Topic 2: Difference Equations (I)

1. Introduction
In this chapter we shall consider systems of equations where each variable has a time
index t = 0, 1, 2, . . . and variables of different time–periods are connected in a non–trivial
way. Such systems are called systems of difference equations and are useful to describe
dynamical systems with discrete time. The study of dynamics in economics is important
because it allows to drop out the (static) assumption that the process of economic adjustment
inevitable leads to an equilibrium. In a dynamic context, this stability property has to be
checked, rather than assumed away.
Let time be a discrete denoted t = 0, 1, . . .. A function X : N −→ Rn that depends on
this variable is simply a sequence of vectors of n dimensions
X0 , X1 , X2 , . . .
If each vector is connected with the previous vector by means of a mapping f : Rn −→ Rn
as
Xt+1 = f (Xt ), t = 0, 1, . . . ,
then we have a system of first–order difference equations. In the following definition, we
generalize the concept to systems with longer time lags and that can include t explicitly.
Definition 1.1. A kth order discrete system of difference equations is an expression of the
form
(1.1) Xt+k = f (Xt+k−1 , . . . , Xt , t), t = 0, 1, . . . ,
where every Xt ∈ Rn and f : Rnk × [0, ∞) −→ Rn . The system is
• autonomous, if f does not depend on t;
• linear, if the mapping f is linear in the variables (Xt+k−1 , . . . , Xt );
• of first order, if k = 1.
Definition 1.2. A sequence {X0 , X1 , X2 , . . .} obtained from the recursion (1.1) with initial
value X0 is called a trajectory, orbit or path of the dynamical system from X0 .
In what follows we will write xt instead of Xt if the variable Xt is a scalar.
Example 1.3. [Geometrical sequence] Let {xt } be a scalar sequence, xt+1 = qxt , t = 0, 1, . . .,
with q ∈ R. This a first–order, autonomous and linear difference equation. Obviously
xt = q t x0 . Similarly, for arithmetic sequence, xt+1 = xt + d, with d ∈ R, xt = x0 + td.
Example 1.4.
• xt+1 = xt + t is linear, non–autonomous and of first order;
• xt+2 = −xt is linear, autonomous and of second order;
• xt+1 = x2t + 1 is non–linear, autonomous and of first order;
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Example 1.5. [Fibonacci numbers (1202)] “How many pairs of rabbits will be produced
in a year, beginning with a single pair, if every month each pair bears a new pair which
becomes productive from the second month on?”. With xt denoting the pairs of rabbits in
month t, the problem leads to the following recursion

xt+2 = xt+1 + xt , t = 0, 1, 2, . . . , with x0 = 1 and x1 = 1.

This is an autonomous and linear second–order difference equation.

2. Systems of first order difference equations

Systems of order k > 1 can be reduced to first order systems by augmenting the number
of variables. This is the reason we study mainly first order systems. Instead of giving a
general formula for the reduction, we present a simple example.

Example 2.1. Consider the second–order difference equation yt+2 = g(yt+1 , yt ). Let x1,t =
yt+1 , x2,t = yt , then x2,t+1 = yt+1 = x1,t and the resulting first order system is
   
x1,t+1 g(x1,t , x2,t )
= .
x2,t+1 x1,t
   
x1,t g(Xt )
If we denote Xt = , f (Xt ) = , then the system can be written Xt+1 =
x2,t x1,t
f (Xt ).
For example, yt+2 = 4yt+1 + yt2 + 1 can be reduced to the first order system
   
x1,t+1 4x1,t + x22,t + 1
= ,
x2,t+1 x1,t

and the Fibonacci equation of Example 1.5 is reduced to

   
x1,t+1 x1,t + x2,t
= ,
x2,t+1 x1,t

For a function f : Rn −→ Rn , we shall use the following notation: f t denotes the t–fold
composition of f , i.e. f 1 = f , f 2 = f ◦ f and, in general, f t = f ◦ f t−1 for t = 1, 2, . . .. We
also define f 0 as the identity function, f 0 (X) = X.

Theorem 2.2. Consider the autonomous first order system Xt+1 = f (Xt ) and suppose that
there exists some subset D such that for any X ∈ D, f (X) ∈ D. Then, given any initial
condition X0 ∈ D, the sequence {Xt } is given by

Xt = f t (X0 ).
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Proof. Notice that

X1 = f (X0 ),
X2 = f (X1 ) = f (f (X0 )) = f 2 (X0 ),
..
.
Xt = f (f · · · f (X0 ) · · · )) = f t (X0 ).

