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Nonlinear Dynamical Economics

and Chaotic Motion

Second Edition


Hans-Walter Lorenz

Volkswirtschaftliches Seminar Georg-August-Universit¨at Platz der G¨ottinger Sieben 3 W-3400 G¨ottingen, Germany


To My Parents



nonlinear differential equations have interesting dynamics.

M. Hirsch (1984)

Unfortunately, many of the most important processes in nature are inherently nonlinear.

R.L. Devaney (1992)

There are no true fractals in nature. ( There are no true straight lines or circles either!)

K. Falconer (1990)

Prefaces Preface to the Second Edition Usually, the first edition of a book still contains


Prefaces Preface to the Second Edition Usually, the first edition of a book still contains a

Preface to the Second Edition

Usually, the first edition of a book still contains a multiplicity of typographic, con- ceptional, and computational errors even if one believes the opposite at the time of publication. As this book did not represent a counterexample to this rule, the current second edition offers a chance to remove at least the known shortcomings. The book has been partly re-organized. The previously rather long Chapter 4 has been split into two separate chapters dealing with discrete-time and continuous- time approaches to nonlinear economic dynamics. The short summary of basic properties of linear dynamical systems has been banned to an appendix because the line of thought in the chapter seems to have been unnecessarily interrupted by these technical details and because the book concentrates on nonlinear systems. This appendix, which mainly deals with special formal properties of dynamical sys- tems, also contains some new material on invariant subspaces and center-manifold reductions. A brief introduction into the theory of lags and operators is followed by a few remarks on the relation between the ‘true’ properties of dynamical systems and their behavior observable in numerical experiments. Additional changes in the main part of the book include a re-consideration of Popper’s determinism vs. inde- terminism discussion in the light of chaotic properties of deterministic, nonlinear systems in Chapter 1. An investigation of a simultaneous price-quantity adjustment process, a more detailed inquiry into the uniqueness property of limit cycles, and a short presentation of relaxation oscillations are included in Chapter 2. Chapter 3 now starts with an extended discussion of different structural stability concepts. While the material on chaotic dynamics in Chapters 4 and 5 still concentrates on the motion on attractors, the importance of complex transient motion is emphasized in the current edition. The literature on chaotic dynamics in economics is rapidly growing. It is there- fore difficult if not impossible to keep track of all the advances made in the last



years. As this book concentrates on methodological aspects and usually discusses only simple economic examples, not all economically relevant contributions in the literature could be presented in detail. The papers known to the author are how- ever listed in the appropriate sections. Most numerical calculations and associated plots in this edition were performed with the help of the Dynamical Software package and the Dynamics program. This is not mentioned because the responsibility for the correctness of the numer- ical results should be shifted to other sources. It should only prevent the reader interested in performing his own calculations from re-inventing the wheel and turn his attention to the existing elaborated packages. All other illustrations were pro- duced with a standard CAD program or commercial plotting routines; the manu- script was again typeset in T E X. It is a pleasure for me to thank all those friends and colleagues who commented on improving the text. Particular thanks go to C. Chiarella, P. Flaschel, D. Furth, L. Nicelli, and B. Woeckner who all provided more or less extensive error lists. G. Konigsberg¨ copy-edited several new parts of the text. The assistance of B.K.P. Horn of Y&Y in the management of diverse PostScript fonts is greatly appreciated.

G¨ottingen, February 1993

Preface to the First Edition

Hans-Walter Lorenz

The plan to publish the present book arose while I was preparing a joint work with Gunter¨ Gabisch (Gabisch, G./Lorenz, H.-W.: Business Cycle Theory. Berlin- Heidelberg-New York: Springer). It turned out that a lot of interesting material could only be sketched in a business cycle text, either because the relevance for business cycle theory was not evident or because the material required an interest in dynamical economics which laid beyond the scope of a survey text for advanced undergraduates. While much of the material enclosed in this book can be found in condensed and sometimes more or less identical form in that business cycle text, the present monograph attempts to present nonlinear dynamical economics in a broader context with economic examples from other fields than business cycle theory. It is a pleasure for me to acknowledge the critical comments, extremely detailed remarks, or suggestions by many friends and colleagues. The responses to earlier versions of the manuscript by W.A. Barnett, M. Boldrin, W.A. Brock, C. Chiarella, C. Dale, G. Feichtinger, P. Flaschel, D.K. Foley, R.M. Goodwin, D. Kelsey, M. Lines, A. Medio, L. Montrucchio, P. Read, C. Sayers, A. Schmutzler, H. Schnabl, G. Silverberg, H.-W. Sinn, J. Sterman, and R. Tscherning not only encouraged me to publish the book in its present form but helped to remove numerous errors (not only typographic ones) and conceptual misunderstandings and flaws. Particular thanks



go to G. Gabisch who initiated my interest in nonlinear dynamics and encouraged the writing of this text. A. Johnson and R. Phillips copy-edited parts of the text and helped to remove many misleading formulations and stylistic shortcomings. It seems to be unnecessary to stress that all remaining errors will debit my personal account. Large parts of the manuscript were written while I was visiting the University of Southern California. Without the inspiring environment of the Modelling Re- search Group and the extraordinary help of the staff the book would not have been completed in due time. The work was partly supported by the Deutsche Forschungsgemeinschaft. The final manuscript was typeset in PCT E X.

