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Tobias Kranz

Persistent Stochastic
Shocks in a New
Keynesian Model
with Uncertainty
BestMasters
Springer awards „BestMasters“ to the best master’s theses which have been com-
pleted at renowned Universities in Germany, Austria, and Switzerland.
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The series addresses practitioners as well as scientists and, in particular, offers guid-
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Tobias Kranz

Persistent Stochastic
Shocks in a New
Keynesian Model
with Uncertainty
Tobias Kranz
Trier, Germany

Master Thesis, University of Trier 2015

BestMasters
ISBN 978-3-658-15638-1 ISBN 978-3-658-15639-8 (eBook)
DOI 10.1007/978-3-658-15639-8

Library of Congress Control Number: 2016954031

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Acknowledgements
I would like to take this opportunity to thank several people who have supported me
during the two years of my master studies and been of great help in the work on this
thesis.
I highly value all the input Jun. Prof. Dr. Matthias Neuenkirch has given me. He
answered every one of my questions swiftly and thoughtfully. I admire his work ethics and
thank him for guiding me through this process in such a supportive manner. Furthermore,
I would like to thank Stefan Geisen for his great mathematical help in past projects and
for the many fruitful conversations we had on the topics of economics and mathematics.
I would also like to express my gratitude to Sarah Cames for developing and improving
my English skills and for being so diligent in correcting my mistakes.
Finally, I wish to thank my family for their endless support and encouragement, not
only throughout my studies, but throughout my whole life.

Tobias Kranz
Trier, November 2015
Contents
Lists of Figures and Tables IX

Lists of Symbols and Acronyms XI

1 Introduction 1

2 New Keynesian Model 3

2.1 The New Neoclassical Synthesis . . . . . . . . . . . . . . . . . . . . . . . . 3
2.2 New Keynesian Phillips Curve . . . . . . . . . . . . . . . . . . . . . . . . . 5
2.3 Forward-Looking IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
2.4 Targeting Rule under Discretion . . . . . . . . . . . . . . . . . . . . . . . . 17

3 Persistent Shocks 20
3.1 AR(1) Process . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
3.2 Uniqueness of an Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . . 21
3.3 Equilibrium Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
3.4 Comparative Static Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . 26
3.5 Parameter Discussion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
3.6 Numerical Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29

4 Model with Uncertainty 32

4.1 Quadratic Approximation . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
4.2 Interest Rate Rule with the Quadratic IS Curve . . . . . . . . . . . . . . . 35
4.3 Equilibrium Condition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
4.4 Further Calculations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
4.5 Numerical Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
4.6 Model Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

5 Conclusion 49

References 51

Appendix 57
List of Figures
1 Graphical Results of Households’ and Firms’ Static Optimization . . . . . 9
2 Section 3.6: Equilibrium Condition . . . . . . . . . . . . . . . . . . . . . . 29
3 Section 3.6: Strict Inflation Targeting . . . . . . . . . . . . . . . . . . . . . 31
4 The Quadratic IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
5 Section 4.5: Equilibrium Condition . . . . . . . . . . . . . . . . . . . . . . 41
6 Section 4.5: Strict Inflation Targeting . . . . . . . . . . . . . . . . . . . . . 42
7 Section 4.5: No Persistence . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
8 Section 4.6: Equilibrium Condition, Differences . . . . . . . . . . . . . . . 44
9 Section 4.6: Equilibrium Condition, Differences with µ = 0.8 . . . . . . . . 44
10 Section 4.6: Differences of it in Several Scenarios (µ variable) . . . . . . . . 46
11 Section 4.6: Differences of it in Several Scenarios (κ variable) . . . . . . . . 46
A1 Linear NKPC and NKPC without Log-Linearization . . . . . . . . . . . . 62
A2 Differences after Log-Linearization of the NKPC . . . . . . . . . . . . . . . 63
A3 IS Curve without Log-Linearization and an Investment Trap Type Case . . 66
A4 Appendix A.17: Strict Inflation Targeting, Differences . . . . . . . . . . . . 70
A5 Appendix A.17: No Persistence, Differences . . . . . . . . . . . . . . . . . 70
A6 Appendix A.18: Difference of it in Several Scenarios (σ variable) . . . . . . 71
A7 Appendix A.18: Difference of it in Several Scenarios (δ variable) . . . . . . 71
A8 Appendix A.18: Difference of it in Several Scenarios (σe2 variable) . . . . . 72

List of Tables
1 Greek Alphabet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XI
2 Latin Alphabet . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XII
3 Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .XIII
4 Overview of all Parameters . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
5 Overview of all Simulations . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Lists of Symbols and Acronyms

Table 1: Greek Alphabet

Letter Description

α Summarizing parameters (αγ , αy , απ , αµ , αe , ασ )

β Discount factor (time preference)
γ Parameter in cost function
δ Weighting on output gap in loss function
ε Elasticity of substitution
ζ Error term of cost shock
η Error term of demand shock
θ Auxiliary parameter
κ Slope of NKPC
λ Lagrange variable (multiplier); Eigenvalue
µ Cost shock persistence
ν Demand shock persistence
ξ Integration variable
π Inflation

σ Reciprocal value of the IES

σe2 Cost shock variance
σu2 Demand shock variance
τ Firm index

φ Price stickiness
χ Lagrange variable (multiplier)
ψ Lagrange variable (multiplier)
 Table 2: Latin Alphabet

Letter Description

c Constants in cost function (cf ix , cvar )

e Cost shock
i Nominal interest rate; Imaginary number
j Control variable
k Cost parameter in Calvo pricing
n Natural number
p Log-linearized price around the steady state
q Parameter in the generalized mean formula
r Long-run real interest rate
s Control variable in intertemporal optimizations
ss Notation for steady state (long-term value)
t Time variable
u Demand shock
x Calvo price
y Log-linearized output growth rate around the steady state
y Growth rate of output gap around the steady state
y Output growth rate
z Example for a log-linearized variable
A Vectors in a system of difference equations (A0 , At , At+1 )
B Bonds
C Consumption
K(.) Cost function
L (.) Lagrange function
M Coefficient matrix
P Price; Price level
U (.) Utility function
V (.) Value function in Bellman equation
W Wage
Y Output
Z Example variable

XII
 Table 3: Abbreviations

Abbr. Term

AD Aggregated Demand
AR Autoregressive
AS Aggregated Supply
BL Baseline
CES Constant Elasticity of Substitution
DSGE Dynamic Stochastic General Equilibrium
ECB European Central Bank
GDP Gross Domestic Product
IES Intertemporal Elasticity of Substitution
IS Investment/Saving
MATLAB Matrix Laboratory
NKM New Keynesian Model
NKPC New Keynesian Phillips Curve
RBC Real Business Cycle

XIII
1 Introduction
The main objective of this paper is to examine a dynamic general equilibrium condition out
of a basic three-equation New Keynesian model (NKM), augmented with stochastic terms
and non-linearity. More precisely, the additive terms behave like persistent stochastic
shocks and are modeled as an exogenous first-order autoregressive process. In line with
the literature (see, among others, the textbooks by Galı́ 2015 and Walsh 2010) cost shock
and demand shock are utilized for the New Keynesian Phillips curve (NKPC) and the
forward-looking IS curve respectively. Non-linearity enters the model through a second-
order Taylor approximation regarding the IS curve. Bauer and Neuenkirch (2015) were
the first to derive such a framework and found empirical evidence that central banks
indeed take the resulting uncertainty into account. Moreover, their paper provides strong
arguments that linear macroeconomic models are a shortcoming in the scientific literature.
The analysis is preceded by an overview of dynamic stochastic general equilibrium
(DSGE) models with the evolution of the Real business cycle (RBC) theory and the New
Keynesian framework resulting in the New neoclassical synthesis. First, in the analytical
part, demand and supply side (including monopolistic competition and price rigidity)
will yield the NKPC, the New Keynesian contribution to the framework. Second, from
the household’s Euler equation follows the forward-looking IS curve, originating in the
RBC theory. Third, the central bank’s optimization under discretion ends in a (standard)
targeting rule.
The rest of the thesis consists of the augmentation with shocks and uncertainty. After
checking the uniqueness of the equilibrium and the derivation of the equilibrium condition,
initially without uncertainty, the examination is going to be conducted both analytically
via differentials and as numerical simulation in MATLAB. A thorough literature research
discusses possible parameter ranges, with a focus on the persistence parameter. Further-
more, strict inflation targeting is considered. In a very similar way, the quadratic approx-
imation of the IS curve is dealt with. In addition, the case without certainty-equivalence
and persistence is going to be taken into consideration. In a last step, all results will be
compared and interpreted in the context of crisis scenarios, booms or relatively tranquil
times. The comparison of models and settings is of great importance, rather than noting
absolute values.
To keep the framework easily understandable, government, investments, money supply,
and labor markets are omitted. Consequently, neither money holdings nor working hours
(or leisure time) will enter the household’s utility function. I also attach a great deal
of importance to the compelling nature and a clear step-by-step derivation of the NKM.

