Differential Equation

Economic dynamics is a study of how economic variables evolve over time. The
economic dynamics focus how economic systems change or move from one position of
rest (i.e., equilibrium) to another. In this sense, it adding the dimension of time to
economic models goes a step beyond economic static. Economic dynamics relies on most
of the mathematical tools, for this reason; there arise differential equations and difference
equations.

Modeling Time
In economic, the dynamic models always consider date related variables. Sometimes, the
dating variables occurred at discrete intervals of time (e.g., once per month) or
continuous (at every instant of time). Time is continuous in reality. If we build an
economic model including date variables which may write y(t), this indicates the value of
the variable y at date t , where t is a continuous variable that represents time or date.
The variable y(t)is allowed to change continuously over time e.g., the price of copper on
the London Metal Exchange.

Similarly, it is more convenient to build economic model as considering the discretely

change variables which indicates only once per fixed period of time (like a month or
day). Then the variable may write y t . Here y indicates the value of the variable for the
period t , t  0, 1, 3, ..... . That is, the value of y is constant for the duration of a period
and can change only as t changes discretely from one period to the next.

Difference Equation
A difference equation specifies the determinants of the difference between successive
values of a variable. It indicates an equation for the change in a variable. The difference
or change in a variable between two periods is
y  y  y , t  0, 1, 2, ......
t t 1 t
A difference equation is any equation that contains  y . For this example, pt stands for
t
the consumer price index :
pt 1  pt   pt ,
where 0    1 . This difference equation says that the change in the consumer price
index from period t to the next period ( t  1 ) is equal to a fraction,  .

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Differential Equation
A differential equation is like a difference equation in that it expresses how a variable
changes over time expect that time is considered to be a continuous variable. Hence the
differential of y can be expressed formally as the difference between successive values
of y when the length of a period becomes extremely small:

dy y y
 lim t  h t
.
dt h0 h
The differential of y is just the derivative of y with respect to the continuous variable
time, which may write
dy
.
y .
dt
Here a dot over a variable indicates the time derivative. For example, let us consider
K (t ) is capital stock in an economy at time t then we may write
.
K  I (t )  K (t ) ,
where 0    1 is the depreciation rate. This differential equation says that the change in
the capital stock is equal to new investment, I (t ) , less depreciation of existing capital,
K (t ) .

Classification of Difference Equations

A difference equation is any equation that contains a difference of a variable. A
difference equation can be classified according to its order (whether it contains a first
difference, second difference or higher difference), whether it is linear or nonlinear, and
whether it is autonomous or nonautonomous.
1. Order : The order of a difference equation is determined by the highest order of
difference contained in the equation.
For example, a first-order difference equation contains only the first difference of a
variable: the difference in the variable between two consecutive time periods  yt 1  yt  .
A second-order difference equation also contains the second difference of a variable : the
difference in the variable between every two successive time periods  yt 2  yt  .
Practically, this means that a first-order difference equation contains variables at most
one period apart, such as
yt 1  3 yt  2 ,

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whereas a second-order difference equation contains variables at most two periods apart,
such as
yt  2  2 yt 1  3 yt  2
or, equivalently,
yt  2 yt 1  3 yt 2  2 .
Therefore, an nth order difference equation contains variables at most n periods apart.

2. Autonomous : A difference equation is said to be autonomous if it does not depend

on time explicitly; otherwise, it is nonautonomous. For example,
yt 1  2 yt  3t
is nonautonomous because it depends explicitly on the variable t . On the other hand,
yt 1  2 yt  3
is an autonomous difference equation because it does not depend explicitly on the
variable t .