G¨ottingen, March 1989

Hans-Walter Lorenz

Contents Introduction 1 1. Economic Dynamics, Linearities, and the Classical Mechanistic Worldview 5 1.1.


Contents Introduction 1 1. Economic Dynamics, Linearities, and the Classical Mechanistic Worldview 5 1.1.



1. Economic Dynamics, Linearities, and the Classical Mechanistic Worldview


1.1. Some Reflections on the Origin of Economic Dynamics


1.2. The Deterministic Worldview and Deterministic Theories


1.3. The Dominance of Linear Dynamical Systems in Economics


2. Nonlinearities and Economic Dynamics


2.1. Preliminary Concepts


2.2. The Poincare-Bendixson´ Theorem


2.2.1. The Existence of Limit Cycles


2.2.2. The Kaldor Model as a Prototype Model in Nonlinear


Economic Dynamics


2.2.3. A Classical Cross-Dual Adjustment Process


2.3. The Uniqueness of Limit Cycles


2.3.1. The Lienard´ Equation and Related Tools


2.3.2. The Symmetric Case: Unique Cycles in a Modified Phillips




2.3.3. The Asymmetric Case: Unique Cycles in a Kaldor Model


2.4. Predator-Prey Models



The Dynamics of Conservative Dynamical Systems




2.4.3. Other Examples and Predator-Prey Structures in


Dissipative Systems


2.5. Relaxation Oscillations


2.6. Irreversibility and Determinism in Dynamical Systems


3. Bifurcation Theory and Economic Dynamics


3.1. Preliminaries and Different Concepts of Structural Stability


3.2. Local Bifurcations in Continuous-Time Dynamical Systems


3.2.1. Fold, Transcritical, and Pitchfork Bifurcations


3.2.2. The Hopf Bifurcation in Continuous-Time Dynamical Systems

95 The Hopf Bifurcation in Business-Cycle Theory

101 Closed Orbits in Optimal Economic Growth


3.3. Local Bifurcations in Discrete-Time Dynamical Systems


3.3.1. Fold, Transcritical, Pitchfork, and Flip Bifurcations


3.3.2. The Hopf Bifurcation in Discrete-Time Dynamical Systems


4. Chaotic Dynamics in Discrete-Time Economic Models


4.1. Chaos in One-Dimensional, Discrete-Time Dynamical Systems


4.1.1. Basic Concepts


4.1.2. Chaos in Descriptive Growth Theory


4.1.3. Chaos in Discrete-Time Models of Optimal Economic Growth


4.1.4. Other Economic Examples


4.2. Chaos in Higher-Dimensional Discrete-Time Systems


4.2.1. Some Basic Ideas


4.2.2. An Economic Example


4.3. Complex Transients in Discrete-Time Dynamical Systems


4.3.1. Complex Transient Behavior in One-Dimensional Systems


4.3.2. Horseshoes, Homoclinic Orbits, and Complicated Invariant Sets


5. Chaotic Dynamics in Continuous-Time Economic Models


5.1. Basic Ideas


5.2. The Coupling of Oscillators


5.2.1. Toroidal Motion


5.2.2. International Trade as the Coupling of Oscillators


5.3. The Forced Oscillator



Forced Oscillator Systems and Chaotic Motion





5.3.3. Keynesian Demand Policy as the Source of Chaotic Motion


5.3.4. Conclusion




Homoclinic Orbits and Spiral-Type Attractors



5.4.1. The Shil’nikov Scenario


5.4.2. Spiral-Type Chaos in a Business Cycle Model with Inventories



Numerical Tools



6.1. Spectral Analysis


6.2. Dimension, Entropy, and Lyapunov Exponents



6.2.1. Phase Space Embedding


6.2.2. Fractal Dimensions


6.2.3. Correlation Dimension


6.2.4. Lyapunov Exponents


6.2.5. Kolmogorov Entropy


6.2.6. Summary



6.3. Are Economic Time Series Chaotic?


6.4. Predictability in the Face of Chaotic Dynamics


7. Catastrophe Theory and Economic Dynamics



7.1. Basic Ideas


7.2. The Kaldor Model in the Light of Catastrophe Theory


7.3. A Catastrophe-Theoretical Approach to Stagflation


8. Concluding Remarks




A.1. Basic Properties of Linear Dynamical Systems


A.2. Center Manifolds and the Reduction of (Effective) Dimensions


A.3. A Brief Introduction to the Theory of Lags and Operators


A.4. Numerical Simulations and Chaotic Dynamics in Theoretical Economics





Name Index


Subject Index


Introduction T he history of economic science abounds in examples of the emergence and decline