© Springer Fachmedien Wiesbaden 2017

T. Kranz, Persistent Stochastic Shocks in a New Keynesian Model
with Uncertainty, BestMasters, DOI 10.1007/978-3-658-15639-8_1
That is why, to the best of my knowledge, graduate readers will receive a comprehensive
and comprehensible introduction to this state-of-the-art framework.
The remainder of this thesis is organized as follows: Section 2 reviews the NKM
evolution and derives a basic version. Section 3 expands this with shocks, discusses the
equilibrium condition, and simulates the results. Section 4 adds uncertainty to the model,
simulates, and compares the findings with those in Section 3. Section 5 concludes.

2
2 New Keynesian Model
Years before the components of the New Keynesian framework were developed or used,
there was already a major turning point in macroeconomic modelling, initiated by the
prominent Lucas critique. Lucas (1976) denounced the shortcomings of economic policies
that try to exploit relationships on the basis of (highly aggregated) historical data, such
as the Phillips curve. As a reaction, households and firms would adapt (or even become
forward-looking) and relationships could change or, in the case of the Phillips curve, break
down.
The following historical recapitulation starts in the early 1980’s and describes how the
different NKM’s origins have developed and coalesced since. Subsequently, the theoretical
part will be introduced including the NKPC (i.e., demand side, supply side, and Calvo
pricing), the forward-looking IS curve, and a monetary policy rule under discretion.

2.1 The New Neoclassical Synthesis

The paper by Kydland and Prescott (1982) is considered to be the starting point in RBC
theory. They explained fluctuations in business cycles with a non-time-separable util-
ity function and focussed on intertemporal substitution. Prescott (1986) added shocks
to technology and examined people’s willingness and ability to intertemporally and in-
tratemporally substitute in detail. Generally, the RBC theory established the use of fully
specified DSGE models with characteristic features as the efficiency of business cycles,
the importance of technology shocks (as a source of fluctuations in economic output), and
the limited role of monetary factors (see Galı́ 2015, 2–3).
During the same time, in the 1980’s, models with market imperfections were devel-
oped. Akerlof and Yellen (1985) gave an explanation of why variations in the nominal
supply of money are not neutral in the short run. They emphasized the suboptimal re-
actions to demand shocks through price (and wage) inertia and that it is important to
implement this property in RBC models. Mankiw (1985) discussed the conflict between
modern neoclassical and traditional Keynesian theories. He modeled price inertia with
fix costs (menu costs) and also assumed a monopoly, another market friction the RBC
theory neglected. Blanchard and Kiyotaki (1987) came to the result that monopolis-
tic competition, together with other imperfections, can explain why aggregated demand
affects output.
The first derivation of a NKPC can be found in the paper by Roberts (1995, 979).
Neither the name nor the mathematical methods (i.a. Calvo pricing) have fundamentally
changed since. Early (complete) New Keynesian frameworks were modeled by Yun (1996)

© Springer Fachmedien Wiesbaden 2017

T. Kranz, Persistent Stochastic Shocks in a New Keynesian Model
with Uncertainty, BestMasters, DOI 10.1007/978-3-658-15639-8_2
and Rotemberg and Woodford (1997). The latter explicitly referenced the Lucas critique
and discussed the new era of macroeconomic models. In the same year, Goodfried and
King (1997) proposed four elements typical for the combination of NKMs and RBC theory:
Intertemporal optimization, rational expectations, imperfect competition, and costly price
adjustment. They labeled it New neoclassical synthesis, in reference to the Neoclassical
synthesis, which was developed and popularized in the decades after Keynes’ main work
and combined Keynesian macroeconomics with neoclassical thoughts.
In a next step, Clarida et al (2000) combined these thoughts and made big strides in
the field of monetary policy. They surveyed the post-war United States economy in terms
of forward-looking monetary policy implications. For their baseline model, they referenced
i.a. Yun’s paper and work by Woodford. As soon as DSGE models proved themselves to
be capable of describing and explaining short-run fluctuations, price stickiness, and evalu-
ating monetary policy; central banks adopted this and developed large-scale models. The
most notable representative is the DSGE model by Smets and Wouters (2002), providing
a theoretical foundation for the work done by the ECB.
The widely respected paper by Christiano et al (2005) showed that stickiness in nomi-
nal wages is more important than price sluggishness. By that time, these models included
common features like households’ habit persistence, that describes how past consumption
influences the marginal utility of present consumption. Furthermore, they included Calvo
pricing in both wages and prices, variable capital utilization, costs for capital adjustment,
and a variety of shocks. These models implicate a monetary policy that is aimed to sta-
bilize the economy. Generally, stabilizing inflation is sufficient, since a stabilized output
goes hand in hand with maintaining perfectly stable inflation rates. In the article by
Blanchard and Galı́ (2007), this property was named the “divine coincidence”.
In the process evolving over the past decades, the main purpose was to understand
(i) fluctuations, (ii) rigidities, and (iii) monetary policy, which can affect real output in
the short run. Therefore, the New Keynesian framework provides the theoretical basis for
much of the contemporary macroeconomic modeling.

4
2.2 New Keynesian Phillips Curve

For deriving the NKPC, two optimization problems concerning private households and
firms are employed, leading to aggregated demand and supply. Furthermore, price rigidity
is modeled through the method introduced by Calvo (1983). The time index t is only
used from the Calvo Pricing section onwards, where it is needed to make a distinction
between the different periods.

Demand Side

On the demand side, the representative consumer can choose from a variety of goods Cξ
which results in an average consumption of C. Usually, the CES function is used to model
monopolistic competition1 , one of the two market frictions incorporated into the NKPC:
 1  ε−1
ε
ε−1
C= Cξ ε dξ . (1)
0

Here, ξ ∈ [0, 1] can be viewed as a continuum of firms from 0 to 100%. The exponent is
a measure for the substitutability between the goods Cξ , where ε represents the elasticity of
substitution. A change in ε would result in a different mean for C.2 Bauer and Neuenkirch
(2015, 5) assume ε > 1, constant over time and common amongst all economic subjects.
A Hicksian-like3 optimization by means of the Lagrangian function helps to solve for
the demand curve:
   ε−1
ε 
1 1 ε−1
L (Cξ , λ) = Pξ · Cξ dξ − λ Cξε
dξ −C . (2)
0 0

Since firms have pricing power, the representative consumer takes prices Pξ as given.

Minimizing expenditures Pξ Cξ with the constraint of a certain consumption level C
requires the following first-order conditions4 :

 1  ε−1
1
∂L −1 ε−1
= Pτ − λCτ ε Cξ ε dξ =0 (3.1)
∂Cτ 0
 1  ε−1
ε
∂L ε−1
= Cξ ε dξ −C = 0. (3.2)
∂λ 0

1
Dixit and Stiglitz (1977) developed this approach. However, they used a discrete sum and no integral
but received the same results.   1/q
n
2
Eq.(1) is an integral notation for the generalized mean x̄ = n1 j=1 xqj with q = ε−1
ε .
See Appendix A.1 for a more detailed comparison.
3
Since Hicksian demand will be determined by minimizing expenditures with a utility constraint, the
present optimization problem will transfer to this type using the simple utility function U (C) = C.
4
Note that τ denotes a continuum of derivatives.

5
 Differentiating with respect to λ provides the constraint, Eq.(1). Rearranging5 (3.1)
and defining λ ≡ P 6 as the aggregated price level yields
 ε
P
Cτ = C, (4)
Pτ

the demand7 for good i. Substituting this in Eq.(1) and rearranging8 gives the formula

 1  1−ε
1

P = Pξ1−ε dξ , (5)
0

which describes the aggregated price level9 . The lack of investment and governmental
spendings in this model leads to Yτ = Cτ . Each firms’ production Yτ will be consumed
completely by private households and hence Y = C. Eq.(4) can now be written in the
aggregated demand form
1
Yτ = · Y P ε, (6)
Pτε
that takes the shape of a hyperbola and is, in consequence, very similar to the tradi-
tional downward sloping AD curve.10

Supply Side

Each firm takes the aggregated demand function and the aggregated price level P as
given since any single firm is too small to directly influence other prices or productions.
It chooses its own price Pτ and faces the typical (real) profit maximization problem
 
Pτ Yτ
max − K(Yτ ) , (7)
Pτ ,Yτ P

5
See Appendix A.3 for more details.
6
There are good reasons for this step. When the consumption constraint is relaxed by one unit,
total consumption expenditures (see Galı́ (2015, 53)) will increase to (C + 1)P = CP + P , where P is
the amount by which the optimum will change. This is exactly the information the Lagrange multiplier
λ contains. See Chiang and Wainwright (2005, 353–354) for a detailed proof with λ expressed as a
derivative.
7
It is straightforward to show that ε is in fact the elasticity of substitution. Dividing two demand
functions (for goods a and b) by each other results in (Cb /Ca ) = (Pa /Pb )ε . Since ε is defined as the
percentage change in relative goods by a percentage change in relative prices, this is exactly what the
equation shows. See Chiang and Wainwright (2005, 396–399) for the definition and the case of the CES
production function.
8
See Appendix A.4 for more details.
9
Again, like Eq.(1), this can be examined through the generalized mean, see Appendix A.5.
10
The concise paper of Kyer and Maggs (1992) recapitulates the topic and analytically derives an AD
curve consisting of both the Keynes and the Pigou effect.

