum at
X
_ 1
A stationary solution of equation (2.2) is a sequence (xt) which is a

solution of (2.2) and is such that Vt, xt = x for some xcsuch that 0 -x c 1.
Graphicallya stationary solution occurs at a point where the graph of fr
crosses the 450 line (e.g., at Yr in Fig. 2). It is easily seen that 0 is a
stationarysolution for all values of r.
Figure 1 can also be used to illustrate the dynamics of the system.
Supposewe start at xo. The height of f(xo) = x1 gives the second state of the
system. We can find the point correspondingto x1 on the horizontalaxis by
reflectingin the 450 line. A similarprocess of going up to the function and
reflectingin the 450 line gives the next state of the system x2. Furtherpoints
in the evolution of the system can be found in a similar manner. The
successive points in the solution,path xO, x1, x2,... are getting closer and
closer to the origin. This will happen for any startingpoint. In Fig. 1 the
unique stationarystate at the origin is (globally) stable.
Now imagine that we are graduallyincreasingthe parameterr, and we


xt?1
XO xI
x2
Yr 1/2
FIG. 2
xt
wish to observe how this affects the properties of the solution. The function
fr has a single hump. As r is increased the height of this hump increases.
When r is greater than 1 the diagram will look like Fig. 2. The graph of fr
crosses the 450 line at two points-the origin and Yr = (r - 1)/r. In fact for
1 - r - 4, these are the only two stationary solutions of the equation. A
change in the dynamics of the system has occurred. Starting from a typical
point x0, subsequent values of x no longer tend to the origin but instead
converge on the stationary point at Yr. For 1 - r - 3 the origin is unstable
and Yris stable. Indeed it can be shown that from almost every initial value
the path will converge to Yr= (r - 1)/r. The exceptions are the origin which
is also a stationary point, and 1, which is mapped to the stationary point at
the origin (fr(1) = 0).
Thus if 0 < r S 3 the solutions of (2.2) are not unlike the solutions of a
linear difference equation. There is a stationary state to which the system
converges from almost all initial values.
2.2. Existence of cycles
A major area of research in economic theory has been to explain
economic phenomena which appear cyclic, particularly business cycles.
One reason why economists are interested in non-linear dynamics is that
cyclic solutions are very common. It is thought that this might be useful in
theories, which try to explain business cycles.
A k-cycle is a set of k distinct points x1, x2,..., Xk, such that for all
i: 1 - i < k - 1: fr(xi) = xi+1 and fr(Xk) = x1. For r > 3 there are cyclic solutions to the logistic equation (2.2). Unlike the linear difference equation
(2.1) there can be cycles of many different periods.
Sarkovskii's theorem is very informative about the structure of cyclic
solutions to non-linear difference equations. It is a very fascinating result,

D. KELSEY
describingunder what circumstanceswe can get cycles of differentperiods

coexisting. We define Sarkovskii'sordering < of the positive integers as
follows:
1 < 2 < 4... <
2k
<2 k+1
<
..< 2k 1(2m+ 1) < 2k+1(2m -1) < ..< 2k+1 . 5 < 2k+1 3 <
...<2 (2m+1)<2
(2m-1)<...<2
5<2 3<
*. < (2m + 1) < (2m - 1) < . .. < 5 < 3.
That is, greatest are the odd numbersgreater than 3, then the powers of 2
times these odd integers, and then the powers of 2 backwards.
Sarkovskii's Theorem: If f is a continuousmap of an interval into itself
with a p-cycle and q < p in Sarkovskii'sorderingthen f has a q-cycle.
It is clear from this, that first-ordernon-linear difference equations can
admit a much richer kind of cyclic solution than the correspondinglinear
differenceequations. Considerthe mth-orderlinear differenceequation
amxt+m + am-1xt+m1
...
+ aixt
=f
(t)
(2.3)
This is not essentially more complicatedto solve than (2.1). The only new
difficultieswhich arise are that it is possible to have multiple or complex
roots.1Complexroots can give rise to cyclic solutions. But even (2.3) has a
less complex structurethan the non-linear equation. With the mth-order
linearequationit is only possible to have a finite numberof cyclic solutions.
It can be seen from Sarkovskii'stheorem that in the non-linearcase it is
possible to get an infinite numberof cycles of differentperiods even with a
first-orderdifferenceequation. Indeed this will be true provided that there
is a cycle of odd period.
2.3. Stability of cycles
By Sarkovskii'stheorem there are a large number of cyclic solutions to

the logistic equation. Thus the set of cycles appears very complex. In
practicesolutionswhich are not stable will not be observed. Fortunatelythe
set of stable cycles is much simpler. Providedthat an appropriateconvexity
conditionis satisfied2there will be at most one stable cycle and trajectories
from a typical starting position will converge to a stable cycle if it exists.
Thus for parametervalues where a stable cycle exists, in the long run, the
cycle is that all that will be observed. This does not however imply that a
stable cycle will exist.
1 The theory of such equations is explained in many places. A good reference for economists
is Sargent (1979).
2 What is required here is that fr have a negative Schwartzian derivative, if differentiable or fr
should satisfy the cross-ratio property if not differentiable. See Preston (1983) for details. This
result was originally proved in Singer (1978).


1
xt+1
Yr,
Yr2
Xt
FIG. 3
Let Yrbe the fixed point (stationaryequilibrium)for fr. A necessaryand

sufficient condition for yr to be stable is that the absolute value of the
< 1. This means that in a
derivativeof fr at yr be less than 1. i.e., Idfr/dx0I
neighbourhoodof yr the mapfr contractslengths.
As the value of r increases, the hump of fr becomes higher. This has the
effect of progressivelymoving the fixed point Yrdown the humpinto regions
where the slope is greater. Thus the fixed point becomes unstable. This is
illustrated in Fig. 3. (In Fig. 3, r2> r1.) Similar considerationsapply to
cycles. If x1, x2..., Xk is a k-cycle, then xi is a fixed point of fk for 1 S i S k.
A
(Here fk denotes f iterated with itself k times, e.g., f2(x) =f(f(x)).)
k-cycle is stable if the absolute value of the derivativeof fk is less than one,
at a point on the cycle. By the chain rule
df
dX(Xl)
dfr
-ld (Xi)
dfr
*d
dfr
dfr
(X2) * d (X3) *--..
(Xk).
(2.4)
Hence the absolute value of the derivativeis the same at any point on the
cycle. Thus our definitionof stabilitydoes not depend on whichpoint on the
cycle we consider. At the maximumx * of fr the value of the derivativeis
zero. Thus the productin (2.4) is zero. We have the simple propositionthat
any cycle which contains the maximum of fr will be stable. In fact as r
increasesfor any cycle there is an r-value for whichx* will be on that cycle.
Hence the cycle will be stable for some r-value. Furtherby continuitythe
cycle will be stable on a neighbourhoodof that r-value. Thus for any k there
is an intervalof r-valuesfor which the system has a stable k-cycle.
We shall now investigate how the set of stable solutions to the logistic

