INTERMEDIATE METHODS:

DIFFERENCE EQUATIONS
DIFFERENCE EQUATIONS
 Not a whole lot of theory, really.
 Difference Equations are concerned with DISCRETE changes in
a variable over time.
 Differential equations were a continuous change, difference
equations look at data which is reported only once a time period.
 For example, lags  if you had a lagged variable in a model, then
it’s rate of change over time would be modelled by a difference
equation.
 A typical difference equation looks like:

 Yt = a + bYt-1

 We call such a difference equation a first order difference

equation because it only goes back one period.
DIFFERENCE EQUATIONS
 Primarily Concerned with two types of Difference
Equation, homogenous and non-homogenous.
 Pretty much the same definition as homogenous + non-
homogenous Dif. Equations.

 Homogenous:
 Yt = bYt-1
 A.k.a, ‘a = 0’
 Non – Homogenous:
 Yt = a + bYt-1
DIFFERENCE EQUATIONS
 Solution of the homogenous case:
 Yt = Y(0).bt
 Solution of the non-homogenous case (when re-arranged):

a  a  t
Yt   Y  0    b
1 b  1 b 

Particular Complementary
Solution Function
 However, note that ‘b’ CANNOT equal 1, otherwise the
solution is undefined. Thus, the equation to use when ‘b’ = 1,
is:
 Yt = at + Y(0)
DIFFERENCE EQUATIONS
 Stability Conditions:
 We can thus model the typical general solution for a difference equation thusly:
 Yt = c + mbt
 ‘c’ and ‘m’ are constants, so the stability of the model depends on ‘bt’  more specifically,
it depends on the value of ‘b’.

 IF:
 b > 1  NON-CONVERGENCE, DIVERGES FROM LONG-RUN SOLUTION (‘c’)

 b = 1  NON-CONVERGENCE, CONSTANT DEVIATION FROM ‘c’.

 1 > b > 0  CONVERGES TOWARDS EQUILIBRIUM.

 b = 0  Y is a CONSTANT.

 -1 < b < 0  CONVERGES TOWARDS EQUILIRBRIUM, OSCILLATES!

 b = -1  NON-CONVERGENCE, OSCILLATING AROUND ‘c’

 b < -1  NON-CONVERGENCE, OSCILLATES IN A DIVERGENT FASHION.

DIFFERENCE EQUATIONS
 Thus, if ‘b’ is less than 1, the effect largely mirrors what
will happen if b > 1, except the path now oscillates about
the long-run equilibrium.
 Another thing; the time path for a difference equations is
different to that for a continuous differential equation.

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DIFFERENCE EQUATIONS
 Questions on Difference Equations:
 Generally just mash equations together to get an equation in
the form of an exact/non-exact difference and solve.
 Only one you need to really know any theory for is the
HARROD-DOMAR model:
 In equilibrium  k(Yt – Yt-1) = sYt
 Where ‘k’ is K/Y and ‘s’ is MPS
 Re-arrange to get into the form of a homogenous difference
equation.
 The WARRANTED GROWTH RATE is (Y1 – Y0)/Y0
 Find ‘Y1’ from the general solution you get from computing the
equilibrium problem, then re-arrange.
 Eventually, should reach the equation:
s
Gw 
k s