6
 where it substracts the real costs K from the real revenue. Using (6) and rearranging
leads to  1−ε  −ε 
Pτ Pτ
max Y −K Y . (8)
Pτ P P

The first-order condition is now straightforward, using the chain rule:

 −ε  −ε−1
∂ Pτ Y Pτ Y
= (1 − ε) · − K  (Yτ ) · (−ε) · = 0. (9)
∂Pτ P P P P

Simplifying and denoting the optimal price with Pτ∗ yields

 −ε  ∗ −ε−1
Pτ∗ Pτ
(ε − 1) = K  (Yτ ) · ε (10.1)
P P
   ∗ −1
ε  Pτ
⇔ 1= K (Yτ ) (10.2)
ε−1 P
 
∗ ε 
⇔ Pτ = K (Yτ ) · P, (10.3)
ε−1

an important result that states that the optimal price Pτ∗ equals the nominal marginal
costs and a mark-up (ε/(ε − 1)) > 1 for all ε > 1. However, perfect substitutes let the
monopolistic structure vanish and show the typical polypolistic result:
 
ε
lim K  (Yτ ) · P = K  (Yτ ) · P = Pτ∗ . (11)
ε→∞ ε−1

Now, with a cost function in real terms of quantities Yτ defined11 as

cvar γ+1
K(Yτ ) = Y + cf ix , (12)
γ+1 τ

where cf ix are the fix costs, cvar is a measure for the variable costs and γ represents
the elasticity of marginal costs, (10.3) becomes a micro-funded AS curve that takes the
form of a power function:  
ε
Pτ∗ = cvar Yτγ · P. (13)
ε−1

Log-linearization. It is convenient to use log-linearized variables instead of level

variables to be able to solve the model analytically. Also, some interpretations of the

11
Bauer and Neuenkirch (2015, 6) showed that an explicit formulation of the cost function is not
necessary. However, to give a better understanding of the mechanics behind the NKPC, an actual
function is used.

7
results, in terms of elasticity and growth rates, become quite useful.12 So both (6) and
(13) will now be approximated through log-linearization around the steady state.13 But
first some preparation is necessary.
Let Z be a state variable that can change over time and Zss its long-term value. When
defining
z ≡ ln Z − ln Zss , (14)

z becomes a good approximation of z, the growth rate around the steady state.14 Fur-
thermore, in the steady state, long-term values for individual variables are by definition
the same as for those on aggregated level, thus Zτ ss = Zss . The state would otherwise in-
clude endogenous forces. And finally, the long-run marginal costs equal the multiplicative
inverse of the firms’ mark-up:15
ε−1
cvar Yssγ = . (15)
ε
An explanation for that would be the long-run version of Eq.(13) and hence Pτ ss = Pss .
Now this can be applied to the previous results. First, Eq.(6), the AD curve will be log-
linearized. Taking logs, expanding with the log long-term values, and using (14) gives

ln Yτ = ln Y + ε(ln P − ln Pτ ) (16.1)
⇔ ln Yτ − ln Y = −ε(ln Pτ − ln P ) (16.2)
⇔ ln Yτ − ln Yss − (ln Y − ln Yss ) = −ε(ln Pτ − ln Pss − (ln P − ln Pss )) (16.3)
⇔ yτ − y = −ε(pτ − p) (16.4)
⇔ yτ = −εpτ + εp + y, (16.5)

a linearized AD curve in terms of growth rates with the slope of −1/ε. A higher
elasticity of substitution would result in a flatter curve, so a change in the firm’s price
growth pτ would have a stronger effect on production growth yτ .

12
See Romer (2012, 207), Judd (1998, 200–202), the paper by Uhlig (1999), and the guide by Zietz
(2008).
13
The approximation becomes more precise with smaller growth rates, that is exactly what the steady
state can offer. Judd (1998, 196–198) provides a goodness of fit comparison.
14
See Appendix A.6 for a detailed calculation regarding z and the actual growth rates z from one
period to the next. Incidentally, there is no need to use z in the basic model. Furthermore, a first-order
Taylor approximation “in reverse”
 shows
 the relationship
  between
 z and z:
z ≈ ln(1 + z) = ln 1 + Z−Z
Zss
ss
= ln 1 + ZZss − 1 = ln ZZss = ln Z − ln Zss ≡ z.
15
Other authors simply define this property, see e.g. Galı́ (2015, 57).

8
 Next, with the use of (15), the AS curve type Eq.(13), can be rewritten in a similar
way:
 
ε
ln Pτ∗ = ln + ln cvar + γ ln Yτ + ln P (17.1)
ε−1
 
ε
⇔ ln Pτ∗ − ln P = ln + ln cvar + γ (ln Yτ − ln Yss + ln Yss ) (17.2)
ε−1
 
ε
⇔ p∗τ − p = γyτ + ln + ln cvar + γ ln Yss (17.3)
ε−1
 
ε−1
⇔ p∗τ − p = γyτ + ln (cvar Yssγ ) − ln (17.4)
ε
 
∗ cvar Yssγ
⇔ pτ − p = γyτ + ln . (17.5)
(ε − 1)/ε
 
=0

The latter expression shows the assumption that the log deviations of marginal costs
from their long-run trend values are linear in the amount of γ. When the firm’s optimized
price growth p∗τ is equal to the aggregated price growth p, then there is no growth in the
firm’s production. Having log-linearized both demand and supply side, Figure 1 sums up.

pτ

y
p+
ε
slo
pe γ
:− pe:
1/ slo
ε

γy
+p
1 + εγ

y εp + y yτ
1 + εγ

Figure 1: Graphical results of households’ and firms’ static optimization.

9
 Finally, inserting (16.5) in (17.5) combines all the results and gives

p∗τ − p = γ(−εp∗τ + εp + y) (18.1)

⇔ p∗τ − p = −γε(p∗τ − p) + γy (18.2)
⇔ (1 + γε)(p∗τ − p) = γy (18.3)
 
γ
⇔ p∗τ − p = y. (18.4)
1 + γε

Recalling that y can be approximated with y, the GDP growth rate around the steady
state, and using αγ ∈ [0, 1[ as a summarizing parameter, Eq.(18.4) yields

p∗τ − p = αγ y, (19)

a description of the steady state output growth rate, depending on price growth and
microeconomic behavior. The next section introduces a non-optimal price setting scheme
which replicates the actual observed economic patterns.16

Calvo Pricing

Nominal rigidities as the second market friction in the basic NKM are implemented
through the assumption that the firms’ infrequent price adjustment follows an exoge-
nous Poisson process17 , where all firms have a constant probability (φ) to be unable to
update their price in each period with φ ∈ [0, 1[ (i.e., φ = 0 in the absence of price rigid-
ity). It is crucial that price-setters do not know how long the nominal price will remain
in place. Only the expected value is known due to probabilities that are all equal and
constant for all firms and periods. This implies a probability of φj for having the same
price in j periods as today and so the average expected duration between price changes
will be 1/(1 − φ).18
From now on, the time index t will be used, as more than one period is being con-
sidered. Simultaniously, the firm index τ is no longer important since it is sufficient to
calculate with a share of firms φ (or 1 − φ). Hence, p∗τ ≡ p∗t and p ≡ pt . When xt is the

16
See the survey by Taylor (1999), that came to abundant evidence. See also Galı́ (2015, 7–8) for a
literature overview.
17
Calvo (1983) originally wrote his article in continuous time. However, using discrete periods im-
mensely helps the clearness and is more realistic with regard to how the central bank actually operates.
Moreover, Calvo (1983, 396–397) shows the equivalence of both approaches. An alternative model of
sticky prices was provided by Rotemberg (1982). See also Ascari and Rossi (2008) for a comparison of
both approaches in the context of the NKPC.
18
See Appendix A.7 for proof.

10
price that firms will set in period t (provided they are able to do so), the following will
apply:

pt = φpt−1 + (1 − φ)x (20.1)

    t
share of sticky prices share of price adjuster
pt − φpt−1
⇔ xt = (20.2)
1−φ
Et pt+1 − φpt
⇒ Et xt+1 = . (20.3)
1−φ

Firms will act on the probability of not being able to adjust prices in future periods.
In consequence, they try to set a price xt that is not necessarily the optimal price p∗t ,
derived in the previous section. Also, in the presence of price rigidities, xt = p∗t generally
holds.
To reveal the mechanics behind the staggered price setting, it is convenient to verbally
treat pt and xt as level variables. Strictly speaking, the firms set price growth paths in
the following optimization problem rather than maximizing a discounted profit as the
difference between revenue and costs19 . This is due to the fact that it is more in line
with the other microfoundations in the model. In the present way, the optimal reset
price, determined by the discounted sum of future profits, is derived through a quadratic
approximation of the per-period deviation from maximum-possible profit with β ∈ [0, 1[,
the discount factor over an infinite planning horizon. Therefore, firms minimize their loss
function, the discounted deviations from p∗t over all t:
 ∞

2
min Et k β j φj xt − p∗t+j . (21)
xt
j=0

The parameter k > 0 enters the loss function multiplicatively and indicates all exoge-
nous factors that will influence the costs of not setting the optimal price in each period.20
The first-order condition is
∞

∂
= Et 2k (βφ)j (xt − p∗t+j ) = 0. (22)
∂xt j=0

Dividing by 2k, using the fact that xt is t-measurable, and expanding the sum gives
∞ ∞
(βφ)j xt − (βφ)j Et p∗t+j = 0. (23)
j=0 j=0
19
See Walsh (2010, 241–242) for the use of level variables in Calvo pricing.
20
Note that it can also come up as an additive term or any other positive monotonic transformation
and does not alter the results.