3. Linear or nonlinear : A difference equation is nonlinear if it involves any

nonlinear terms in y t , y t 1 , y t  2 , and so on. It is linear if all of the y terms are raised to
no power other than one. For example,
yt 1  2 yt2  3
is a nonlinear, autonomous, first-order difference equation, and
yt 1  2 log yt  3
is a nonlinear, autonomous, first-order difference equation. But
yt 1  2 yt  3 t 2
is a linear, nonautonomous difference equation. Note that the word linear applies only to
whether the equation is linear in y terms.
Further, a linear, autonomous, second-order difference equation is defined as
yt  2  5 yt 1  2 yt  3
and a nonlinear, autonomous, second-order difference equation is defined as
2
yt  2  5 yt 1  3 .
yt

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Classification of Differential Equations
A differential equation is any equation that contains a differential, or derivative. These
equations also classified into a linear or nonlinear for autonomous or nonautonomous
according to its order. Here we studied only ordinary differential equations. Ordinary
differential equations contain only ordinary derivatives as opposed to partial derivatives.

1. Order : The order of a differential equation is determined by the highest order of

derivative contained in the equation.
For example, a first-order differential equation contains only the first derivative of a
function, whereas a second-order differential equation contains the second derivative
(and possibly first derivative). An example of a second-order differential equation is
.. .
3y  2y  y  2
Here two dots over a variable indicate its second derivative with respect to t . An example
of a third-order differential equation is
d3y d2y dy
3
 4 2
2  y2
dt dt dt

2. Autonomous : A differential equation is said to be autonomous if it does not

depend on time explicitly; otherwise, it is nonautonomous. For example,
.
y  5y  t
is a nonautonomous first-order differential equation. But
.
y  5y  3
is an autonomous first-order differential equation.

3. Linear or nonlinear : A differential equation is nonlinear if it involves any

nonlinear terms in y , y , y , and so on. It is linear if all of the y terms are raised to no
power other than one. For example,
y  t 2 y  cos t
is a linear, but nonautonomous first-order differential equation, whereas
y  y 2  2
is a nonlinear, autonomous, first-order differential equation.

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Differential Equations in Economic Statics and Partial Differential
Equations

Differential equations need not apply only to equations that are functions of time. Any
equation that contains a derivative is a differential equation. For example, suppose that
we know that the marginal-cost function for a firm is given by
dc( x)
b
dx
where c(x) is the total-cost function defined on non-negative real values of x , where x
is the output of the firm, and dc( x) dx is the marginal-cost function, which is equal to a
constant b . This is a differential equation and its solution is found by integration to
recover the primitive function, which is this case is the total-cost function. The solution is
c( x)  bx  C
where, as before, C is an arbitrary constant of integration. If we consider that C (0)  F ,
which means that even when the output of the firm is zero, costs are equal to F (fixed
costs), then the solution becomes
c( x)  bx  F .
Any equation containing an ordinary derivative is an ordinary differential equation. Thus
differential equations can arise in economic statics as well as in economic dynamics.

An equation containing partial derivatives is called a partial differential equation. For

example, suppose a household-utility function depends on the consumption of two goods,
x and y , and suppose the marginal utility from consuming x depends on how much x
and y are being consumed. Then the marginal-utility function could be
 u ( x, y) 
  x 1 y
x
where u is the utility function and  and  are each between 0 and 1 . This is a
partial differential equation because it contains the partial derivative of the function u .

First-Order Differential Equations

The general form of the linear, autonomous, first-order differential equation is
y  ay  b
where a and b are known constants.

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  The differential equation is linear because y and y are not raised to any power
order than 1 .
 It is of the first-order because that is the highest-order derivative in the equation.
 It is autonomous because the coefficient a and b are constant.
 If a or b vary with t , the equation is nonautonomous.

The homogeneous form of the linear, autonomous, first-order differential equation is

y  ay  0, a0
 If a  0 , the solution is easy to obtain by direct integration. It is simply y(t )  C
, where C is an arbitrary constant of integration.
 If a  0 , the solution can be made by direct integration after manipulating it into
a suitable form.
Subtract ay from both sides of the equation and then divide through by y . This gives
y
a
y
In this form we can integrate each side with respect to t without too much difficulty. The
integral of the right-hand side is just  at  c1 , where c1 is a constant of integration. The
integral of the left-hand side is written as
y
 y dt
Recalling that y is actually dy dt , this becomes
dy dt 1
 y
dt   y dy
Since the integral of 1 y is just ln y  c2 , where c 2 is a constant of integration, we now
have integrated both sides, giving
In y  c2   at  c1
 at c  c
 y  e 1 2

c c
 at
 y  e e 1 2

 at
 y  Ce
c c
where C  e 1 2 is still an arbitrary constant of integration. This gives the solution to
the homogeneous form.