D. KELSEY
equation (2.2) changes as the parameter, r, increases. As we have already

mentioned, for any given value of r, there is at most one cycle which is
stable. However, the cycle which is stable changes as r increases. For
o S r - 1, the stationary solution at the origin is stable. (A stationary
solution is a cycle of period 1.) If 1 - r - 3 the stationary solution
yr = (r - 1)Ir is stable. By setting xt = (r - 1)Ir in equation (2.2) one can see
that for all r, lrsr<4,
yr is a fixed point of fr. At r=3 the system,
however, undergoes a bifurcation. That is there is a change in the structure
of the set of solutions. After r = 3, Yris no longer stable. There is however a
2-cycle which is stable. In this region for an arbitrary starting value the
system will eventually settle down into a cycle of period 2.
Figure 4 shows a highly simplified account of how the structure of the set
of stable solutions to (2.2) changes as the parameter r varies. At a
somewhat higher value of r there occurs what is essentially a repeat of the
behaviour at r = 3. The 2-cycle becomes unstable, and a stable 4-cycle
appears. This process is known as a period-doubling bifurcation. The system
now goes through an infinite number of such period-doublings. Stable cycles
of length 8, 16, 32,..., 2",... successively appear and become unstable. This
all occurs before a limit point r,, which is approximately equal to 3.57. In
fact all of the cycles in this sequence would look to a casual observer like
noisy 2-cycles. At r. the system behaves in a very complex manner which is
different to that at neighbouring parameter values. Since r,. is a single point
in the parameter space I think that such behaviour is unlikely to arise in an
economic model.
The order in which cycles appear bears a close relation to Sarkovskii's
ordering of the natural numbers. Thus Sarkovskii's ordering starts 1 < 2 <
Donates a stable cycle
Donates an unstable cycle
3.57
FIG. 4

4... < 2k < ... First we get a fixed point, then an orbit of period 2, followed
by an orbit of period 4. The cycles whose periods are powers of two appear
first. In particularif there is a cycle of period 3, there are cycles of all other
periods.
Since all the cycles before r., had been obtained from period-doubling
bifurcationsthey all had periods which were powers of 2, (i.e., for some n
the period was equal to 2n). In fact between r = 3 and r = 4 stable cycles of
all periods can be seen. The behavior of the cycle of period 3 is fairly
typical.
Below the r-values for which a stable 3-cycle can be observed the system
is chaotic (see section 2.4 for a descriptionof chaos). As r approachesthe
value at which a 3-cycle appearsa phenomenonknown as intermittentchaos
occurs. In this, the system essentially alternates between following an
approximate3-cycle and chaotic behaviour.It has been suggestedthat intermittentchaos maybe importantduringthe onset of turbulentmotionin fluids.
Then as r is increased a stable 3-cycle appears. Like our fixed point the
3-cycle undergoes a chain of period-doublingbifurcations.It is successively
replaced by stable cycles of period 6, 12, 24,..., 2n *3, ... . These
bifurcationsaccumulateat a limit point where the behaviour is similar to
that at rOO
(the limit point of the period-doublingsequence following the
2-cycle). After the limit point the system returnsto chaotic behaviour.The
set of r values from the beginning of the 3-cycle to the limit point of the
sequence of bifurcationsis known as a period-doublingwindow.
Between r = 3 and r = 4 there are, in theory, period-doublingwindows
containing cycles of all possible lengths. Clearly most of these perioddoubling windows occupy a very small interval in the parameterspace. In
numericalsimulationsthe only period-doublingwindows which can be seen
are those startingwith cycles of relativelyshort periods such as 3, 5 or 7.
2.4. Chaos
Consider the logistic equation (2.2) when r = 4. In this case an analytic

solution can be found. Substitute x0 = 4(1 - cos (u)) (where as before xo is
the initialvalue of x). Then with some simple algebraand using the addition
formulae for trigonometric functions one can find that the solution is,
xt = 4(1 - cos (2tu)). It can be seen that the solution is periodic if u/2jr is
rational. Furtherby choosing u appropriatelya cycle of any desired length
can be found. If u/2jr is irrationalthen the solution is aperiodic.
In addition the motion has a propertyknown as sensitive dependenceon
initial conditions. Suppose x0 = 4(1 - cos (u)) and Yo= 1(1 - cos (u + E))
then the solutions of (2.2) starting from initial values x0 and yo are
xt = (1
cos (2tu)) and yt = 4(1 - cos (2tu + 2tE)) respectively. The term 2tE
becomes large very rapidlyindeed. Thus no matter how small E is, xt and yt
will diverge very rapidly. (But the time taken to diverge will in general
depend on E.)

D. KELSEY
Although the difference equation (2.2) is completely deterministicthe

behaviorof the system appears random. Practicalattempts to observe the
system will involve errors, in initial measurementand rounding errors in
computation. Because of sensitive dependence on initial conditions these
errors will be important and will introduce significantand unpredictable
errors into the forecasts made by the system. It is this kind of behavior
which has been called chaotic. The term chaos may be misleading since
there is much that can be said about the structureof such a system. Indeed
in this case we have an explicit analyticformulafor the solution.
We have given the behavior for r = 4. Between rO.and r = 4 many
complicatedchanges occur in the system. For a set of values of r having
positive measure this system behaves chaotically.3(Somewhat similar to
what happens at r = 4.) For other values of r cycles can be observed. The
set of parametervalues which gives rise to cycles also has positive measure.
So far we have analyzed the solutions to the dynamicsystems generated
by a particular family of functions (fr). One of the more surprising
conclusions which have been produced by mathematical theory is that
similarresults can be obtained for a wide class of families of functions. If a
family (gr) of functionsis single peaked, satisfiesa convexitycondition4and
is increasing in r then our results will go through. In other words our
conclusionis largely independentof the particularfamily of functions (fM).
The reason for this appearsto be that after sufficientlymany iterationsthe
behavior of the system only depends on the local propertiesof fr near its
maximumvalue.
We shall not give a precise definitionof chaos here. It is not possible to
define chaos without using a large number of technical terms. Secondly
there are a number of different definitions of chaos in use (positive
topological entropy, positive Liapunov exponents, existence of a strange
attractor,etc.). Informallychaos occurswhen for a typicalinitialvalue there
is both sensitive dependence on initial conditions and aperiodic motion.
Note that it is possible to have aperiodic motion, without sensitive
dependence on initial conditions, and sensitive dependence on initial
conditionswithout aperiodicmotion. (An example of the latter is given in
the conclusion.) Sensitive dependence on initial conditions is the more
problematic, since it implies that the system is essentially impossible to
predict.
3This is proved in Jakobson(1981). Furtherit appearsthat the set of parametervalues for
which there is sensitive dependence on initial conditions has quite a complex structure,in
particularit containsno intervals.For detailssee Collet and Eckman(1980), p. 31.
These qualificationsmight suggestthat parametervalues for whichcomplexbehavioroccurs
are quite rare. This impressionmay be false since, i) cycles of very long periodsare empirically
difficultto distinguishfrom aperiodicmotion. ii) In the presence of noise, which is almost
inevitablein an economic system, the range of parametervalues which give rise to chaos is
considerablyenlarged.
4 Technicallythe functions shouldhave negativeSchwartzian
derivative.(See also footnote
g,
2.)

10

xt+1
1/2
FIG.
Xt1
In practice the difference between aperiodic motion and a cycle of very

large period (e.g., 10100)is very small. Both of these may be seen as chaotic
by agents in the economy.
Consider the logistic map for the case r = 4 (illustratedin Fig. 5). The
unit interval is divided into two regions. Region 0= {x: 0 < x 2 } and
Region 1 {x: 2 - x - 1}. Apart from the end point both regions are mapped
onto the whole interval. Thus lengths expand roughlyby a factor of two on
each application of the map. We have a process of expansion and
reinjectionwhich is somewhat like successivelycutting and shufflinga pack
of cards. Viewed this way it is not surprisingthat the dynamicsof the system
have an unpredictablecharacter.
An interesting result in this area was a paper by Li and Yorke (1975)
which showed that if there is a cycle of period 3 then there is 'chaos'. By
chaos Li and Yorke meant that there are periodic orbits of all periods.
(Note that this is essentiallya corollaryof Sarkovskii'stheorem, discussedin
Section 2.2) There is also an uncountableset S of initial values, which all
have aperiodictrajectories.Furthermoreif x, y are in S then the orbits of x
and y come arbitrarilyclose together and move apart again an infinite
numberof times. Formallythis is expressedas:
limsup If (X)-f
nl th
(Y)l >0
liminf If (x) -f
n
doo
(Y)l = 0.
Essentially this says that within S we have sensitive dependence on initial