11
 Excluding xt from the sum, using the formula for an infinite geometric series, and
multiplying by (1 − βφ) gives

∞
xt = (1 − βφ) (βφ)j Et p∗t+j . (24)
j=0

Again, using t-measurability (Et p∗t = p∗t ) and excluding the first summand provides a
sum from j = 1 to infinity that can be substituted in a subsequent step:

∞

xt = (1 − βφ) (βφ) j
Et p∗t+j + p∗t . (25)
j=1

Furthermore, Eq.(24) can be rewritten for t + 1 (since firms optimize in each period),

∞
Et xt+1 = (1 − βφ) (βφ)j−1 Et p∗t+j (26.1)
j=1
∞
⇔ βφEt xt+1 = (1 − βφ) (βφ)j Et p∗t+j , (26.2)
j=1

for eliminating the sum in (25):

xt = βφEt xt+1 + (1 − βφ)p∗t . (27)

Inserting (20.2) and (20.3) leads to the expression

pt − φpt−1 Et pt+1 − φpt

= βφ + (1 − βφ)p∗t (28.1)
1−φ 1−φ
⇔ pt − φpt−1 = βφ(Et pt+1 − φpt ) + (1 − φ)(1 − βφ)p∗t , (28.2)

that only contains parameters and variants of the variable p. Then, with the definition
of (14) and first-order Taylor expansion, the inflation rate π can be expressed through
differences of p:

pt − pt−1 = ln Pt − ln Pss − (ln Pt−1 − ln Pss ) = ln Pt − ln Pt−1

   
Pt Pt − Pt−1
= ln = ln + 1 = ln(πt + 1) ≈ πt . (29)
Pt−1 Pt−1

In the same way, the conditional expectation value for period t + 1 can be expressed
with
Et pt+1 − pt ≈ Et πt+1 . (30)

12
 Since this approximation is sufficiently exact for small values of π, an equality sign
will be used for all following calculations. Now (28.2) can be rearranged to insert approx-
imations (29) and (30):

φ(pt − pt−1 ) = βφ(Et pt+1 − φpt ) + (1 − φ)(1 − βφ)p∗t − (1 − φ)pt (31.1)

(1 − φ)(1 − βφ) ∗ 1 − φ
⇔ πt = βEt πt+1 + pt − pt + β(1 − φ)pt . (31.2)
φ φ

Isolating (p∗t − pt ) and replacing it with the result from last section, Eq.(19), gives

αγ (1 − φ)(1 − βφ)
πt = βEt πt+1 + yt . (32)
φ

Usually21 , in a final step, a summarizing parameter κ > 0 for all parameters, multiplied
with yt , will be defined to end up in the NKPC:

πt = βEt πt+1 + κyt . (33)

Both the expected inflation rate Et πt+1 and the GDP growth rate around the steady
state yt (or output gap) have a positive impact on πt since β, κ > 0. Moreover, the slope
of the NKPC (κ), depends on all four parameters (β, γ, ε, and φ) of this section.22
So far, households’ optimization led to aggregated demand and firms’ profit opti-
mization led to aggregated supply. Price rigidity was modeled via Calvo pricing which
received the NKPC. In the next section, private households optimize their consumption
intertemporally under a budget constraint. This leads to a forward-looking IS curve.

2.3 Forward-Looking IS Curve

The objective is to derive an Euler equation via maximizing utility with a dynamic budget
constraint. Initially, it is not necessary to formulate an explicit utility function. On
the contrary, the general marginal utility gives a better insight into the intertemporal
mechanics. Only one specific assumption will be made, namely not considering money,
working hours or any other possible utility-gainer. It solely relies on consumption and
thus households maximize their intertemporal discounted utility
 ∞

max Et β s−t U (Cs ) , (34)
Ct
s=t
21
See e.g. Galı́ (2015, 63) or Walsh (2010, 338).
22
See Appendix A.8 for a more detailed analysis of κ. Depending on the exact model, the slope of the
NKPC can have a slightly different meaning, e.g. Walsh (2010, 336) with a measure for the firm’s real
marginal costs instead of the output gap.

13
 under the constraint

Ct · Pt + Bt+1 = Wt + (1 + it−1 ) · Bt , (35)

where W is the nominal wage and B the amount of bonds. The latter provides the
link between two periods.23 The Lagrangian brings both together:

∞

L (Ct , Ct+1 , Bt+1 ) = Et β s−t U (Cs ) − λs (Cs Ps + Bs+1 − Ws − (1 + is−1 )Bs ) . (36)
s=t

Here, the control variable is s, while t always designates the starting period. Let W
be exogenous, then the households’ first-order conditions24 are

∂L
= U  (Ct ) − λt Pt =0 (37.1)
∂Ct
∂L
= βEt [U  (Ct+1 )] − λt+1 Et [Pt+1 ] = 0 (37.2)
∂Ct+1
∂L
= −λt + λt+1 (1 + it ) = 0. (37.3)
∂Bt+1

Inserting (37.1) and (37.2) in (37.3) yields

βEt [U  (Ct+1 )] U  (Ct ) Pt

(1 + it ) = ⇔ U  (Ct ) = β · (1 + it ) · Et [U  (Ct+1 )], (38)
Et [Pt+1 ] Pt Et [Pt+1 ]

the Euler equation, revealing the intertemporal relationship of the marignal utility out
of consumption.25 Marginal utility in period t equals the counterpart in t+1, corrected by
discount factor, nominal interest rate, and the ratio of current and expected future price
level. Assuming it rises, marginal utility in t would also rise relative to period t + 1. Given
the diminishing marginal utility property and therefore concavity, consumption will be
higher in the future.26

23
Depending on the definition of the interest rate, the period can vary. Here it has been chosen in a
way so that the interest from period t enters the Euler condition.
24
Differentiating with respect to Ct+1 is possible because of linearity and Fatou’s lemma regarding the
conditional expectation.
25
See in Appendix A.10 for more about the mechanics behind intertemporal optimization by an alter-
native calculation via Dynamic Programming.
26
Note that present consumption could also increase because of the income effect.

14
 One possible formulation27 for such a function is U (Ct ) = (1 − σ)−1 · (Ct1−σ − 1) with
σ > 0 implying 1/σ as the intertemporal elasticity of substitiution (IES).28 Substituting
this in the Euler equation gives

Pt
Ct−σ = β · (1 + it ) · −σ
Et [Ct+1 ], (39)
Et [Pt+1 ]

which can be expressed as

Pt
Yt−σ = β · (1 + it ) · −σ
Et [Yt+1 ], (40)
Et [Pt+1 ]

when recalling the market clearing condition Y = C. The long-run real interest r
enters the equation through β since it equals 1/β − 1.29 Solving for Yt results in the
typical downward sloping IS relationship with real interest and expectations expressed in
level variables or including Et πt+1 :
 1/σ
1 Et [Pt+1 ] σ
Yt = 1/σ
· (1 + r) Et [Yt+1 ]
(1 + it ) Pt
1 σ 1/σ
= · (1 + r)(1 + Et πt+1 )Et [Yt+1 ] . (41)
(1 + it )1/σ

To prepare the approximation, Eq.(40) will be rearranged. Treating t-measurable

variables as constants for the conditional expectation, assuming30 Covt [Pt+1 , Yt+1
σ
] = 0,
and taking logs yields
  σ

Pt+1 Yt+1
ln Et · σ = ln (β(1 + it )) . (42)
Pt Yt

27
In an early study, Pratt (1964, 132–134) examined the different classes of utility functions in the
context of risk aversion. See also Kranz (2013, 6–8) for an alternative subdivision into square root,
logarithm, exponential, and broken rational functions.
28
The first study about Euler equations describing intertemporal private consumption came from Hall
(1978). The Appendix A.11 shows that 1/σ is indeed the intertemporal elasticity of substitution with
respect to (39) and (40).
29
The relation follows from the steady state Euler equation or see e.g. the Ramsey–Cass–Koopmans
model, where in the utility maximizing steady state, the net marginal product of capital equals 1/β − 1
and therefore β = 1/(1 + r). See Galı́ (2015, 132) for a more complex definition of the long-term real
interest rate.
30 σ σ σ
Since Et [Pt+1 ]·Et [Yt+1 ] = Et [Pt+1 ·Yt+1 ]−Covt [Pt+1 , Yt+1 ], the values are potentially overestimated.
However, the assumption at this point (in contrast to Section 4.1) does not alter the results and is only
for clarity. The following linearization eliminates second order moments.

