Log-linearization of Equilibrium Conditions

Dr. Tai-kuang Ho

Associate Professor. Department of Quantitative Finance, National Tsing Hua University, No.
101, Section 2, Kuang-Fu Road, Hsinchu, Taiwan 30013, Tel: +886-3-571-5131, ext. 62136, Fax:
+886-3-562-1823, E-mail: tkho@mx.nthu.edu.tw. This note draws heavily from Uhlig (1999).
1 Principles
The principle of log-linearization is to use Taylor expansion around the steady
state to replace all equations by approximations.
The approximations are linear functions in the log-deviations of the variables.
A
t
:vector of variables

A :steady state
a
t
:vector of log-deviations
a
t
= log A
t
log

A
The vector 100 a
t
tell us, by how much the variables dier from their steady
state levels in period t in percent.
Write the necessary equations characterizing the equilibrium as:
1 = ) (a
t
, a
t1
)
1 = 1
t
[j (a
t+1
, a
t
)]
Equilibrium implies
) (0, 0) = 1
j (0, 0) = 1
Taking rst-order approximation around (a
t
, a
t1
) = (0, 0) yields
0 )
1
a
t
+ )
2
a
t1
0 1
t
[j
1
a
t+1
+ j
2
a
t
]
One obtains a linear system in a
t
and a
t1
in the deterministic equations and
a
t+1
and a
t
in the expectational equations.
2 Techniques
There is no need to dierentiate the functions ) and j explicitly.
The following are the techniques.
A
t
=

Ac
a
t


A (1 + a
t
)
c
a
t
+oj
t
1 + a
t
+ oj
t
a
t
j
t
0
1
t
[oc
a
t+1
] 1
t
[oa
t+1
] up to a constant
For examples
c
a
t
1 + a
t
oA
t
o

Aa
t
up to a constant
(A
t
+ o) Y
t

A

Y a
t
+

A + o

Y j
t
up to a constant
1. Multiply out everything before log-linearization.
2. Constants drop out of each equation in the end, since they satisfy steady state
relationships.
Example 1: the neoclassical growth model
Lower case letters denote log deviations from respective steady-state values while
capital letters denote levels.
The necessary conditions:
C
t
= Z
t
1
j
t
+ (1 c) 1
t
1
t+1
(1)
1
t
= jZ
t
1
j1
t
+ (1 j) (2)
1 = 1
t
"
o

C
t
C
t+1
!
j
1
t+1
#
(3)
log Z
t
= (1 ) log

Z + log Z
t1
+ c
t
, c
t
i.i.o.N

0; o
2

(4)
The steady state:

C =

Z

1
j
+ (1 c)

1

1 =

Z

1
j
c

1

1 = j

Z

1
j1
+ (1 c)
1 = o

1
Log-linearization of the necessary conditions
c
t
=

Y

C
:
t
+

1
o

C
I
t

C
I
t+1
v
t
= (1 o (1 c)) (:
t
(1 j) I
t
)
0 = 1
t
[j (c
t
c
t+1
) + v
t+1
]
:
t
= :
t1
+ c
t
Details 1.
C
t
= Z
t
1
j
t
+ (1 c) 1
t
1
t+1
Cc
c
t
= Z1
j
c
:
t
+jI
t
+ (1 c) 1c
I
t
1c
I
t+1
C + Cc
t
Z1
j
+ (1 c) 1 1 + Z1
j
(:
t
+ jI
t
) + (1 c) 1I
t
1I
t+1
Y = Z1
j
C = Y c1
Cc
t
Z1
j
(:
t
+ jI
t
) + (1 c) 1I
t
1I
t+1
c
t

Y
C
:
t
+
1
C
1I
t

1
C
I
t+1
Details 2.
1
t
= jZ
t
1
j1
t
+ 1 c
1c
v
t
= jZ1
j1
c
:
t
+(j1)I
t
+ 1 c
1 + 1v
t
jZ1
j1
+ 1 c + jZ1
j1
(:
t
+ (j 1) I
t
)
1
o
= 1 = jZ1
j
+ 1 c
1v
t
jZ1
j1
(:
t
+ (j 1) I
t
)
v
t
(1 o (1 c)) (:
t
(1 j) I
t
)
Details 3.
1 = 1
t
"
o