D. KELSEY
11
conditions.Finally if z is a periodicpoint and x is in S then

liM sup
If (X) -f
(z)I > 0
This says that the path of x will wanderaway from any periodic orbit.
The Li and Yorke result has the advantagethat it is fairly easy to check
that its sufficientcondition (i.e., existence of a 3-cycle) is satisfied.Many of
the articles on chaos in economics have used the Li and Yorke result to
argue that economic variables are likely to follow an erraticpath. See, for
exampleBenhabib and Day (1981), (1982) and Day (1982), (1983).
Recently these papers have been attacked, see for instance Grandmont
(1985) and Melese and Transue (1986). The criticismof the use of the Li
and Yorke result is as follows. While the result is certainlytrue it does not
preclude the possibility that there is a stable cycle of period 3 (or some
other number). Further it is possible that for a generic initial value the
motion will eventuallyconverge to that cycle. The reason that this does not
contradictthe Li and Yorke result is that it is possible for an uncountable
set to have Lebesgue measure zero. Thus the set S mentioned above could
have measure zero, and hence be essentiallyunobservable.For the logistic
map a more useful indicator of chaos is when all cycles are unstable.
Jakobson(1981) has shown that, chaos, in this latter sense will occur for a
set of parametervalues which are not negligible.
In some ways the behaviour of differentialequations is unlike that of
differenceequations. In this section we have shown that the solution of a
one-dimensionaldifferenceequation with fairly simple non-linearitiescould
be extremely complex. This is not true for one-dimensional systems of
differentialequations, nor even for two-dimensionalsystems. In these cases
chaos cannot arise because of the Poincare-BendixsonTheorem (see Hirsch
and Smale (1974)) which says that any limit of a two-dimensionalsystem of
differentialequations is either a fixed point or a cycle. In three dimensions
this is no longer true. The Lorenz equations are an example of a chaotic
three-dimensionalsystem of differentialequations.
I think it is clear that this theory has potential for explainingeconomic
phenomena. Two of the most strikingfeatures of any macro-economicdata
are its random-likeappearanceand its seemingly cyclical character.Cycles
in economic data have often been noticed, from short-runbusiness cycles,
to 50-year Kondratievwaves. There have been many attempts to explain
them, e.g., Lucas (1975), who argues that random shocks combined with
various lags can give rise to phenomena which have the appearance of
cycles, and Samuelson (1939) who uses the familiar multiplier-accelerator
model. Despite these and other pieces of research one is still under the
impression, that something further could be said about business cycles.
Dynamic models of the sort we have been examining here are able to
generate cyclic behavior. There is therefore a good case that they will be
able to help us understandbusiness cycles.

12
2.5. Random disturbances
One interesting question raised by this research is are there truly

random events? In the previous section we showed how it was possible
for a system which is in fact deterministicto behave in a way which appears
random. It could be the case that there are no random events. All of the
apparentlyrandom phenomena we observe in the universe could be the
products of very complex but non-random systems. This is an accurate
descriptionof so-called 'random number generators'. In economics, however, it seems inevitablethat we will have randomterms in our equations. If
for no other reason, this will be because economic activity is affected by
biological and meteorological phenomena. These systems will almost
certainlybe chaotic in nature. As far as economics is concerned they will
appear as random terms in our equations. Further when we are only
modelling part of the economy we have to include random terms to
representchaotic processes in other sectors of the economy.
Having noted that random terms are inevitable in purely economic
systems of equations, we proceed to examine the consequence of such
randominfluences.Suppose that we add a randomerrorterm to the logistic
equation (2.2). There are two ways in which we could do this. We could
consider an additive error term of the form:
Xt+i =fr(xt) + Et= rxt(1 -xt) + Et
(2.5)
Alternatively we could consider the case where the parameterr, is itself

subject to randomperturbations:
Xt+i =fr+nt(xt)
(r + nt)xt(l
xt)
(2.6)
Here Etand nt are randomvariableswith mean zero. Perhapssurprisinglyit

has been found that the systems (2.5) and (2.6) behave in similarways. In
fact Crutchfield, Farmer and Huberman (1982) explain that there is an
equivalence between the two systems. Furtherthe behavior of the systems
changes little with changes in the distributionsof the error terms Etand nt.
In all cases the system behaves at r as a mixture of the behavior of the
deterministicsystem at neighboringr values.
This sort of system is studied in Crutchfieldet al. (1982). As one would
expect when (2.5) is following a stable cycle it will be perturbedfrom that
cycle by the noise term. Thus this cyclic orbit will consist of broad bands
rather than points. Chaotic behavior becomes more common. Since the
system follows a mixture of the behavior at adjacent parameter values,
many cyclic orbits disappear as they are averaged with chaotic attractors.
For instance if the noise is sufficientlylarge the system will have a stable
fixed point, then a 2-cycle, then a 4-cycle, and then pass directlyto chaos.
Thus the full period-doublingsequence no longer occurs. As an added
complicationthere are no longer clear points of bifurcation.These points
have become somewhatblurred.

D. KELSEY
13
40
03.0
FIG. 6
This agrees with what has been observed in experiments on fluid motion.
In these only a finite number of period-doubling bifurcations are seen
before turbulent flow commences. This number is usually low, typically less
than six. (See Citanovic (1984a) for further details.) Figure 6 shows the
results of a computer simulation of this system.5
Compared with the system with no random errors, chaos will appear in
equation (2.5) at a lower value of the parameter r. This follows from the
fact that in the noisy system, the behavior is essentially a mixture of the
behavior at neighboring parameter values. As the noise level is increased
this averaging occurs over a wider range of parameters. Hence successively
lower r's get averaged with chaotic orbits.
Within the chaotic region, the presence of random errors eliminates most
of the periodic windows. In numerical experiments only the period 3 orbit is
visible. A curious fact is that the influence of noise on the period 3 orbit is
different to its effect on the period 4 orbit. In the deterministic case the
probability density for the period 4 orbit consists of four point masses. In
the presence of random errors these broaden into four bands with
essentially zero density between them. In the case of the period 3 orbit as
well as the three points thickening into bands, a broad background fills in
between the peaks. As noise increases this background increases until the
peaks are washed out. This arises because the period 3 cycle is much closer
to a chaotic orbit than the period 4 cycle. Figure 7 shows the effect on the
period 3 orbit of raising the level of noise.
5
I would like to thank Jim Crutchfield and the North Holland Publishing Company for
permission to reproduce Figures 6 and 7 which previously appeared in Crutchfield et al. (1982).

THE ECONOMICSOF CHAOS OR THE CHAOS OF ECONOMICS
14
0
0.0
0.001
FIG.
Chaotic behavior is less sensitive to noise than periodic orbits. Many of

the periodicorbits with shorterrangesof stabilitywill not be visible. Indeed
it seems that only a finite number of periodic orbits will be visible at any
given noise level. Hence an infinite number of orbits are lost. In contrast
chaotic behavior if anything becomes more common as the noise level is
raised. Because of this relative sensitivityof cycles to randomerrors, a case
can be made for paying more attention to chaotic solutions than to cyclic
solutions.
3. Chaos in economic theory
3.1. The overlapping generations model
Conditions under which chaos can arise in the overlappinggenerations

model have been investigated by Benhabib and Day (1982) and by
Grandmont(1985). In this section I will consider a simplifiedversion of
Grandmont'smodel. We present this principallyas an example of how an
economic system can behave chaotically.We shall then considersome other
uses of dynamicalsystems theory in economics.
Consider an overlappinggenerationsmodel where each generation lives
two periods. We shall look at a pure distribution economy with one
consumptiongood and a fiat money. Therefore we need only consider a
representativemember of each generation. The representativeconsumeris
assumedto have an additivelyseparableutility function.
U(C1,
C2) = v1(c1)
V2(C2)-
Although most of our results are true for more general v-functionswe shall