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Example
Solve the homogeneous form of the differential equation
y  3 y  2
Solution
The homogeneous form is
y  3 y  0
y
 3
y
Integrating both sides gives
In y  c2  3t  c1
Taking the antilogarithm of both sides and simplifying gives the solution
y h (t )  Ce3t ,
where the subscript, h stands for homogeneous.

Example
Let y represent national energy consumption and suppose it grows at a constant rate of
2%. Derive and solve the differential equation implied this statement.

Solution
The rate of growth of something is just its growth divided by its level ( y y) . If the
percentage rate of growth is a constant 2%, then the rate of growth itself is just 0.02. Thus
we can express the statement that energy consumption grows at a constant 2% as follows:
y
 0.02
y
Then we have y(t )  Ce 0.02t
The solution gives the level of energy consumption at time t .

Steady-state Value
A steady-state value of a differential equation is defined by the condition y  0 . It is the
value of y , which we call y , at which y is stationary.
To find the steady-state value of y , set y  0 in the complete differential equation. This
b
gives 0  ay  b  y , a0 as the steady state value of y .
a

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Example
Let K (t ) represent the quantity of capital available in an industry at time t . Suppose that
capital depreciates at the rate  and that the rate of investment in the industry is a
constant I . Derive and solve the differential equation implied by these statements or
find the capital stock model at time 𝑡 using differential equation.

Solution
If   0 is the constant rate of depreciation, then  K (t ) is the total amount of
depreciation at time t . The change in the stock (quantity) of capital then is just I   K .
The differential equation for capital is therefore
K  I   K
The homogeneous form is
K   K  0
The solution to the homogeneous form is

K
h
C e  t

The particular solution we use is the steady-state solution, which is found by setting
K  0 and solving. This gives
I
K 

This tells us that if the capital stock ever reaches the level I  , depreciation will just
equal new investment, so there will be no further increases or decreases in the size of the
capital stock.
The general solution to the complete differential equation therefore is
 t I
K (t )  C e 

Setting t  0 and K (0)  K 0 gives
I
K0  C 

which implies that
I
C  K0 


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Substituting for C in the general solution and rearranging gives
 I   t I
K (t )   K 0   e 
   
which indicates the initial-value problem.

The Initial-Value Problem

Let us we consider the initial value of y at time t  t 0 , when t 0 is the initial value of t ,
then the solution to the initial-value problem is one which both solves the differential
equation and satisfies the initial value of y .

Example
Solve the differential equation
y  0.1y  1
and ensure that it satisfies the initial condition y(0)  5 at t  0 .

Solution
The homogeneous form of the differential equation is
y h (t )  C e 0.1 t
Under particular solution, the steady-state solution is obtained as
y  10 .
Then the general solution is given by
y(t )  C e 0.1 t  10
To find the solution that also satisfies the initial condition, evaluate the general solution
at t  0 . This gives
y(0)  C  10 .
To ensure that y(0)  5 , we set C   5 . The solution to this initial-value problem then is
y(t )   5 e 0.1 t  10 .
The arbitrary constant takes on a particular value when the solution is also required to
satisfy an initial condition.

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In general, if the initial time is t 0 , and the initial condition is y(t 0 )  y0 , then the general
solution at time t 0 becomes
 a t0 b
y0  C e 
a

which means that

 b a t
C   y0   e 0 .
 a
The solution then becomes
 b a t  a t b
y (t )   y 0   e 0 e 
 a a

After simplifying, this becomes

 b  a (t  t0 ) b
y (t )   y 0   e 
 a a

Usually we take t 0  0 , in which case the expression simplifies to

 b
y (t )   y 0   e at 
b
 a a

Example
Let y stand for energy demand and suppose that it grows according to
y  5 y  10 .
If energy demand has a value of 100 at time t  0 , determine whether it ever converges
to a steady state.