15
 With the help of the exponential function, prices and output can be rewritten in their
log deviations:
   σ

Pt+1 Yt+1
ln Et exp ln · σ = ln Et [exp (ln Pt+1 − ln Pt + σ(ln Yt+1 − ln Yt ))]
Pt Yt
= ln Et [exp (pt+1 − pt + σ(yt+1 − yt ))] . (43)

The next steps involve approximations of both inflation rate and output gap and also a
first-order Taylor expansion of both the exponential and the logarithmic function:

t+1 − y
⇒ ln Et [exp (πt+1 + σ(y t ))] (44.1)
t+1 − y
≈ ln Et [1 + πt+1 + σ(y t+1 − y
t )] = ln (1 + Et [πt+1 + σ(y t )]) (44.2)
t+1 − y
≈ Et [πt+1 + σ(y t+1 − σ y
t )] = Et πt+1 + σEt y t . (44.3)

Steps (44.2) and (44.3) were to bypass Jensen’s inequality31 since the function’s cur-
vature is sufficiently small32 . Together with the right side of Eq.(42), after expressing β
with r, log-linearizing, and rearranging,

1
t+1 −
yt = Et y (it − r − Et πt+1 ) (45)
σ

follows, a dynamic IS curve with the output gap instead of the actual GDP. Referring
to the original graphical IS relation, the curve shifts to the right if the long-term real
interest rate r, the output gap expectations Et y
t+1 or the inflation expectations Et πt+1

rise. However, the slope will rise and the curve becomes flatter if the intertemporal
elasticity of substitution (1/σ) rises.
After a dynamic utility optimization that yielded the Euler equation, the result could
be approximated to an equation dependend on the nominal interest rate it , explaining the
output gap yt . Until now, there are two equations describing the economy, a linearized
Phillips curve and a linearized forward-looking IS curve. Consequently, the equation
system cannot be solved for the three t-measurable variables yt , πt , and it . The next
section adds a third equation, originating from a loss function by the central bank that
links output gap to inflation rate.

31
See Jensen (1906, 190–192) that f (EX) ≥ E[f (X)] holds for concave functions, i.e. the logarithm.
See also Billingsley (1995, 449) that Jensen’s inequality still holds for the conditional expected value.
32
The accuracy is comparable to log-linearization for small growth rates. Moreover, the exactness
increases for larger values because of (ln(x)) → 0 for increasing x. However, resulting values will always
be underestimated.

16
2.4 Targeting Rule under Discretion

The central bank takes NKPC and IS curve as given and wants to optimally set the
interest rate for period t. There are several ways to proceed and before describing the
optimization problem, a short summary introduces the different concepts.
An early discussion on how to model policy decisions can be found in the work by
Kydland and Prescott (1977). Also, Givens (2012, 1) provides an excellent overview:
“In macroeconomic models that embody rational expectations, optimal monetary policies
are separated by a dichotomy known in the literature as commitment and discretion.” He
further writes about discretion: “Changes in the interest rate are [. . . ] the result of period-
by-period reoptimization in which foregoing policy intentions are considered irrelevant for
current decision making (Givens 2012, 1).” In contrast, under commitment, the central
bank has a mandatory inflation target and is able to affect expectations. However, a
discretionary monetary policy is more flexible, since the interest or inflation rate (path)
is not fixed. Drawbacks could be credibility problems that arise if the central bank has
to readjust the interest rate frequently due to a volatile economy or if it sets the interest
rate in big leaps. The latter is rarely seen in practice and the more realistic central bank
behavior is referred to as inertia, “[. . . ] a series of small adjustments in the same direction,
drawn out over a period of months, rather than through an immediate once-and-for-all
response to the new development (Woodford 2003a, 1).”
Because of the far simpler approach, it is more tempting to start with an optimization
unter discretion. Therefore, the central bank’s targeting rule will be derived by minimizing
the discounted loss function over all periods33
 ∞

s−t ∗ 2 2
min Et β (πs − π ) + δ ys , (46)
π, y
s=t

under the constraints (33) and (45), the Phillips curve and IS curve respectively.
Every difference between the inflation rate and the central bank’s target π ∗ results in a
loss. In the first instance, π ∗ = 0 as it does not change the essential findings. Also, every
output gap leads to a loss but is reduced by a weighting factor δ, normally smaller than
one. Squaring ensures that higher deviations yield disproportionately higher losses and
the optimized variables will not vanish in the derivatives. Moreover, it makes the loss

33
The loss function can be derived by a second order approximation of the households’ welfare loss,
first introduced by Rotemberg and Woodford (1999, 54–61). It can also be found in the textbooks by
Galı́ (2015), Walsh (2010), and Woodford (2003b).

17
function symmetrical34 . The Lagrangian has to be differentiated with respect to yt , πt ,
and it , since the central bank sets the nominal interest rate:

∞
L (πt , yt , it ) = Et β s−t πs2 + δ ys 2 − χs (πs − βπs+1 − κys )
s=t

1
−ψs (ys − y
s+1 + (is − r − πs+1 )) . (47)
σ

First-order conditions:

∂L
= 2πt − χt =0 (48.1)
∂πt
∂L
= 2δ yt + χt κ − ψt = 0 (48.2)
∂ yt
∂L ψt
=− = 0. (48.3)
∂it σ

From condition (48.3) follows that ψt = 0, hence the minimized loss will not change if
the IS curve shifts, as the central bank can counteract it one by one through resetting the
nominal interest rate.35 Combining (48.1) and (48.2), the standard targeting rule under
discretion arises:
κ
δ yt = −κπt ⇔ yt = − πt . (49)
δ
Although the optimal interest rate is not explicitly given, all relationships between
the macroeconomic variables are derived. The process is as follows: the nominal interest
rate has an effect on the output gap (IS curve), which in consequence affects the inflation
rate (NKPC). Furthermore, Eq.(49), the “leaning against the wind” condition, implies a
countercyclical monetary policy, that is, to stabilize prices and eventually contract the
economy. The degree of this contraction increases in κ and decreases in δ, the weight on
output stabilization. Former President of the EBC, Jean-Claude Trichet, picked this up
in one of his speeches36 : “The leaning against the wind principle describes a tendency to
cautiously raise interest rates even beyond the level necessary to maintain price stability
over the short to medium term [. . . ].”
Despite these explanations, Eq.(49) could give the impression of the central bank
acting too contractive (i.e. hawkish37 ). Every (positive) deviation from the inflation

34
See Nobay and Peel (2003, 661) for an asymmetric loss function (Linex form) that becomes quadratic
in a special case.
35
Blanchard and Galı́ (2007) call this “divine coincidence,”the lacking trade-off in the basic NKM, and
argue that it comes from the absence of real imperfections. Also, Galı́ (2015, 129) takes only the NKPC
and not the IS curve as a constraint since results will not change.
36
“Asset price bubbles and monetary policy,” 8 June 2005, Singapore.
37
Note that, on the other hand, an expansive monetary policy is referred to as dovish.

18
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Cimbex she finds a similar arrangement, but there are ten chambers,
and no aorta.

The dorsal vessel is connected with the roof of the body by some
short muscles, and is usually much surrounded by fat-body into
which tracheae penetrate; by these various means it is kept in
position, though only loosely attached; beneath it there is a delicate,
incomplete or fenestrate, membrane, delimiting a sort of space
called the pericardial chamber or sinus; connected with this
membrane are some very delicate muscles, the alary muscles,
extending inwards from the body wall (b, Fig. 72): the curtain formed
by these muscles and the fenestrate membrane is called the
pericardial diaphragm or septum. The alary muscles are not directly
connected with the heart.

Fig. 72.—Dorsal vessel (c), and alary muscles (b), of Gryllotalpa (after
Graber); a, aorta. N.B.—The ventral aspect is here dorsal, and
nearly the whole of the body is removed to show these parts.

Fig. 73.—Diagram of transverse section of pericardial sinus of

Oedipoda coerulescens. (After Graber, Arch. Mikr. Anat. ix.) H,
heart; s, septum; m, muscles—the upper suspensory, the lower
alary.

It has been thought by some that delicate vessels exist beyond the
aorta through which the fluid is distributed in definite channels, but
this does not appear to be really the case, although the fluid may
frequently be seen to move in definite lines at some distance from
the heart.

There is still much uncertainty as to some of the details of the action

of the heart, and more especially as to the influence of the alary
muscles. The effect of the contraction of these must be to increase
the area of the pericardial chamber by rendering its floor or septum
less arched, as shown in our diagram (Fig. 73), representing a
transverse section through the pericardial chamber, H being the
dorsal vessel with m its suspensory muscles, and s its septum, with
m the alary muscles. The contraction of these latter would draw the
septum into the position of the dotted line, thus increasing the area
of the sinus above; but as this floor or septum is a fenestrated
structure, its contraction allows fluid to pass through it to the
chamber above; thus this arrangement may be looked on as a
means of keeping up a supply of fluid to the dorsal vessel, the
perforated septum, when it contracts, exerting pressure on the
tissues below; these are saturated with fluid, which passes through
the apertures to the enlarged pericardial chamber.

Some misconception has prevailed, too, as to the function of the

pericardial chamber. This space frequently contains a large quantity
of fat-body—pericardial tissue—together with tracheae, and this has
given rise to the idea that it might be lung-like in function; but, as
Miall and Denny[58] have pointed out, this is erroneous; the tissues in
Insects have their own ample supplies of air. It has also been
supposed that the alary muscles cause the contraction of the heart,
but this is not directly the case, for they are not attached to it, and it
pulsates after they have been severed. It has been suggested that
the contractions of this vessel are regulated by small ganglia placed
on, or in, its substance. However this may be, these contractions
vary enormously according to the condition of the Insect; they may
be as many, it is said, as 100 or more in a minute, or they may be
very slow and feeble, if not altogether absent, without the death of
the Insect ensuing.
The expulsion of the blood from the front of the dorsal vessel seems
to be due to the rhythm of the contraction of the vessel as well as to
its mechanical structure. Bataillon says,[59] confirming an
observation of Réaumur, that at the period when the silkworm is
about to change to the chrysalis condition, the circulation undergoes
periodical changes, the fluid moving during some intervals of about
ten minutes' duration in a reversed direction, while at other times the
blood is expelled in front and backwards simultaneously, owing
apparently to a rhythmical change in the mode of contraction of the
dorsal vessel.