D. KELSEY
15
postulate specificforms for v1 and v2

1-aV
v1(cl) = in (c1)
v2(c2)
C2
Where c1 and c2 denote consumptionin the first and second periods of life
respectivelyand acis a parameter.The consumeris assumedto have positive
endowments e1, e2 of the consumption good in the two periods. He
maximizesutility subject to the budget constraints
pic, + m1 = p1e,
(3.1)
p2c2 = m1 + p2e2
where m1 is the money balance the consumerholds from the first period to
the second. The consumptiongood cannot be stored. Thus the only way the
consumercan transferconsumptionfrom one date to another is by holding
money. It is still possible that consumerswill choose not to trade or hold
money, simply consuming their own endowments in each period. This
possibilityis usuallyreferredto as an autarkicequilibrium.We assume that
this does not occur. In all the equilibria we consider the consumershold
positive money balances. (Technicallythis can be ensured by choosing the
endowmentsappropriately.)
Examiningthe constraints(3.1) we see that the consumer'sconsumption
in the two periods only depends upon 0 = P1/P2. That is, demand is
homogenousof degree 0 in prices. Note thatP2 here is the expected price in
the second period. In this example we are assumingperfect foresight(which
is the same as rational expectations in a deterministicmodel). People's
expectationsof prices in the second period are the actual equilibriumprices
in that period. Thus we may write a typical consumer'sexcess demands as
z1(O) and
z2(0)
where zi(O) = ci(0) - ei
i = 1, 2.
We now consider an infinite sequence of market clearingprices which gives

us the corresponding sequence of relative prices (0a).
The consumers'
budget constraintsays
Ozt(0t)
= 0
+ Z2(0t)
(3.2)
For the consumerto maximizeutility the first order conditionis

Pt
VI(cI(00))
-0
Pt+1
V2'(C2(0at))
(3.3)
Substituting(3.3) into (3.2) we obtain

v'(el ? zl(0t))
vI(e2 ? z2( 0))
Z1(ot)
-Z2(0t)
(3.4)
We also have the marketequilibriumcondition

Z1(0t)+ Z2(0t-1) = 0

(3.5)
16
Using this (3.4) may be rewrittenas

V'(el - z2(0-1))z2(0-1)
Define i,
z2(0-1).
vt(e2
+ Z2(0O))Z2(0O)
(3.6)
It happens that Mtis the most convenient variable with
which to work. We can interpretMt as the level of real balancesheld by a

representativeconsumer.If we rewrite (3.6) in terms of Mwe obtain:
V'(el - M,)Mt = v4(e2 +
(3.7)
1t+l)Pt+l
This implicitly defines a non-linear difference equation in M. If we write

ul(M) = pvw(el - M) and
u2(P)
Mt =
pv'(e2
U1
+ M)
then (3.7) becomes
U2(Pt+l)
(If f and g are functions f o g(x) =f(g(x)).)
(3.8)
Let
differenceequation becomes
x=
u71 0 U2 then our basic

(3.9)
Mt= X(Mt+l)
The first thing we would like to ask about this model is what are the steady
states? This is answeredin the following lemma.
Lemma 3.1: The only steady states are constant prices 0 = 1 or the
no-trade (autarkic)equilibrium0 = 0.
Proof
Suppose M is the real balances correspondingto a steady state. Then

M= X(M).By Lemma A. I
M=
()
M=O
If M= 0 we are in the no-trade state. If
or
z21(M)
z-'(M)=l
=
1 then prices are constant.
Recall z-1(M) is equal to relative prices between the first and second
periods. E1
The next proposition relates this overlappinggenerations model to the
theory of Section 2.
Proposition 3.2: The function x is single-peaked, its maximum value
occurs at M*=e2/(aC- 1). As a Moo, 0* O> and (y*)(M el.
Proof
Recall x(M)= u11 0 U2(M) and ul(M) = M/(ei - M), U2(P) = M(e2+ M).
Thus
Differentiating we obtain u'(p) = (e2 -(a - 1)M)/(e2 + M)-1.
u2'() Z 0 as M e2/(Ca-1). Hence u2 is a single-peakedfunctionwhich has
its maximumat M*= e2/(CV- 1) Since ul (and hence ulT1)is an increasing
function, it follows that x is also a single-peakedfunctionwith maximumat

M*.ClearlyM* 0 as c- oo.We assert that the maximumvalue of u2 tends
to infinity as a&tends to infinity. Now U2(P)= M(e2 + M)- this tends to
infinityas v-*oo if M< 1 - e2. Since M* >O as &-*oo the assertionfollows.

D. KELSEY
Since u '(y) = e1y/(1 +y) it follows that u1(y)
17
tends to e1 as y tends to
infinity. By monotonicity of uj1 the maximumvalue of

functionof caand tends to el as catends to infinity. C]
x is an increasing
The main message of Proposition3.2 is that we are now in a position to

apply the theory of one-dimensionalmappings outlined in Section 2. We
have a single-peaked function x. The size of the peak increases as ac
increases.Since e1 is the effective maximumpossible value of A, the limiting
case where actends to infinity correspondsto the case of the logistic map
(2.2) where r = 4. In both cases the map takes the entire intervalonto itself.
In light of Sarkovskii'stheorem it is interestingto check whetherthe system
is capable of generating a 3-cycle. If so there will be cycles of all other
periods. Hence we are well into the chaotic region. The following
proposition shows that 3-cycles do in fact occur provided that a is
sufficientlylarge.
Proposition 3.3: For all sufficiently large cr, a 3-cycle exists provided
e2 <1 and e1+ e2 >1/e2.
Proof.
See Appendix. EZ
Thus the overlappinggenerationsmodel which we have set up is capable
of generating both cycles and chaotic behavior. In my opinion the main
message of this is that non-linear dynamics is a possible cause of the
irregular cycles which we see in macroeconomic data. The particular
structureof this model should not be taken too seriously. For instance the
average life of a generation is about 25 years. If we take the division into
generations very literally then the shortest cycle which this model can
producelasts about 50 years. This would make it a sort of Kondratievwave.
We are however much more interestedin explainingshort-termfluctuations
in employment and output. Grandmontgoes on to argue that there is a
possible counter-cyclicpolicy, which will smooth out the fluctuationshe
discovers.It is indeed possible that there may be a governmentpolicy which
will be able to smooth out Kondratievwaves. But this is a differentissue
from what is usuallymeant by a counter-cyclicalpolicy.
3.2. Other economic models involving chaos
Below we give a summaryof some of the other economic models which

find chaotic behavior. Most of these are based on the same theory of
one-dimensionaldifferenceequationswhich we have examinedin Section 2.
Thus mathematicallythe papers tend to be rather similar although they
make importantcontributionsto differentareas of economic theory.
Day (1983) considers classical economic growth. This is a "Malthusian"
type model where the level of output determines the rate of population
growth. Output in turn depends on the size of the labor force. The
interactionof these two effects can produce cycles or chaos.