Solution
Let us consider the general solution, we have
y(t )  C e 5 t  2
At time t  0 the solution must satisfy y(0)  100 . This means
100  C  2 .
Therefore C = 98. The solution becomes
y(t )  98 e 5 t  2

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This equation indicates that y (t ) becomes infinitely large as t goes to infinity. Thus
energy demand does not converge to its steady-state value in this model.

Dynamics of National Debt Accumulation

Many countries have run persistent budget deficits in recent years. This has led to a
dramatic growth in national debts and a concern that this trend could lead to bankruptcy.

Let D(t ) represent the dollar value of the debt at time t , and let Y (t ) represent the dollar
value of the nation’s income, or GNP, at time t . Here, we assume that the deficit
(positive value equal to expenditures minus revenue) is a constant proportion of national
income at any point in time. Since the change in the debt is just the deficit, we have
D  bY , b0 (1)
as the ordinary differential equation that describes the behavior of debt. For instance, the
value for b in many countries would fall in the range 0.02 to 0.08 which means that
deficits are about 2% to 8% of the size of national income. Further, assume that national
income grows over time according to the following differential equation:
Y  gY (2)
where g is a positive constant which represents the growth rate of national income.
Together, equations (1) and (2) is a model of debt accumulation. To analyze the
implications of the model for the long-run ratio of interest payments to national income,
we need to solve these equations. Then the equation (2) may be written as
Y
 g.
Y
Integrating both sides gives
In Y (t )  c2  gt  c1
which we can rewrite as
gt
Y (t )  C1 e
(c  c )
where C1  e 1 2 . Assuming that the initial time is t 0  0 and that the initial values
of income and debt are Y0 and D0 respectively, we require Y (0)  Y0  C1 . Thus the
solution in the initial value problem for equation (2) is
g t
Y (t )  Y0 e
Substitution of this solution into equation (1) gives

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 gt
D  b Y0 e
Due to nonautonomous equation, it can be solved by integrating both sides, we have
gt
e
D(t )  b Y0  C2
g
Since D(0)  D0 , the value of C 2 must be set to ( D0  b g Y0 ). Using this value, we have
the solution
b gt
D(t )  D0  Y0 (e  1) .
g
This equation indicates the national debt, D(t ) grows model. However, country’s
requirement is to meet the interest obligations on the debt. Under constant interest rate r ,
the ratio of interest payments r D(t ) to national income Y (t ) is defined as
gt
r D(t ) D  b Y0 (e  1) / g
r 0 gt .
Y (t ) Y0 e
Defining z(t )  r D(t ) Y (t ) as the share of national income absorbed by interest
payments on the national debt and simplifying procedures

z (t ) 
r D0  g t
Y0
e
b
 r 1 e
g
gt
 
This expression gives the ratio of interest payments to national income at any point in
time. Our main interest is to determine whether this ratio converges to a finite limit less
than 1 (interest payments never become as large as national income). This equation
indicates that z (t ) , the ratio of interest obligations to income, converges to a finite limit
as t   . Then we have
b
lim z (t )  r g
t 

Interest payments on the debt converge to a constant proportion of national income equal
to rb g . If rb g  1 , then even if a government forever runs a deficit which is a constant
proportion of a growing national income, the burden on the economy of the resulting debt
converges to a constant share of national income. That means the economy would always
be able to meet its debt payments and bankruptcy would never occur. On the other hand,
if rb g  1 , then the process converges to a finite limit where interest payments exceed
national income. In this case the economy would be destined to experience bankruptcy if
it continued to run deficits.

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Further, D  bY and Y  gY , the ratio of the increase in debt to the increase in income,
D Y , is just b g . Thus, for every dollar increase in national income, debt increases by
b g . Suppose that b g  0.5 , then for every dollar increase in national income, debt
increases by 50 cents. Clearly, income is growing faster than the debt, so the ratio of debt
to income will always be less than unity. Then, because interest rates are typically much
less than 1, the ratio of interest on debt to income will always be less than unity.

