ECON009: Advanced Mathematical Methods for Economics
Problem Set 6 (First-order difference equations)
Instructor: Mr. Rohit
Question 1: Harrod- Domar Model (It attempts to explain the dynamics of growth in the
economy)
Supply of savings is given by
St = sYt where s is both the MPS and APS.
The demand for savings is given by
It = θ (Yt − Yt−1) ; θ is both the marginal and average capital-output ratios (Acceleration Principle)
(a) Deduce the difference equation determining the path of national income Yt, given Y0 and solve
it.
(b) Determine the warranted rate of growth (Hint: gw is the rate of growth the economy must
follow to have equilibrium between savings and investment each year)
(c) Calculate the warranted rate of growth when MPS is 12 % and capital-output ratio is 2.12
Question 2: (Cobb-web Model, First order difference equation)
Suppose that the market for hogs is characterised by the demand and supply equations:-
Pt = a − bQtD and Qst = − c + d Et−1(Pt ) ; a, b, c, & d all are positive.
where Pt is market price in period t, QtD is the quantity demanded in period t , QtS is the quantity
supplied in period t. Et−1(Pt ) represents the expected price. The supply equation shows that farmers
must decide in the year t − 1 how many hogs to raise and bring to market in year t.
(a) Assuming Et−1(Pt ) = Pt−1, deduce a difference equation determining the path of Pt , given P0
and solve it. What is the steady state price?
Modify the way in which price expectations are formed, as follows:
Et−1(Pt ) = pt−1 + θ ( p* − pt−1) ; 0≤θ ≤1
where p* is the stationary state (i.e. suppliers have an accurate forecast of steady-state equilibrium
price p*)
(b) Solve the difference equation for price and analyze the convergence properties of the solution.
ECON009: Advanced Mathematical Methods for Economics
Problem Set 6 (First-order difference equations)
Question 3: (Lagged Income Determination Model)
Suppose that aggregate consumption in period t , Ct is a linear function of aggregate income in the
previous period Yt−1.
Ct = a + bYt−1 where a, b > 0 are constant.
If aggregate investment is a constant amount, I, and aggregate income is equal to consumption plus
investment
Yt = Ct + I
(a) write down the difference equation for aggregate income and solve it.
(b) What restriction must be placed on b to ensure that income converges monotonically to the
steady-state equilibrium?
(c) What is the short-run (one-period) and the long-run (steady-state) impact of an increase in I on
aggregate income?
Question 4: (A Market model with Inventory)
Consider the economic model for the market of a commodity
Qtd = α − βPt (α, β > 0)
Qts = − γ + δPt (γ, δ > 0)
Pt+1 = pt − σ (Qts − Qtd ) (σ > 0)
where σ denotes the stock-induced-price-adjustment coefficient.
The price of the commodity is not determined by the equality of quantity demanded and quantity
supplied rather The price of the commodity in every period is set by the sellers through a process of
price-setting. Sellers set the price for each period after considering the inventory in that period.
(Qts − Qtd is inventory for the period t − 1).
(a) Derive the time path for Pt, given P0, and solve it.
(b) Find the stationary state and discuss the stability of the price.
ECON009: Advanced Mathematical Methods for Economics
Problem Set 6 (First-order difference equations)
(c) If the sellers in our model always increase the price by 10 % of the amount of the decrease in
the inventory, and if the demand curve has a slope of −1 and the supply curve has the slope of
1
, then explain how the solution to the equation in part (a) behaves.
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Question 5: (A market model for a commodity characterised by habit formation)
A perfectly competitive industry has the following supply function:
Qt = − c + dpt
The demand for this product is a function of price and the lagged value of quantity
Qt = a − bpt + θQt−1
It says the current quantity demanded is equal to the fraction θ of the last period’s value of quantity
plus a constant a and an amount that depends negatively on price, −bpt. A demand function such as
this might apply to a commodity characterised by habit formation (like cigarettes, bonus questions
in MME class). Assuming that the market clears each period,
(a) Derive a first-order difference equation for quantity, Qt , given Q0, and solve it.
(b) Find the steady-state equilibrium and determine whether quantity converges monotonically, in
oscillations, or not at all.