18
Benhabib and Day (1981) analyze consumerchoice. In this model actual

consumptioncan influencetastes in futureperiods (e.g., by addiction).They
reach the interesting conclusion that increasing wealth can cause more
complicateddynamicsto emerge. Thus the choices of a poor consumermay
be quite constant, while the choices of a richerconsumercan be cyclicalor
chaotic. Gaertner (1984), (1986) analyzes a similar model. In his theory
however, non-linearitiesarise not only because currentchoices affect future
tastes but also because an individual'stastes are affected by the choices of
others in society.
There is a problem in consumer theory. It does not seem irrationalif a
woman eats pork one day and beef the next. This is however difficultto
model within conventional consumer theory. If the prices do not change
from one day to the next it would seem that she is violating the axioms of
revealed preference. This could be explained as a change in preferences.
Such an approachis unsatisfactorysince consumertheory should be able to
explain a whole range of choices within one framework. Having different
preferencesto explain the choices of beef and pork fails to do this.
A second approach would be to model a consumer as choosing all
consumptionfor a long period of time, say a month, at one time. Then the
fact that both pork and beef are consumed, rather than just pork can be
explained by concavity of the utility function. This approach has the
disadvantage that certain goods are only consumed once a year, e.g.,
holidays. Thus our basic time period would have to be at least a year. For
empiricalobservationswe would need data from several years. Could we be
sure that preferences would remain constant over such a long period of
time?6
Benhabib and Day's model gives a third explanation.Alternatingchoices

of beef and pork are a cyclic solution of a dynamicalsystem. This is driven
by the assumption that what is actually consumed on one day affects
preferencesfor the next. In the frameworkof Benhabib and Day it may be
better to think of preferences as defined over a much shorter time period.
For instance, alternatingchoices of beef and pork would be explained by
postulating preferences which only covered a single day's consumption.
Thus the consumption of pork one day actually causes the consumer's
preferencesto change, in such a way that the next day pork is rankedlower
vis-a-vis beef. "I couldn't face pork two days in a row."
Benhabib and Day have abandoned stable preferences and put in their
place preferenceswhich change in a stable way. This has the disadvantage
that such preferences are much harder to work with, and very difficult
indeed to apply to actualdata. Also, it is not very easy to talk of a consumer
having a taste for variety.
One may ask whether chaos will emerge for plausible values of the
parameters.The answer is uncertain. Grandmontreports some computer
6
This issue is also discussed in Sen (1979), pp. 14-16.

D. KELSEY
19
simulationson an overlappinggenerationsmodel similarto that describedin

this section. For cycles to appearit is necessaryfor the relativerisk aversion
(as) to rise from 2 to 4 between the firstand last periodsof a consumer'slife.
To obtain chaos relative risk aversionin the second period of a consumer's
life must be 8. These both represent marked changes in an individual's
behavior, and it is not easy to believe that they are realistic. Similarlyin
Day's (1983) model of economic growth, the emergenceof chaotic behavior
depends on a very steep hump in the function relating one period's
population to that of the next period. While it is hard to dispute that this
relationshipis non-linearit is doubtfulwhetherit possesses sufficientlysharp
curvatureto generate chaos. Related criticismscan be made of the model of
duopoly in Rand (1978). The shapes of the reaction functions he assumes
are very extreme indeed. It does not look like they could be generated by
plausible demand and cost functions. In physics there is a similarproblem.
The Lorenz equations are a simple model of the weather, they can give rise
to chaos, however it has been arguedthat the parametervalues which do so
are unlikely.
Montrucchio(1984) and Boldrin and Montrucchio(1985), (1986) discuss
circumstancesin which optimal growth paths may be chaotic. This is
differentfrom most of the other economic articles in the area which show
that not necessarilycoordinatedsystems can give rise to chaos. In particular
it is known that the behavior of the overlappinggenerationsmodel is not
necessarily optimal, even in the Pareto sense. Thus it is not so surprising
that the system can generate chaotic behavior. The discovery that optimal
behavioris chaotic is in some senses more worrying.Given the difficultyof
following chaotic paths, in these circumstancesactual behavior will almost
inevitably be sub-optimal. Simon (1979) has argued that due to the
difficulties of calculating an optimal strategy economic agents will not
behave in an optimizing way, but will instead aim for a satisfactory
outcome. This sort of behavior is referred to as bounded rationalityor
satisficing.The possibilitythat the optimalstrategymight be chaotic strongly
reinforcesSimon's argument. Given the immense difficultiesin following a
chaotic path agents might well opt for a sub-optimal but less complex
strategy.
4. Chaos and rational expectations
Time series of many economic variables have the appearanceof being
noisy cycles. The traditional explanation of this is that the economy is
subjectto randomshocks. These may be due to the weather, earthquakesor
any similarexogenous phenomenawhich could influenceeconomic activity.
An importantexample of this approachcan be found in the work of Lucas
(1975).
In this paper Lucashas a macroeconomicmodel whichis based on a set of

linear difference equations with stochastic error terms. The economy is

20
subdividedinto "islands". Informationflows between different islands are

imperfect. Because of this when agents see that prices are rising, they are
not able to tell whether prices are rising only on the island on which they
are situated or whether they are witnessinga general rise in the price level.
Hence purely nominal shocks, which cause prices to rise can induce people
to invest, even though they make no differencein real profit opportunities.
The capital which they have invested will remain in place even after the
nominalshock has passed. Hence real effects will be felt for some time after
a disturbance.(Similarlyshocks which cause the price level to fall will have
effects which will persist.)
In particular Lucas shows that his model will generate pro-cyclical
movements in both prices and the share of output devoted to investment.
These he argues are a possible explanationof the auto-correlationsseen in
macroeconomicdata. He furtherarguesthat when the economy is subject to
a sequence of random shocks, it will behave in a way which resembles a
real-lifebusinesscycle. (For a surveyof businesscycle theory see Zarnowitz
(1985).)
An alternativeexplanationof the businesscycle would be to use a model
involvingnon-lineardifference(or differential)equations. If a model of this
sort exhibited chaotic or cyclic behavior, then it could provide an explanation of the business cycle. Such an approachwould have the advantageof
not relying on exogenous randomshocks.7A second contrastto the results
of Lucas is that monetary policy may be effective even if agents have
rationalexpectations.The policy ineffectivenessresult does rely very heavily
on the assumptionthat economic relationsare log-linear.Grandmont(1985)
shows that monetary policy can be highly effective within his overlapping
generationsmodel. Snower (1984) also shows that non-linearitiescan cause
monetary policy to be effective. While this is true, in a chaotic model it
might be very difficultin practiceto calculatethe optimalpolicy.
The question ariseswhich approachis correct?Does Lucas or Grandmont
have the true model of the business cycle? First the question should be
reformulatedas which model is better. Both are extremely drasticsimplifications of actual economic processes. Neither even pretends to be realistic
or true. As Friedman (1953) argues realism in economic models is not a
desirable end in itself. It should only be incorporatedin models to the
extent that it tells us something useful about the economy. Nevertheless a
good economic theory should indicatethe essentialmechanismswhich cause
economic phenomena. If businesscycles are caused by non-lineardynamics,
it is not helpful to explain them by randomshocks, tradingon islands, and
linear relationships.
7 It should perhaps be pointed out that business cycles can also be modelled as "sunspot
equilibria". In this case fluctuations arise because people condition their expectations on some
Markov process, which does not directly affect the economy. This approach is connected with
non-linear dynamics since the existence of a 2-cycle implies the existence of a sunspot
equilibrium. (See Azariadis and Guesnerie (1986).)