As the dorsal vessel consists of a number of distinct chambers, it

has been suggested that there is normally one of these for each
segment of the body; and it appears that the total number is
sometimes thirteen, which is frequently that of the segments of the
body without the head. The number of chambers differs, however,
greatly, as we have previously stated, and cannot be considered to
support the idea of an original segmental arrangement of the
chambers. The dorsal vessel, though in the adult a single organ,
arises in the embryo from two lateral, widely separated parts which
only in a subsequent stage of the embryonic development coalesce
in the median line.

Fat-Body.

In discussing the tracheae we remarked on the importance of their

function and on their abundant presence in the body. Equally
conspicuous, and perhaps scarcely less important in function, is the
fat-body, which on opening some Insects, especially such as are in
the larval stage, at once attracts attention. It consists of masses of
various size and indefinite form distributed throughout the body,
loosely connected together, and more or less surrounding and
concealing the different organs. The colour varies according to the
species of Insect. This fat-body is much connected with fine tracheal
twigs, so that an organisation extending throughout the body is thus
formed. It may be looked on as a store of nutritious matter which
may be added to or drawn on with great rapidity; and it is no doubt
on this that many of the internal parasites, so common in the earlier
stages of Insects' lives, subsist before attacking the more permanent
tissues of their hosts. There is some reason to suppose that the fat-
body may have some potency in determining the hunger of the
Insect, for some parasitised larvae eat incessantly.

The matter extracted from the food taken into the stomach of the
Insect, after undergoing some elaboration—on which point very little
is known—finds its way into the body-cavity of the creature, and as it
is not confined in any special vessels the fat-body has as unlimited a
supply of the nutritive fluid as the other organs: if nutriment be
present in much greater quantity than is required for the purposes of
immediate activity, metamorphosis or reproduction, it is no doubt
taken up by the fat-body which thus maintains, as it were, an
independent feeble life, subject to the demands of the higher parts of
the organisation. It undoubtedly is very important in metamorphosis,
indeed it is possible that one of the advantages of the larval state
may be found in the fact that it facilitates, by means of the fat-body,
the storage in the organisation of large quantities of material in a
comparatively short period of time.

A considerable quantity of fat tissue is found in the pericardial sinus,

where it is frequently of somewhat peculiar form, and is spoken of as
pericardial cells, or pericardial tissue. Some large cells, frequently of
pale yellow colour, and containing no fat, are called oenocytes by
Wielowiejski. They are connected with the general fat-body, but are
not entirely mingled with it; several kinds have been already
distinguished, and they are probably generally present. The
phagocytes, or leucocytes, the cells that institute the process of
histolysis in the metamorphosis of Muscidae, are a form of blood
cell; though these cells are amoeboid some writers derive them from
the fat-body. The cells in the blood have no doubt generally an
intimate relation with the fat-body, but very little accurate information
has been obtained as to these important physiological points, though
Graber has inaugurated their study.[60]

Organs of Sex.

The continuation of the species is effected in Insects by means of

two sexes, each endowed with special reproductive organs. It has
been stated that there are three sexes in some Insects—male,
female, and neuter; but this is not correct, as the so-called neuters
are truly sexed individuals,—generally females,—though, as a rule,
they are not occupied with the direct physiological processes for
continuing the species.

The offspring is usually produced in the shape of eggs, which are

formed in ovaries. These organs consist of egg-tubes, a cluster of
which is placed on each side of the body, and is suspended,
according to Leydig[61] and others, to the tissue connected with the
heart by means of the thread-like terminations of the tubes.

Fig. 74.—Sex organs of female of Scolia interrupta (after Dufour); a,

egg-tubes; b, oviducts; c, poison glands; d, duct of accessory
gland (or spermatheca); e, external terminal parts of body.

The number of egg-tubes varies greatly in different Insects; there

may be only one to each ovary (Campodea), but usually the number
is greater, and in the queen-bee it is increased to about 180. In the
Queens of the Termitidae, or white ants, the ovaries take on an
extraordinary development; they fill the whole of the greatly
distended hind-body. Three thousand egg-tubes, each containing
many hundred eggs, may be found in a Queen Termite, so that, as
has been said by Hagen,[62] an offspring of millions in number is
probable. There is considerable variety in the arrangements for the
growth of the eggs in the egg-tubes. Speaking concisely, the tubes
may be considered to be centres of attraction for nutritive material, of
which they frequently contain considerable stores. Next to the
terminal thread, of which we have already spoken, there is a greater
or smaller enlargement of the tube, called the terminal chamber; and
there may also be nutriment chambers, in addition to the dilatations
which form the egg-chambers proper. Korschelt[63] distinguishes
three principal forms of egg-tubes, viz. (1) there are no special
nutriment chambers, a condition shown in Figure 74; (2) nutriment
chambers alternate with the egg-chambers, as shown in our Figure
of an egg-tube of Dytiscus marginalis; (3) the terminal chamber
takes on an unusual development, acting as a large nutriment
chamber, there being no other special nutriment chambers. This
condition is found in Rhizotrogus solstitialis. The arrangements as to
successive or simultaneous production of the eggs in the tubes
seem to differ in different Insects. In some forms, such as the white
ants, the process of egg-formation (oogenesis) attains a rapidity that
is almost incredible, and is continued, it is said, for periods of many
months. There is no point in which Insects differ more than in that of
the number of eggs produced by one female. The egg-tubes are
connected with a duct for the conveyance of the eggs to the exterior,
and the arrangements of the tubes with regard to the oviduct also
vary much. An interesting condition is found in Machilis (see Fig. 94,
p. 188), where the seven egg-tubes are not arranged in a bunch, but
open at a distance from one another into the elongated duct. The
two oviducts usually unite into one chamber, called the azygos
portion or the uterus, near their termination. There are a few Insects
(Ephemeridae) in which the two oviducts do not unite, but have a
pair of orifices at the extremity of the body. Hatchett-Jackson has
recently shown[64] that in Vanessa io of the Order Lepidoptera, the
paired larval oviducts are solid, and are fixed ventrally so as to
represent an Ephemeridean stage; that the azygos system of ducts
and appended structures develop separately from the original
oviducts, and that they pass through stages represented in other
Orders of Insects to the stage peculiar to the Lepidoptera. Machilis,
according to Oudemans, is a complete connecting link between the
Insects with single and those with paired orifices.

There are in different Insects more than one kind of diverticula and
accessory glands in connexion with the oviducts or uterus; a
receptaculum seminis, also called spermatheca, is common. In the
Lepidoptera there is added a remarkable structure, the bursa
copulatrix, which is a pouch connected by a tubular isthmus with the
common portion of the oviduct, but having at the same time a
separate external orifice, so that there are two sexual orifices, the
opening of the bursa copulatrix being the lower or more anterior. The
organ called by Dufour in his various contributions glande sébifique,
is now considered to be, in some cases at any rate, a spermatheca.
The special functions of the accessory glands are still very obscure.

Fig. 75.—Egg-tube of Dytiscus marginalis; e.c, egg-chamber; n.c,

nutriment chamber; t.c, terminal chamber; t.t, terminal thread.
(After Korschelt.)

The ovaries of the female are replaced in the male by a pair of

testes, organs exhibiting much variety of form. The structure may
consist of an extremely long and fine convoluted tube, packed into a
small space and covered with a capsule; or there may be several
shorter tubes. As another extreme may be mentioned the existence
of a number of small follicles opening into a common tube, several of
these small bodies forming together a testis. As a rule each testis
has its own capsule, but cases occur—very frequently in the
Lepidoptera—in which the two testes are enclosed in a common
capsule; so that there then appears to be only one testis. The
secretion of each testis is conveyed outwards by means of a slender
tube, the vas deferens, and there are always two such tubes, even
when the two testes are placed in one capsule. The vasa deferentia
differ greatly in their length in different Insects, and are in some
cases many times the length of the body; they open into a common
duct, the ductus ejaculatorius. Usually at some part of the vas
deferens there exists a reservoir in the form of a sac or dilatation,
called the vesicula seminalis. There are in the male, as well as in the
female, frequently diverticula, or glands, in connexion with the sexual
passages; these sometimes exhibit very remarkable forms, as in the
common cockroach, but their functions are quite obscure. There is,
as we have already remarked, extreme variety in the details of the
structure of the internal reproductive apparatus in the male, and
there are a few cases in which the vasa deferentia do not unite
behind, but terminate in a pair of separate orifices. The genus
Machilis is as remarkable in the form of the sexual glands and ducts
of the male as we have already mentioned it to be in the
corresponding parts of the female.

Fig. 76.—Tenthredo cincta. a, a, testes; b, b, vasa deferentia; c, c,

vesiculæ seminales; d, extremity of body with copulatory
armature. (After Dufour.)

Although the internal sexual organs are only fully developed in the
imago or terminal stage of the individual life, yet in reality their
rudiments appear very early, and may be detected from the embryo
state onwards through the other preparatory stages.