Example
Find the demand function Q  f (P) if point elasticity  is  1 for all P  0 .
dQ P dQ Q
  1  
dP Q dP P
dQ dP
Separating the variables,   0 . Integrating, In Q  In P  In c , then QP  c
Q P
c
 Q .
P

Example
Find the demand function Q  f (P) if point elasticity  =  k , a constant,
dQ P dQ kQ
  k  
dP Q dP P
dQ k dP
Separating the variables,   0.
Q P
Integrating, In Q  k In P  In c ,
then QP k  c  Q  cP  k .

Example
Find the demand function Q  f (P) if    (5P  2P 2 ) / Q and Q  500 when P  10 .
dQ P  (5P  2 P 2 )
  
dP Q Q

dQ  (5P  2 P 2 ) Q
   (5  2 P)
dP Q P

Separating the variables, dQ  (5  2P) dP  0 .

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Integrating, Q  5 P  P 2  c , Q   P 2  5P  c .
At P  10 and Q  500 ,
500   100  50  c ,
 c  650 .
Thus, Q  650  5P  P 2 .

Example
Assume that the demand for money is for transaction purposes only. Thus,
M d  kP(t )Q (1)
Where k is constant, P is the price level, and Q is real output. Assume M s  M d and is
exogenously determined by monetary authorities. If inflation or the rate of change of
prices is proportional to excess demand for goods in society and, from Walras’ law, an
excess demand for goods is the same thing as an excess supply of money, so that
dP(t )
 b (M s  M d ) (2)
dt
find the stability conditions, when real output Q is constant.
Substituting (1) in (2), we have
dP(t )
 b M s  bkP(t ) Q (3)
dt
If we let Pˆ  P(t )  P (4)

where P̂ is the deviation of prices from the equilibrium price level P , then taking the
derivative of (4),
dPˆ dP(t ) dP
  .
dt dt dt
But in equilibrium dP dt  0 . Hence,

dPˆ dP(t )
 . (5)
dt dt
Substituting in (3),
dPˆ
 b M s  bkP(t ) Q (6)
dt
In equilibrium, M s  M d  kP Q . Hence M s  kP Q  0 and b(M s  kP Q)  0 .
Subtracting this from (6),

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 dPˆ
 bM s  bkP(t )Q  bM s  bkP Q   bkQ( P(t )  P )   bkQPˆ (7)
dt
which is a differential equation. Separating the variables,
dPˆ
  bkQ dt .
Pˆ
bkQ t
Integrating, In Pˆ   bkQ t  c , Pˆ  A e , where e c  A .
Since b, k , Q  0, Pˆ  0 as t   , and the system is stable.

Example
If the expectation of inflation is a positive function of the present rate of inflation
 dP(t )  dP(t )
 dt   h dt (8)
E
and the expectation of inflation reduces people’s desire to hold money, so that
 dP(t ) 
M d  kP(t )Q  g  (9)
 dt  E
check the stability conditions, assuming that the rate of inflation is proportional to the
excess supply of money as in (2).
Substituting (8) in (9),
dP(t )
M d  kP(t )Q  gh (10)
dt
Substituting (10) in (2),
dP(t )  dP(t ) 
 bM s  b kP(t )Q  gh
dt  dt 
By a process similar to the steps involving (4) to (7),
dPˆ dP(t ) dP(t )
 bM s  bkP(t )Q  bgh  bM s  bkP Q   bkQPˆ  bgh (11)
dt dt dt
Substituting (5) for dP(t ) dt in (11)
dPˆ dPˆ  bkQPˆ
  bkQPˆ  bgh 
dt dt 1  bgh
Separating the variables,
dPˆ  bkQ
 dt
ˆ
P 1  bgh
Integrating, In Pˆ   bkQ t (1  bgh)

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  bkQ t (1bgh)
Pˆ  A e
Since b, k , Q  0, Pˆ  0 as t   , if bgh  1 . Hence even if h is greater than 1 ,
meaning people expect inflation to accelerate, the economy need not be unstable, as long
as b and g are sufficiently small.

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