D. KELSEY
21
It is still the mainstream view that economic fluctuations are caused

primarily by random shocks. Relatively few people would regard the main
cause as being non-linear dynamics. The reason for this is not clear. It is
certainly not the case that there is significant empirical evidence supporting
the random shock viewpoint. Indeed at present there is very little evidence
at all which could be used to discriminate between the two theories.
Probably the reason why the random shock theory has become established
is simply that it was proposed the first, and that it is based on statistical
techniques commonly taught to graduate students. In fluid mechanics, in
contrast, the view is that the seemingly random character of turbulent
motion is due to chaotic dynamics. The idea that exogenous random shocks
may be responsible, is given little consideration.
This is not to deny that the economy is not subject to random shocks. The
impact of shocks is however determined by the system. In a strongly stable
system, which returns to equilibrium quickly the impact of an external shock
will be small. In a non-linear system with sensitive dependence on initial
conditions the impact of even a very small shock can be large, and the
economy will show no tendency to return to its original time path.
Non-linear dynamics have the advantage that they give a purely economic
explanation of business cycles. There is no need to rely upon unexplained
exogenous shocks. Lucas (1975) states
In all of the models discussed in the paper, real output fluctuationsare triggered
by unanticipatedmonetary-fiscalshocks. The first theoretical task-indeed, the

centraltheoreticalproblemof macroeconomics-is to find an analyticalcontext in
which this can occur and which does not at the same time imply the existence of
persistent, recurrent, unexploited profit opportunities. Section 2 develops a
neoclassicalmonetarygrowthmodel, with the aim of illustratingwhy this problem
cannot be resolved within the class of aggregativemodels which view trade as
taking place each period in a single, centralizedmarket. This abstractenvironment, while analyticallyconvenient, places too much informationat the disposal
of tradersfor cyclicalbehaviorto be consistentwith rationality.
When we use non-linear models Lucas's conclusions have to be modified
quite significantly. The theory of business cycles which we developed in
Section 3.1 of this paper essentially has trade taking place each period in a
single centralized market with rational expectations.
It must be admitted that information flows in the economy are not
perfect, and that some sections of the economy operate more or less
independently of one another. Despite this Lucas's model of an economy
situated on different 'islands' seems very arbitrary and unrealistic. Also the
assumption of linearity in fundamental economic relationships does not
appear plausible. In summary chaotic economic models can explain the fact
that macroeconomic data has the appearance of being at the same time
erratic and containing cycles. They have the advantage over the model of
Lucas (1975) in that they avoid certain rather ad hoc assumptions.

22
It is clear that rational expectations is a difficult hypothesis to maintain in

chaotic models. It should be pointed out that even in non-chaotic models
there are several problems with rational expectations. To be consistent one
should really be able to describe a process by which expectations are
acquired. It should be shown that such a process will lead to a rational
expectations equilibrium.8 This is difficult to analyze. The learning process
will affect the behavior of economic variables, but this will feedback on the
learning process itself. (Indeed it could be the case that the learning process
could cause chaos in an otherwise non-chaotic model. A feedback loop of
this kind being one of the common features of chaotic systems.) In any
event this kind of feedback has made describing the learning process very
problematic. To date only very simple cases have been analyzed, where
agents know the basic structure of the economy apart from a single
unknown parameter. Agents then use ordinary least squares to estimate this
parameter. More complicated cases have not yet been analyzed.
Suppose agents attempt to learn about the economy, using econometric
techniques which are based on a correct specification of rational expectations equilibria. Bray (1982) states:
In doing so they fail to take account of the dependence of outcomes on beliefs.
Their estimation technique is based on a misspecificationof the situation. For
examplein the rationalexpectationsequilibriumof the asset marketmodel studied
in this paper, the price and return on the asset at different dates form an
independentidenticallydistributedsequence of normalrandomvariables.In this
situation, ordinaryleast squares (OLS) is an appropriatestatisticalprocedurefor
learningabout the price returnrelationship.However, suppose that the agents in
the model use OLS (or any other statisticalprocedure)to estimatethe price return
relationshipoutside the rational expectationsequilibrium,and use their estimate
in forecastingreturns. The stochasticprocess of price and returnis then neither
stationarynor independent.The use of OLS estimationis inappropriate.
Despite this misspecification Bray shows that the use of OLS can, in certain
simple cases, cause the system to converge to rational expectations
equilibrium.
In chaotic models all these problems are still present. Chaos does cause
some additional problems. Even if the functional relations are known
completely it is the case that errors in measurement and computing will
eventually make forecasts unreliable. Traditionally in a deterministic model
rational expectations would be assumed to imply perfect foresight. In this
model this view is difficult to maintain if the equilibrium path is chaotic.
Perfect foresight must rely on agents observing and learning about their
environment. With aperiodic motion there is no scope for them to observe
regularities in the environment. Moreover, if they understand the sensitive
8
Though this is not particularly a criticism of rational expectations. To be consistent any

alternative theory of expectations should be able to describe a learning process whereby
expectations are acquired.

D. KELSEY
23
dependence on initial conditions they will realize that it is impossible for

them to make forecasts about anythingbut the immediatefuture.
If the parametersof the economy are such as to generate cycles the story
is different. There is a regularity in the environment. Hence there is a
chance that agents can learn to predict the paths of equilibriumvariables.
Grandmont(1985) actually models a learning process and shows that the
system can convergeto the long-runrationalexpectations(perfectforesight)
behavior. It should be mentioned that this result only applies to the
overlappinggenerations model discussed in Section 3.1. Nevertheless it is
very interestingand suggeststhat similarresultscould be producedfor more
general systems.
Invariant measures
Thus in a model with chaotic dynamics, perfect foresight is not a good

way to formulate rational expectations. Nobody has been able to suggest
any learningprocess by which an individualmight acquireperfect foresight
in a chaotic economy. (The learning process suggested by Grandmont
(1985) has only been shown to converge to perfect foresight in a cyclic
regime.) It seems very unlikely that such a learning process does in fact
exist.
Fortunatelythere does exist an alternative way of formulatingrational
expectations.In some circumstancesit is possible to find statisticaldescriptions of aperiodicmotion. Supposef is a map of an intervalinto itself. Then
sometimesit is possible to find a probabilitydistribution(or measure)which
describesthe likelihood of the system taking a particularvalue after a large
numberof iterations.Let ft denote a measureon the intervalconcerned,say
I. To describe the motion under f, y must be invariantand ergodic. (See
Grandmont(1983).)
The distribution y is said to be invariant under f if p (f1(A))
i(A) for
all sets A, on which y is defined. This says that the probabilityis preserved
by the mapf. It should be clear why it is necessaryfor the measureto have
this property.
The measurey is ergodicfor f if for any p-integrablefunctiong.
lim-E
n-,-
g(f'j(x))
n =11
fgdy
for every x (except possibly in a set of y measure zero). This is a

mathematicallyprecise way of saying that from a typical startingpoint, the
points on the future path of x are distributedlike randomlychosen points
from the probabilitydistributiony.
This implies in particularthat if one considersfor given x the distribution,
which assigns probability 1/n to each f (x) for i = 0, 1,..., n - 1, then this
sequence of distributionswill approximatey unlessx is in a set of fi measure
zero. Hence the ultimate distributionis the same for all typical starting

24
values. Notice that after the system has been runningfor some time, values
of the variablex in a set of i-measurezero will not be observedin practice.
In such circumstancesit may be reasonableto assume that an individual
with rational expectations would use the probability y. Given the complexity of non-linear dynamics, it is not reasonable to suppose that an
individualwould actuallybe able to calculate,u. Indeed even highly trained
pure mathematicianshave only been able to calculateinvariantmeasuresin
a few special cases. It is, however, possible that by observingthe outcome
of the system a large numberof times, that an individualwould be able to
get a close approximationto the true distribution.A very interestingpiece
of research would be to construct an actual learning process which could
model this. It may be possible to base such a process on our observation
above, that when there is an ergodic measure, giving equal probabilityto all
observations will result in expectations that converge to the true
distribution.
The best known example of an invariantmeasureis the case of the logistic
map (equation (2.2)) when r = 4, x,+1= 4x,(1 - xt). Recall we have found an
analytic solution for this equation in section 2.4. This system has an
invariantmeasure with density function 1brV(x(1 - x)). Just as a general
probability distributiondoes not always have a density function, (e.g., a
discrete distribution would not have a density function), so a density
function cannot always be found for an invariantmeasure. There may be
point masses in the distribution. Other complicating factors are also
possible. Hence we are especiallyfortunatein the case of r = 4.
For an individualwho is interestedin the long-runbehaviorof the system
a sensible interpretationof rationalexpectationswould be that he used the
invariantmeasure as his expected distributionof the variable. There are
however known examples where there is no invariant measure. In such
cases it is not at all clear what a rational expectation would be. This is a
difficultproblem for those who advocate rational expectations. Most other
suggested expectations rules, e.g., adaptive expectations, will continue to
work in chaotic regimes. A qualificationshould be introducedhere. It is not
the case that the invariant measure would give a good estimate of next
period's value of a particularvariable conditional on the currentobservation. It might, however, be the case that such a measure would provide a
reasonablelong-runexpectationof a chaotic variable.
We shall now give an example of circumstancesin which it might be
correct to base expectations on an invariant measure. Suppose that
consumersbehave in a manner similar to that described in Benhabib and
Day (1981). Because of the effects of previous consumptionupon tastes
actual consumption follows a chaotic path. Suppose further that all
consumers behave in a similar way, that the preferences of a given
consumer are independent of the preferences of any other consumer.
Finally assume that there are sufficientlymany consumersthat the law of
large numbers applies. Then if the dynamicprocess generatingconsumers'
demand has an invariant measure, that measure should be the rational