The theorem provides the current value of X, Xt , in terms of the initial value, X0 . We
are interested what is the behavior of Xt in the future, that is, in the limit
lim f t (X0 ).
t→∞
Generally, we are more interested in this limit that in the analytical expression of Xt . Nev-
ertheless, there are some cases where the solution can be found explicitly, so we can study
the above limit behavior quite well. Observe that if the limit exists, limt→∞ f t (X0 ) = X 0 ,
say, and f is continuous
f (X 0 ) = f ( lim f t (X0 )) = lim f t+1 (X0 ) = X 0 ,
t→∞ t→∞
0
hence the limit X is a fixed point of map f . This is the reason fixed points play a distin-
guished role in dynamical systems.
Definition 2.3. A point X 0 ∈ D is called a fixed point of the autonomous system f if,
starting the system from X 0 , it stays there:
If X0 = X 0 , then Xt = X 0 , t = 1, 2, . . . .
Obviously, X 0 is also a fixed point of map f . A fixed point is also called equilibrium,
stationary point, or steady state.
Example 2.4. In Example 1.3 (xt+1 = qxt ), if q = 1, then every point is a fixed point; if
q 6= 1, then there exists a unique fixed point: x0 = 0. Notice that the solution xt = q t x0 has
the following limit (x0 6= 0) depending the value of q.
−1 < q < 1 ⇒ lim q t x0 = 0,
t→∞
q = 1 ⇒ lim q t x0 = x0 ,
t→∞
q ≤ −1 ⇒ the sequence oscillates between + and − and the limit does not exist
In Example 1.5, x0 = 0 is the unique fixed point. Consider now the difference equation
xt+1 = x2t − 6. Then, the fixed points are the solutions of x = x2 − 6, that is, x0 = −2 and
x0 = 3.

In the following definitions, kX − Y k stands for the Euclidean distance between X and
Y . For example, if X = (1, 2, 3) and Y = (3, 6, 7), then
p √
kX − Y k = (3 − 1)2 + (6 − 2)2 + (7 − 3)2 = 36 = 6.
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Definition 2.5.
• A fixed point X 0 is called stable if for any close enough initial state X0 , the resulting
trajectory {Xt } exists and stays close forever to X 0 , that is, for any positive real ε,
there exists a positive real δ(ε) such that if kX0 − X 0 k < δ(), then kXt − X 0 k < ε
for every t.
• A stable fixed point X 0 is called locally asymptotically stable (l.a.s.) if the trajectory
{Xt } starting from any initial point X0 close to enough to X 0 , converges to the fixed
point.
• A stable fixed point is called globally asymptotically stable (g.a.s.) if any trajectory
generated by any initial point X0 converges to it.
• A fixed point is unstable if it is not stable or asymptotically stable.
Remark 2.6.
• If X 0 is stable, but not l.a.s., {Xt } need not approach X 0 .
• A g.a.s. fixed point is necessarily unique.
• If X 0 is l.a.s., then small perturbations around X 0 decay and the trajectory generated
by the system returns to the fixed point as the time grows.
Definition 2.7. Let P be an integer larger than 1. A series of vectors X0 , X1 , . . . , XP −1 is
called a P –period cycle of system f if a trajectory starting from X0 goes through X1 , . . . , XP −1
and returns to X0 , that is
Xt+1 = f (Xt ), t = 0, 1, . . . , P − 1, XP = X0 .
Observe that the series of vectors X0 , X1 , . . . , XP repeats indefinitely in the trajectory,
{Xt } = {X0 , X1 , . . . , XP −1 , X0 , X1 , . . . , XP −1 , . . .}.
For this reason, the trajectory itself is called a P –cycle.
Example 2.8. In Example 1.3 (xt+1 = qxt ) with q = −1 all the trajectories contains 2–
cycles, because a typical path is
{x0 , −x0 , x0 , −x0 , . . .}.
Example 2.9. In Example 1.4 where yt+2 = −yt , to find the possible cycles of the equation,
first we write it as first order system using Example 2.1, to obtain
   
x1,t+1 −x2,t
Xt+1 = = ≡ f (Xt ).
x2,t+1 x1,t
Let X0 = (2, 4). Then
X1 = f (X0 ) = (−4, 2),
X2 = f (X1 ) = (−2, −4),
X3 = f (X2 ) = (4, −2),
X4 = f (X3 ) = (2, 4) = X0 .
Thus, a 4–cycle appears starting at X0 . In fact, any trajectory is a 4–cycle.
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3. First order linear difference equations