The spermatozoa of a considerable number of Insects, especially of

Coleoptera, have been examined by Ballowitz;[65] they exhibit great
variety; usually they are of extremely elongate form, thread-like, with
curious sagittate or simply pointed heads, and are of a fibrillar
structure, breaking up at various parts into finer threads.

External Sexual Organs.—The terminal segments of the body are

usually very highly modified in connexion with the external sexual
organs, and this modification occurs in such a great variety of forms
as to render it impossible to give any general account thereof, or of
the organs themselves. Some of these segments—or parts of the
segments, for it may be dorsal plates or ventral plates, or both—may
be withdrawn into the interior, and changed in shape, or may be
doubled over, so that the true termination of the body may be
concealed. The comparative anatomy of all these parts is especially
complex in the males, and has been as yet but little elucidated, and
as the various terms made use of by descriptive entomologists are of
an unsatisfactory nature we may be excused from enumerating
them. We may, however, mention that when a terminal chamber is
found, with which both the alimentary canal and the sexual organs
are connected, it is called a cloaca, as in other animals.

Parthenogenesis.

There are undoubted cases in Insects of the occurrence of

parthenogenesis, that is, the production of young by a female without
concurrence of a male. This phenomenon is usually limited to a
small number of generations, as in the case of the Aphididae, or
even to a single generation, as occurs in the alternation of
generations of many Cynipidae, a parthenogenetic alternating with a
sexual generation. There are, however, a few species of Insects of
which no male is known (in Tenthredinidae, Cynipidae, Coccidae),
and these must be looked on as perpetually parthenogenetic. It is a
curious fact that the result of parthenogenesis in some species is the
production of only one sex, which in some Insects is female, in
others male; the phenomenon in the former case is called by
Taschenberg[66] Thelyotoky, in the latter case Arrhenotoky;
Deuterotoky being applied to the cases in which two sexes are
produced. In some forms of parthenogenesis the young are
produced alive instead of in the form of eggs. A very rare kind of
parthenogenesis, called paedogenesis, has been found to exist in
two or three species of Diptera, young being produced by the
immature Insect, either larva or pupa.

Glands.

Insects are provided with a variety of glands, some of which we have

alluded to in describing the alimentary canal and the organs of sex;
but in addition to these there are others in connexion with the outer
integument; they may be either single cells, as described by Miall in
Dicranota larva,[67] or groups of cells, isolated in tubes, or pouches.
The minute structure of Insect glands has been to some extent
described by Leydig;[68] they appear to be essentially of a simple
nature, but their special functions are very problematic, it being
difficult to obtain sufficient of their products for satisfactory
examination.

CHAPTER V

DEVELOPMENT

EMBRYOLOGY–EGGS–MICROPYLES–FORMATION OF EMBRYO–VENTRAL
PLATE–ECTODERM AND ENDODERM–SEGMENTATION–LATER STAGES–
DIRECT OBSERVATION OF EMBRYO–METAMORPHOSIS–COMPLETE AND
 INCOMPLETE–INSTAR–HYPERMETAMORPHOSIS–METAMORPHOSIS OF
INTERNAL ORGANS–INTEGUMENT–METAMORPHOSIS OF BLOWFLY–
HISTOLYSIS–IMAGINAL DISCS–PHYSIOLOGY OF METAMORPHOSIS–
ECDYSIS.

The processes for the maintenance of the life of the individual are in
Insects of less proportional importance in comparison with those for
the maintenance of the species than they are in Vertebrates. The
generations of Insects are numerous, and the individuals produced
in each generation are still more profuse. The individuals have as a
rule only a short life; several successive generations may indeed
make their appearances and disappear in the course of a single
year.

Although eggs are laid by the great majority of Insects, a few species
nevertheless increase their numbers by the production of living
young, in a shape more or less closely similar to that of the parent.
This is well known to take place in the Aphididae or green-fly Insects,
whose rapid increase in numbers is such a plague to the farmer and
gardener. These and some other cases are, however, exceptional,
and only emphasise the fact that Insects are pre-eminently
oviparous. Leydig, indeed, has found in the same Aphis, and even in
the same ovary, an egg-tube producing eggs while a neighbouring
tube is producing viviparous individuals.[69] In the Diptera pupipara
the young are produced one at a time, and are born in the pupal
stage of their development, the earlier larval state being undergone
in the body of the parent: thus a single large egg is laid, which is
really a pupa.

The eggs are usually of rather large size in comparison with the
parent, and are produced in numbers varying according to the
species from a few—15 or even less in some fossorial Hymenoptera
—to many thousands in the social Insects: somewhere between 50
and 100 may perhaps be taken as an average number for one
female to produce. The whole number is frequently deposited with
rapidity, and the parent then dies at once. Some of the migratory
locusts are known to deposit batches of eggs after considerable
intervals of time and change of locality. The social Insects present
extraordinary anomalies as to the production of the eggs and the
prolongation of the life of the female parent, who is in such cases
called a queen.

The living matter contained in the egg of an Insect is protected by

three external coats: (1) a delicate interior oolemm; (2) a stronger,
usually shell-like, covering called the chorion; (3) a layer of material
added to the exterior of the egg from glands, at or near the time
when it is deposited, and of very various character, sometimes
forming a coat on each egg and sometimes a common covering or
capsule for a number of eggs. The egg-shell proper, or chorion, is
frequently covered in whole or part with a complex minute sculpture,
of a symmetrical character, and in some cases this is very highly
developed, forming an ornamentation of much delicacy; hence some
Insects' eggs are objects of admirable appearance, though the
microscope is of course necessary to reveal their charms. One of the
families of butterflies, the Lycaenidae, is remarkable for the complex
forms displayed by the ornamentation of the chorion (see Fig. 78, B).

Fig. 77.—Upper or micropylar aspect of egg of Vanessa cardui. (After

Scudder.)

The egg-shell at one pole of the egg is perforated by one or more

minute orifices for the admission to the interior of the spermatozoon,
and it is the rule that the shell hereabouts is symmetrically sculptured
(see Fig. 77), even when it is unornamented elsewhere: the
apertures in question are called micropyles. They are sometimes
protected by a micropyle apparatus, consisting of raised processes,
or porches: these are developed to an extraordinary extent in some
eggs, especially in those of Hemiptera-Heteroptera (see Fig. 78, C).
Some of these peculiar structures have been described and figured
by Leuckart.[70] The purpose they serve is quite obscure.

Fig. 78.—Eggs of Insects: A, blowfly (after Henking); B, butterfly,

Thecla (after Scudder); C, Hemipteron (Reduviid).

Formation of Embryo.

The mature, but unfertilised, egg is filled with matter that should
ultimately become the future individual, and in the process of
attaining this end is the seat of a most remarkable series of changes,
which in some Insects are passed through with extreme rapidity. The
egg-contents consist of a comparatively structureless matrix of a
protoplasmic nature and of yolk, both of which are distributed
throughout the egg in an approximately even manner. The yolk,
however, is by no means of a simple nature, but consists, even in a
single egg, of two or three kinds of spherular or granular
constituents; and these vary much in their appearance and
arrangement in the early stages of the development of an egg, the
yolk of the same egg being either of a homogeneously granular
nature, or consisting of granules and larger masses, as well as of
particles of fatty matter; these latter when seen through the
microscope looking sometimes like shining, nearly colourless,
globules.
 Fig. 79.—Showing the two extruded polar bodies P1, P2 now nearly
fused and reincluded, and the formation of the spindle by junction
of the male and female pronuclei. (After Henking.)

The nature of the matrix—which term we may apply to both the

protoplasm and yolk as distinguished from the minute formative
portions of the egg—and the changes that take place in it have been
to some extent studied, and Kowalewsky, Dohrn,[71] Woodworth,[72]
and others have given some particulars about them. The early
changes in the formative parts of the mature egg have been
observed by Henking in several Insects, and particularly in
Pyrrhocoris, his observations being of considerable interest. When
the egg is in the ovary and before it is quite mature,—at the time, in
fact, when it is receiving nutriment from ovarian cells,—it contains a
germinal vesicle including a germinal spot, but when the egg is
mature the germinal vesicle has disappeared, and there exists in its
place at one portion of the periphery of the egg-contents a cluster of
minute bodies called chromosomes by Henking, whom we shall
follow in briefly describing their changes. The group divides into two,
each of which is arranged in a rod or spindle-like manner, and may
then be called a directive rod or spindle. The outer of these two
groups travels quite to the periphery of the egg, and there with some
adjacent matter is extruded quite outside the egg-contents (not
outside the egg-coverings), being in its augmented form called a
polar or directive body. While this is going on the second directive
spindle itself divides into two groups, the outer of which is then
extruded in the manner we have already described in the case of the
first polar body, thus completing the extrusion of two directive bodies.
The essential parts of the bodies that are successively formed during
these processes are the aggregates, called chromosomes; the
number of these chromosomes appears to be constant in each
species; their movements and dispositions are of a very interesting
character, the systems they form in the course of their development
having polar and equatorial arrangements. These we cannot further
allude to, but may mention that the extrusion of the directive bodies
is only temporary, they being again included within the periphery of
the egg by the growth and extension of adjacent parts which meet
over and thus enclose the bodies.