D. KELSEY
25
expectationof demand for the supplierof the good (after resealingto allow
for the difference in magnitude between market demand and individual
demand).
5. Multi-DimensionalMaps
So far we have only dealt with first-orderdifference equations in one
variable. This is not because we believe that such systems provide a good
description of economic activity, but because such systems are the best
understood. Chaos can also arise in higher-orderdifferencesequations, in
systems with more than one variable, and in systems of differential
equations of dimension at least 3. These are less well understoodthan the
one-dimensional maps studied in Section 2. Nevertheless certain multidimensionalsystems have been reasonablywell studied. Examples are the
Lorenz equations and the Henon map. (These both are very simplified
models of the weather.)
Most of the studies which have been carried out have had physical
applicationsin mind. Although a couple of papers have suggestedpossible
economic applications of the Henon map. See Deneckere and Pelikan
(1986) and Boldrin and Montrucchio (1985). Most physical systems are
dissipative,i.e., the system contains forces due to friction. This means that
they are volume contracting.In general there will be a single direction in
which the rate of contractionis the least. In the long run only effects in this
directionwill be important.It follows from this that a dissipativesystem is
essentially one-dimensional. The theory of one-dimensionalmaps as outlined in Section 2 can be applied to a system of this sort.
Another possibilityis that the principleof conservationof energy can be
invoked to require that a multi-dimensionalsystem be conservative or
Hamiltonian (i.e., they preserve areas). There has been a considerable
amountof work done on conservativedynamicalsystems.
These conditionsarise from propertiesof the physicalsystems motivating
the equations. Economic systems cannot in general readily be classifiedas
dissipative or conservative since there is no economic concept which
correspondsto energy. Optimal growth models do, however, have Hamiltonian properties. Thus it is not clear that we shall be able to make use of
these simplificationswhich have proved very useful for studying physical
systems.
While in general it is not possible to say that an economic system is
dissipative or conservative, there are many other properties we believe
economic systems have. It is possible that such properties (e.g., concavity)
could be used to simplify multi-dimensionaldynamicalsystems. This may
lead to very major advances in economic theory, as dynamicsystems have
alreadyadvancedour knowledge of fluid motions. What sort of progressis
possible in economic theory cannot be said. Almost no work has been done
in this area, though a qualificationto this must be mentioned. Grandmont

26
(1985) considers a multi-periodlearning process. He shows that this can

converge to two-period perfect foresight behavior. This is analogous to
frictionreducingphysicalsystems to a single dimension.
6. Conclusion
In this paper we have shown that mathematicalsolutions of non-linear
differentialor differenceequations are capable of generatingeither cyclic or
random-like behavior. These ideas have already begun to be applied in
economics as we have describedin Section 3. Traditionallyeconomic theory
has been concerned primarilywith finding steady states and to a lesser
extent with finding cycles. Perhaps one of the greatest services dynamic
systems theory has done is to make economists aware that other types of
solutions are possible.
As mentioned before, dynamic systems theory has been successfully
employed in the study of fluid mechanics. Many of the phenomena (e.g.,
period-doublingsequences) described in Section 2 have been observed in
experiments on fluid motion. (See Citanovic (1984a) for further details.)
Barnett and Chen (1986) have empirical evidence of chaotic behavior in
monetary aggregates. This confirmsthe usefulness of these theories. The
theory has also been applied in biology to the dynamic behavior of
populationsof certain species.
Fluid mechanicshas one advantageover economics. The basic equations
of motion are known. (These are the Navier-Stokes equations.) It is true
that they are capable of generating extremely complicated behavior, and
that in many cases they are unsolvable. Economic theory has both these
disadvantages,and the additionalproblemthat we are not really sure of the
economic equations of motion. This is the major difference between
problemsof economic predictionand those of weather forecasting.
Economics contains the following paradox. In microeconomicsall economic variablesare seen as producedby the rational decisions of maximizing
agents. Hence in microeconomicsvariablesare completely deterministic.In
macroeconomics, however, economic variables are frequently viewed as
being random. How can the same variablesbe randomand deterministicat
the same time? This paradox may be explained if the economic system is
chaotic.
Withinnon-linearsystems of the sort describedin this chapteradjustinga
parametercan move the model from a stable steady state or cycle into the
chaotic region. It is possible that such a transition occurred in the
macroeconomy around 1967. At this time many industrializedcountries
switchedfrom conditionsof steady growthwith some cyclic fluctuationsinto
a period in which economic activity was much more erratic. Since about
1967 the behavior of many economic variables, e.g., the price level or
exchange rates have become much less predictable. It is not certain that
what we are observing is chaotic dynamics. There are many independent

27
D. KELSEY
sources of noise which affect economic data. It is, however, possible that
some of the observed noise is not extrinsic noise independent of the
economic system but intrinsic noise generated by chaotic dynamics of the
system itself.9
Sensitive dependence on initial conditions is not a new discovery. It is
exhibitedin the following problemfrom classicalphysics.
Solve ,f32f+ 32f
f = 0 (this is Laplace'sequation)
subject to the boundarycondition
f(x,y)=ecos(x)
at y=0,
a3f
-=0
at y=0
Here E is assumed to be small. It is best to think of the term Ecos (x) as

representingour error in the measurementof x on the boundary.It is easy
to check that the solution is
f(x,y)=vcos(x)cosh(y).
Even though ? is small as y increases this will become very large indeed.
Thus any error, however small, in measuringthe value of the function on
the boundarywill have a major effect on the value of the solution in the
interiorof the domain. The behaviorof this system is essentiallyimpossible
to predict.'0
The results of dynamicsystems theory have a fine structurewhich is hard
to reconcile with observed economic behavior. In the theory of the logistic
map in Section 2, as the parameterr is varied in the interval[3 4] an infinite
numberof stable orbits can be found. There are also several other features
of the behavior which occur in infinitely minute detail which we have not
discussed. (An importantexample of this is Feigenbaum'suniversalscaling
theory. See Feigenbaum (1980) and Citanovic (1984a).) In the chaotic
region the probabilitydistributionsdescribingthe motion can be extremely
complex. They can contain a large number of point masses. Typicallythey
will not be continuous, that is the distributioncannot be representedby a
densityfunction.
The inclusion of random errors changes this quite dramatically.The
theoreticaldynamicsbecomes a much more plausible descriptionof actual
economic data. All but a finite numberof periodic orbits disappear.Usually
the numberof such orbits is very low, say around4, so they do not need to
be closely packed. Similarly the probability distributions become much
smoother. Thus in the presence of noise it is much easier to believe that
chaotic dynamicsprovides a good descriptionof economic behavior.
9 This point is due to Richard Day of U.S.C.
10 I heard about this example through Hermann Bondi.