The linear equation is of the form
(3.1) xt+1 = axt + b, xt ∈ R, a, b ∈ R.
Consider first the case b = 0 (homogeneous case). Then, by Theorem 2.2 the solution is
xt = at x0 , t = 0, 1, . . .. Consider now the non–homogeneous case, b 6= 0. Let us find the
fixed points of the equation. They solve (see Definition 2.3)
x0 = ax0 + b,
hence there is no fixed point if a = 1. However, if a 6= 1, the unique fixed point is
b
x0 = .
1−a
Define now yt = xt − x0 and replace xt = yt + x0 into (3.1) to get
yt+1 = ayt ,
hence yt = at y0 . Returning to the variable xt we find that the solution of the linear equation
is
xt = x0 + at (x0 − x0 )
 
b t b
= + a x0 − .
1−a 1−a
b
Theorem 3.1. In (3.1), the fixed point x0 = 1−a
is g.a.s. if and only if |a| < 1.
Proof. Notice that limt→∞ at = 0 iff |a| < 1 and hence limt→∞ xt = limt→∞ x0 + at (x0 − x0 ) =
x0 iff |a| < 1, independently of the initial x0 . 
The convergence is monotonous if 0 < a < 1 and oscillating if −1 < a < 0.
Example 3.2 (A Multiplier–Accelerator Model of Growth). Let Yt denote national income,
It total investment, and St total saving—all in period t. Suppose that savings are propor-
tional to national income, and that investment is proportional to the change in income from
period t to t + 1. Then, for t = 0, 1, 2, . . .,
St = αYt ,
It+1 = β(Yt+1 − Yt ),
St = It .
The last equation is the equilibrium condition that saving equals investment in each period.
Here β > α > 0. We can deduce a difference equation for Yt and solve it as follows. From
the first and third equation, It = αYt , and so It+1 = αYt+1 . Inserting these into the second
equation yields αYt+1 = β(Yt+1 − Yt ), or (α − β)Yt+1 = −βYt . Thus,
 
β α
Yt+1 = Yt = 1 + Yt , t = 0, 1, 2, . . . .
β−α β−α
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The solution is  t
α
Yt = 1 + Y0 , t = 0, 1, 2, . . . .
β−α
Thus, Y grows at the constant proportional rate g = α/(β − α) each period. Note that
g = (Yt+1 − Yt )/Yt .
Example 3.3 (A Cobweb Model). Consider a market model with a single commodity where
producer’s output decision must be made one period in advance of the actual sale—such as
in agricultural production, where planting must precede by an appreciable length of time
the harvesting and sale of the output. Let us assume that the output decision in period t is
based in the prevailing price Pt , but since this output will no be available until period t + 1,
the supply function is lagged one period,
Qs,t+1 = S(Pt ).
Suppose that demand at time t is determined by a function that depends on Pt ,
Qd,t+1 = D(Pt ).
Supposing that functions S and D are linear and that in each time period the market clears,
we have the following three equations
Qd,t = Qs,t ,
Qd,t+1 = α − βPt+1 , α, β > 0,
Qs,t+1 = −γ + δPt , γ, δ > 0.
By substituting the last two equations into the first the model is reduced to the difference
equation for prices
δ α+γ
Pt+1 = − Pt + .
β β
The fixed point is P 0 = (α + γ)/(β + δ), which is also the equilibrium price of the market,
that is, S(P 0 ) = D(P 0 ). The solution is
 t
0 δ
Pt+1 = P + − (P0 − P 0 ).
β
Since −δ/β is negative, the solution path is oscillating. It is this fact which gives rise to the
cobweb phenomenon. There are three oscillations patterns: it is explosive if δ > β (S steeper
than D), uniform if δ = β, and damped if δ < β (S flatter than D). The three possibilities
are illustrated in the graphics below. The demand is the downward–slopping line, with slope
−β. The supply is the upward–slopping line, with slope δ. When δ > β, as in Figure 3, the
interaction of demand and supply will produce an explosive oscillation as follows: Given an
initial price P0 , the quantity supplied in the next period will be Q1 = S(P0 ). In order to
clear the market, the quantity demanded in period 1 must be also Q1 , which is possible if
and only if price is set at the level of P1 given by the equation Q1 = D(P1 ). Now, via the S
curve, the price P1 will lead to Q2 = S(P1 ) as the quantity supplied in period 2, and to clear
the market, price must be set at the level of P2 according to the demand curve. Repeating
this reasoning, we can trace out a “cobweb” around the demand and supply curves.
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Figure 1. Cobweb diagram with damped oscillations

Figure 2. Cobweb diagram with uniform oscillations

Figure 3. Cobweb diagram with explosive oscillations