C
t
C
t+1
!
j
1
t+1
#
1 = 1
t
"
o

Cc
c
t
c
t1
C
!
j
1c
v
t+1
#
1 1
t
h
o1 + o1(j (c
t
c
t+1
) + v
t+1
)
i
1 = o1
0 1
t
[j (c
t
c
t+1
) + v
t+1
]
Details 4.
log Z
t
= (1 ) log Z + log Z
t1
+ c
t
log

Zc
:
t

= (1 ) log Z + log

Zc
:
t
1

+ c
t
:
t
= :
t1
+ c
t
Example 2: Hansens real business cycle model
The rst order conditions are:
C
t
+ 1
t
= Y
t
(1)
1
t+1
= 1
t
+ (1 c) 1
t
(2)
Y
t
= Z
t
1
j
t
.
1j
t
(3)
log Z
t
= (1 ) log

Z + log Z
t1
+ c
t
, c
t
i.i.o.N

0; o
2

(4)
= C
j
t
(1 j)
Y
t
.
t
(5)
1 = o1
t
"
C
t
C
t+1
!
j
1
t+1
#
(6)
1
t
= j
Y
t
1
t
+ 1 c (7)
The steady state for the real business cycle model above is obtained by dropping
the time subscripts and stochastic shocks in the equations above.
=

C
j
(1 j)

Y

.
1 = o

1

1 = j

Y

1
+ 1 c
Log-linearization of the necessary conditions

Cc
t
+

1i
t
=

Y j
t

1I
t+1
=

1i
t
+ (1 c)

1I
t
j
t
= :
t
+ jI
t
+ (1 j) a
t
:
t
= :
t1
+ c
t
0 = jc
t
+ j
t
a
t
0 = 1
t
[j (c
t
c
t+1
) + v
t+1
]

1v
t
= j

Y

1
(j
t
I
t
)
Details 1.
C
t
+ 1
t
= Y
t

Cc
c
t
+

1c
i
t
=

Y c
j
t

C (1 + c
t
) +

1 (1 + i
t
) =

Y (1 + j
t
)

Cc
t
+

1i
t
=

Y j
t
Details 2.
1
t+1
= 1
t
+ (1 c) 1
t

1c
I
t+1
=

1c
i
t
+ (1 c)

1c
I
t

1 (1 + I
t+1
) =

1 (1 + i
t
) + (1 c)

1 (1 + I
t
)

1I
t+1
=

1i
t
+ (1 c)

1I
t
Details 3.
Y
t
= Z
t
1
j
t
.
1j
t

Y c
j
t
=

Z

1
j

.
1j
c
:
t
+jI
t
+(1j)a
t
c
j
t
= c
:
t
+jI
t
+(1j)a
t
j
t
= :
t
+ jI
t
+ (1 j) a
t
Details 4.
log Z
t
= (1 ) log

Z + log Z
t1
+ c
t
log

Zc
:
t

= (1 ) log

Z + log

Zc
:
t
1

+ c
t
:
t
= :
t1
+ c
t
Details 5.
= C
j
t
(1 j)
Y
t
.
t
=

Cc
jc
t
(1 j)

Y

.
c
j
t
a
t
1 = c
jc
t
c
j
t
a
t
0 = jc
t
+ j
t
a
t
Details 6.
1 = o1
t
"
C
t
C
t+1
!
j
1
t+1
#
1 = o1
t
"

C

C
c
c
t
c
t+1
!
j

1c
v
t+1
#
1 = 1
t
h
c
j(c
t
c
t+1
)
c
v
t+1
i
0 = 1
t
[j (c
t
c
t+1
) + v
t+1
]
Details 7.
1
t
= j
Y
t
1
t
+ 1 c

1c
v
t
= j

Y

1
c
j
t
I
t
+ 1 c

1(1 + v
t
) = j

Y

1
(1 + j
t
I
t
) + 1 c

1v
t
= j

Y

1
(j
t
I
t
)
References
[1] Uhlig, Harald (1999), "A Toolkit for Analyzing Nonlinear Dynamic Stochastic
Models Easily," in Ramon Marimon and Andrew Scott (eds.), Computational
Methods for the Study of Dynamic Economies, Oxford University Press.