The arrangements and movements we have briefly alluded to have

been limited to the unfertilised condition of the egg (we should rather
say, the fertilising element has taken no part in them), and have as
their result the union of the chromosomes existing after the extrusion
of the two polar bodies, into a small body called the female
pronucleus or egg-nucleus (Eikern), while the position of the
movements has been an extremely minute portion of the egg near to
its outer surface or periphery. The introduction of a sperm, or male,
element to the egg through the micropyle gives rise to the formation
of another minute body placed more in the interior of the egg, and
called the sperm-nucleus. The egg-nucleus, travelling more into the
interior of the egg, meets the sperm-nucleus; the two amalgamate,
forming a nucleus or body that goes through a series of changes
resulting in its division into two daughter-bodies. These two again
divide, and by repetitions of such division a large number of nuclei
are formed which become arranged in a continuous manner so as to
form an envelope enclosing a considerable part (if not quite the
whole) of the egg-mass. This envelope is called the blastoderm, and
together with its contents will form the embryo. We must merely
allude to the fact that it has been considered that some of the nuclei
forming the blastoderm arise directly from the egg-mass by a
process of amalgamation, and if this prove to be correct it may be
admitted that some portions of the embryo are not entirely the result
of division or segmentation of combined germ and sperm-nuclei.
Wheeler states[73] that some of the nuclei formed by the first
differentiation go to form the vitellophags scattered throughout the
yolk. We should also remark that, according to Henking, the
blastoderm when completed shows at one part a thickening,
immediately under which (i.e. included in the area the blastoderm
encloses) are the two polar bodies, which, as we have seen, were
formed by the germinating body at an earlier stage of its activity. Fig.
79 represents a stage in the development of Pyrrhocoris, showing
the interior of the egg after a body has been formed by the union of
the sperm and egg-nuclei; this body is about to undergo division or
segmentation, and the equatorial arrangement where this will take
place is seen. The two polar bodies P1, P2, after having been
excluded, are nearly reincluded in the egg.

The Ventral Plate.

The next important change after the formation of the blastoderm is

the partial detachment of a part of its periphery to become placed in
the interior of the other and larger portion. The way in which this
takes place will be gathered from the accompanying diagrammatic
figures taken from Graber: a thickened portion (a b) of the
blastoderm becomes indrawn so as to leave a fold (c d) at each point
of its withdrawal, and these folds afterwards grow and meet so as to
enclose the thickened portion. The outer envelope, formed in part by
the original blastoderm and in part by the new growth, is called the
serosa (e f), the inner layer (g) of the conjoined new folds being
termed the amnion: the part withdrawn to the interior and covered by
the serosa and amnion is called the ventral plate, or germinal band
(Keimstreif), and becomes developed into the future animal. The
details of the withdrawal of the ventral plate to the interior are very
different in the various Insects that have been investigated.
 Fig. 80.—Stages of the enclosure of the ventral plate: A, a, b, ventral plate;
B, c, d, folds of the blastoderm that form the commencement of the
amnion and serosa; C, e, f, part of the serosa; g, amnion.

One of the earliest stages in the development is a differentiation of a

portion of the ventral plate into layers from which the future parts of the
organisation will be derived. This separation of endoderm from ectoderm
takes place by a sort of invagination, analogous with that by which the
ventral plate itself is formed. A longitudinal depression running along the
middle of the ventral plate appears, and forms a groove or channel, which
becomes obliterated as to its outer face by the meeting together of the
two margins of the groove (except on the anterior part, which remains
open). The more internal layer of the periphery of this closed canal is the
origin of the endoderm and its derivatives. Subsequently the ventral plate
and its derivatives grow so as to form the ventral part and the internal
organs of the Insect, the dorsal part being completed much later by
growths that differ much in different Insects; Graber, who has specially
investigated this matter, informing us[74] that an astonishing
multifariousness is displayed. It would appear that the various modes of
this development do not coincide with the divisions into Orders and
Families adopted by any systematists.

We should observe that the terms ectoderm, mesoderm, and endoderm

will probably be no longer applied to the layers of the embryo when
embryologists shall have decided as to the nature of the derived layers,
and shall have agreed as to names for them. According to the
nomenclature of Graber[75] the blastoderm differentiates into Ectoblast
and Endoblast; this latter undergoing a further differentiation into
Coeloblast and Myoblast. This talented embryologist gives the following
table of the relations of the embryonic layers and their nomenclature, the
first term of each group being the one he proposed to use:—
Nussbaum considers[76] that "there are four layers in the cockroach-
embryo, viz. (1) epiblast, from which the integument and nervous system
are developed; (2) somatic layer of mesoblast, mainly converted into the
muscles of the body-wall; (3) splanchnic layer of mesoblast, yielding the
muscular coat of the alimentary canal; and (4) hypoblast, yielding the
epithelium of the mesenteron."

Fig. 81.—Early stages of the segmentation of a beetle (Lina): A,

segmentation not visible, 1 day; B, segmentation of head visible; C,
segmentation still more advanced, 2¼ days; PC, procephalic lobes; g1,
g2, g3, segments bearing appendages of the head; th, thorax; th1, th2,
th3, segments of the thorax; a1, a2, anterior abdominal.

Turning our attention to the origin of the segmentation, that is so marked

a feature of Insect structure, we find that evidence of division or
arrangement of the body into segments appears very early, as shown in
our Figure of some of the early stages of development of Lina (a beetle),
Fig. 81. In A the segmentation of the ectoderm has not commenced, but
the procephalic lobes (P C) are seen; in B the three head segments are
distinct, while in C the thoracic segmentation has occurred, and that of
the abdomen has commenced. Graber considers that in this species the
abdomen consists of ten segmental lobes, and a terminal piece or telson.
According to Graber[77] this is not a primitive condition, but is preceded by
a division into three or four parts, corresponding with the divisions that will
afterwards be head, thorax, and abdomen. This primary segmentation, he
says, takes place in the Hypoblast (Endoderm) layer of the ventral plate;
this layer being, in an early stage of the development of a common
grasshopper (Stenobothrus variabilis), divided into four sections, two of
which go to form the head, while the others become thorax and abdomen
respectively. In Lina the primary segmentation is, Graber says, into three
instead of four parts. Graber's opinion on the primary segmentation does
not appear to be generally accepted, and Wheeler, who has studied[78]
the embryology of another Orthopteron, considers it will prove to be
incorrect. When the secondary segmentation occurs the anterior of the
two cephalic divisions remains intact, while the second divides into the
three parts that afterwards bear the mouth parts as appendages. The
thoracic mass subsequently segments into three parts, and still later the
hind part of the ventral plate undergoes a similar differentiation so as to
form the abdominal segments; what the exact number of these may be is,
however, by no means easy to decide, the division being but vague,
especially posteriorly, and not occurring all at once, but progressing from
before backwards.

The investigations that have been made in reference to the segmentation

of the ventral plate do not at present justify us in asserting that all Insects
are formed from the same number of embryonic segments. The matter is
summarised by Lowne, to the effect that posterior to the procephalic lobes
there are three head segments and three thoracic segments, and a
number of abdominal segments, "rarely less than nine or more than
eleven." It will be seen by referring to Figure 81 that the segmentation
appears, not simultaneously, but progressively from the head backwards;
this of course greatly increases the difficulty of determining by means of a
section the real number of segments.
 Fig. 82.—Embryo of a moth (Zygaena) at the fifth day (after Graber): am,
amnion; s, serosa; p, procephalic lobes; st, stomodaeum; pr,
proctodaeum; g1, g2, g3, the mouth parts or head appendages; th1, th2,
th3, appendages of the thoracic segments; a1-a10, abdominal
segments; s.g, salivary gland.

The later stages in the development of Insects are already proved to be

so various that it would be impossible to attempt to follow them in detail;
but in Fig. 82 we represent a median section of the embryo of Zygaena
filipendula at the fifth day. It shows well some of the more important of the
general features of the development at a stage subsequent to those
represented in Fig. 81, A, B, C. The very distinct stomodaeum (st) and
proctodaeum (pr) are seen as inflexions of the external wall of the body;
the segmentation and the development of the ventral parts of the embryo
are well advanced, while the dorsal part of the embryo is still quite
incomplete.

The method of investigation by which embryologists chiefly carry on their

researches is that of dividing the egg after proper preparation, into a large
number of thin sections, which are afterwards examined in detail, so as to
allow the arrangement to be completely inferred and described. Valuable
as this method is, it is nevertheless clear that it should, if possible, be
supplemented by direct observation of the processes as they take place
in the living egg: this method was formerly used, and by its aid we may
still hope to obtain exact knowledge as to the arrangements and
rearrangements of particles by which the structures develop. Such
questions as whether the whole formative power in the egg is absolutely
confined to one or two small centres to which the whole of the other egg
contents are merely, as it were, passive accessories, or whether an egg is
a combination in which some portion of the powers of rearrangement is
possessed by other particles, as well as the chromosomes, in virtue of
their own nature or of their position at an early period in the whole, can
scarcely be settled without the aid of direct observation of the processes
during life.

The importance of the yolk is recognised by most of the recent writers.

Nussbaum states (loc. cit.) that "scattered yolk-cells associate themselves
with the mesoblast cells, so that the constituents of the mesoblast have a
twofold origin." Wheeler finds[79] that amoeboid cells—he styles them