28
For those interestedin furtherreading,two good mathematicalreferences

are Collet and Eckman (1980) and Preston (1983).
ChurchillCollege, Cambridge,UK.
APPENDIX
In this appendix we show that a 3-cycle can occur in the overlapping generations model
which we studied in Section 3.
Lemma A.1: The function X has the following properties
(i)
(ii
X (Y)
%'(O)=
IZ 2-
(Y)
1/0
(iii) X(y) < M/O the function X lies below its tangent at the origin.
(where 0 = v'(el)Iv'(e2) a consumer will hold a positive money balance if and only if 0 > 0.)
Proof
From the market equilibrium condition we have
Yt-l
= - zl(Z2
+ Z2(01)
Zl(0t+1)
(A.1)
(A.2)
(P))
from (A.1) and the fact that , = z2(0,+?). The consumer's budget constraint is
=-Z2(0)
Z(0)
Substituting (A.3) into (A.2) we obtain
Yt-l
i.e., X(M)=
Differentiating
(A.4)
we
obtain
= 0
+ Z2(0t)
OtZl(0t)
(pt)
=PtIZ2
which proves (i)
1()
X'(M) =
(A.3)
))
(Z2l(j)Z2(Z-l(z'
(A.4)
-
I)/(Z2-l()2Z1(Z-l(Y
>
x' (0) = 1/zj-'(0) = 1/0 which proves (ii). Now zj-1(y) > 0 whenever y > 0 hence using (A.4)
xAM)< Y/0 when y > 0 which proves (iii).
Lemma A.2: For all sufficiently large a we can find i(a)

(i) U2(M*)>Ul(ft) or X(j*)>ft
y*(a) such that:
or X(ft)< 0p*
(ii) u2(ft) U1(0p*)
provided that e1 + e2 > 1/e2 and e2 < 1. (Recall that y is the value of y which maximizes X*)
Proof
Since el + e2 > l/e2 it follows that el + e2 > 1. Hence we can choose
g
el. Consider
g(a?) = u2(ft)I(V'(e 1)0(cv)y*(a))
We assert that if
ft + e2 >
l/e2 then g()
-0> as
0 v(el
v2(e2)
-.
such that 1 - e2 < ft <
Note
e"
el
Writing out g explicitly we obtain

fie~l (-1
e2 (e2(e2 +f))
This tends to zero provided e2(e2 + i)>
1. The assertion follows.

D. KELSEY
29
If el + e2> l/e2 then we may pick ft such that ft + e2> l/e2 and our other conditionsare
satisfied. Then for sufficientlylarge a,, g(a) < 1, hence u2(JA)< v'(el)OMl*. Now ul(M) =
pl(el - M) therefore
el(-)=
1-
(el-M)"
Since u' is an increasingfunctionof A, ul is convex and thereforelies above its tangentat the
origin, i.e., ul(M) > u(0) = v(el)
so u2(t) <ul(&M*). This satisfies (ii). Since as a,-e 00,
M* ->O and X(M*)->el we have M*< P andX(M*)> Pffor all sufficientlylarge a,. This completes
the proof of LemmaA.2.
Lemma A.3: A sufficientcondition for the existence of a 3-cycle is that X3(y*)
xi*) > W*
M
,* and
Proof
By (ii) of LemmaA.1 the derivativeof x3 at 0 is 1/&3 > 1. Hence for Mclose to 0, X3(L) > P.
If x3(p*) - * it follows from the IntermediateValue Theorem that there is a P* such that
O< M' M* and X3(p,)=W'. By Lemma 3.1 the only steady states are zero and 1. Now
P* = e2/(a, - 1) which for aM 2 is certainlyless than 1. Hence M'# 1, M' 0O.It follows that M'
mustbe a point of period 3. [
Proposition 3.3: A cycle of period 3 will exist for all sufficientlylarge a,, provided
and e2<1.
el+e2>1/e2
Proof
By Lemma A.2, for all sufficientlylarge a,, we can find Pf such that X(ft) O * and
t < X(*). Since X(y) is a decreasingfunctionfor M M*,
P*
x2(tt*) < X(p)
as*
Since x lies below its tangentat the origin (LemmaA. 1).

%3(p*) <% 2(M )Sy
0
By LemmaA.3 we have satisfiedthe sufficientconditionsfor a 3-cycle. W
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acknowledges Benhabib and Day (1982).

30
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Economics of Chaos

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The Economics of Chaos or the Chaos of Economics

Author(s): David Kelsey

This content downloaded from 128.239.218.133 on Wed, 11 Jun 2014 11:47:02 AM

Oxford Economic Papers 40 (1988), 1-31

a simple account of non-linear dynamics, focussing on

THIS PAPER gives

This content downloaded from 128.239.218.133 on Wed, 11 Jun 2014 11:47:02 AM

THE ECONOMICS OF CHAOS OR THE CHAOS OF ECONOMICS

argumentssuggest that it could be of use to economists. This paper aims to

The simplest differenceequation is linear and first order:

This content downloaded from 128.239.218.133 on Wed, 11 Jun 2014 11:47:02 AM

first-order,but are non-linear then the behavior we find is very different.

Equation(2.2) is often known as the logistic equation. While equation (2.2)

A stationary solution of equation (2.2) is a sequence (xt) which is a

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THE ECONOMICS OF CHAOS OR THE CHAOS OF ECONOMICS

This content downloaded from 128.239.218.133 on Wed, 11 Jun 2014 11:47:02 AM

describingunder what circumstanceswe can get cycles of differentperiods

*. < (2m + 1) < (2m - 1) < . .. < 5 < 3.

By Sarkovskii'stheorem there are a large number of cyclic solutions to

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THE ECONOMICS OF CHAOS OR THE CHAOS OF ECONOMICS

Let Yrbe the fixed point (stationaryequilibrium)for fr. A necessaryand

(X2) * d (X3) *--..

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equation (2.2) changes as the parameter, r, increases. As we have already

This content downloaded from 128.239.218.133 on Wed, 11 Jun 2014 11:47:02 AM

THE ECONOMICS OF CHAOS OR THE CHAOS OF ECONOMICS

Consider the logistic equation (2.2) when r = 4. In this case an analytic

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Although the difference equation (2.2) is completely deterministicthe

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THE ECONOMICS OF CHAOS OR THE CHAOS OF ECONOMICS

In practice the difference between aperiodic motion and a cycle of very

Essentially this says that within S we have sensitive dependence on initial

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conditions.Finally if z is a periodicpoint and x is in S then

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THE ECONOMICS OF CHAOS OR THE CHAOS OF ECONOMICS

2.5. Random disturbances

One interesting question raised by this research is are there truly

Alternatively we could consider the case where the parameterr, is itself

Here Etand nt are randomvariableswith mean zero. Perhapssurprisinglyit

This content downloaded from 128.239.218.133 on Wed, 11 Jun 2014 11:47:02 AM

This content downloaded from 128.239.218.133 on Wed, 11 Jun 2014 11:47:02 AM

THE ECONOMICSOF CHAOS OR THE CHAOS OF ECONOMICS

Chaotic behavior is less sensitive to noise than periodic orbits. Many of

Conditions under which chaos can arise in the overlappinggenerations

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postulate specificforms for v1 and v2

where zi(O) = ci(0) - ei

We now consider an infinite sequence of market clearingprices which gives

For the consumerto maximizeutility the first order conditionis

Substituting(3.3) into (3.2) we obtain

We also have the marketequilibriumcondition

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THE ECONOMICSOF CHAOS OR THE CHAOS OF ECONOMICS

Using this (3.4) may be rewrittenas

It happens that Mtis the most convenient variable with

which to work. We can interpretMt as the level of real balancesheld by a

This implicitly defines a non-linear difference equation in M. If we write

then (3.7) becomes

(If f and g are functions f o g(x) =f(g(x)).)