Introduction T he history of economic science abounds in examples of the emergence and decline of

T he history of economic science abounds in examples of the emergence and decline of fashionable trends in economic thought. Basic and paradigmatic

attitudes toward the conceptual understanding of an economy, concentrations on specific classes of economic models which are believed to be an optimal reflection of economic reality, or the usage of formal or verbal techniques whose applications are believed to provide new insights into existing paradigms have rarely gained lasting serious attention over the decades. It is this transitoriness which allows to assign many textbooks and monographs to a certain era. In order for a discipline to be considered a serious scientific field, a standard collection of ideas, methods and concepts has to emerge over the decades which is accepted by the majority of scientists in that field and which is not easily vulnerable to the challenge of fashionable and short-lived trends. These scientific fundamentals of economics are characterized by two essential properties:

The foundation of modern economics dates back to the 18th century and has not undergone a drastic restructuring in the subsequent years. Unlike other disciplines in which the emergence of a new set of ideas has had revolution- ary effects on the development of the field (e.g., consider the changes arising in biology with evolution theory, or quantum mechanics’ revolutionary effect in physics), scientific progress in economics seems to consist mainly in refine- ments and/or modifications (as sophisticated they may be) of accepted central theories.

The formal apparatus of mainstream economics is borrowed from mathematics and the natural sciences, especially from physics. Abstracting from the tight connections between mathematical statistics and econometrics, economics has only rarely contributed to the advances of formal science and has adapted itself to existing formalisms.

Modern economic theory not only has its heritage in but also continues to em- ploy the ideas of classical and neoclassical economists of the 18th and 19th cen-



tury. Classical and neoclassical economics emerged in a scientific environment that was dominated by the grandiose inventions of classical physics and tremendous advances brought through the application of classical mechanics to engineering problems. The mechanistic weltanschauung that characterized scientific thought in many different disciplines at least until the turn of the century postulates a deter- ministic framework in which empirically observable phenomena follow strict and well-defined laws comparable to Newton’s famous basic laws of gravitation. If the involved laws are precisely known, predictions on the outcome of a process can be made with the same precision. The task of the scientist therefore remains to uncover these immanent rules. The writings of Walras, Marshall, Jevons, or Pareto are dominated by the attempt to find these immanent rules in economic activities and to formalize them in the way of classical mechanics. A major part of microeco- nomic theory and welfare economics, whose invention is usually attributed to these authors, is characterized by the attempt to explain human behavior deterministi- cally from assumed preference orderings and associated optimization procedures which resemble methods of mechanical or engineering problem solving. This ba- sic attitude toward an understanding of economic life has obviously survived until today and will probably persist as the mainstream paradigm of economic thought for years to come. This characterization of economic theory is not an attempt to classify economics as a dependance of other more advanced sciences. Due to its character as a dis- cipline which has to rely more than other practical sciences on abstract thought experiments, and in which measurement procedures depend more than in other fields on theoretical reflections, economics obviously has not experienced incen- tives strong enough to necessitate any drastic modifications of its formal apparatus and conceptual framework. Furthermore, it may be argued that advances made in several natural sciences such as biology, physics, and chemistry simply have had no relevance to economic theory. During the last two or three decades several of the natural sciences have expe- rienced increasing efforts to diverge from their immanent heritage in the mecha- nistic weltanschauung, which continues to prevail in many other disciplines. While qualitative advances made in physics like the development of quantum mechanics, relativity theory, and thermodynamics already suggested a basic failure of classical mechanics as early as around the beginning of this century, a formal phenomenon seems to initiate a divergence from the mechanistic attitude in other disciplines as well. The mathematical discovery of chaotic or irregular dynamical systems has initiated a renewed interest in nonlinear dynamics, which do not simply constitute some kind of a generalization of known linear systems, but which indeed concern the very conceptual framework of an understanding of actual phenomena. As it will be demonstrated at some length below, the mechanistic worldview can be referred to as the linear worldview, and the concept of nonlinearities can have dramatic ef- fects on the capability to predict the behavior of even simply structured dynamical models. With unusual immediacy, new results on the effects of nonlinear dynamical systems in experimental mathematics, physics, chemistry, and biology have been promptly applied to economic dynamics, though these early works were surely out-



side mainstream theorizing. Meanwhile, an impressive list of publications now ex- ists, indicating that nonlinear systems with chaotic properties are not untypical in economics. This book attempts to introduce the basic concepts of chaotic dynami- cal systems and to familiarize the reader with the existing literature. Furthermore, the aim of the book consists in activating interest in the consequences of the pres- ence of nonlinearities for economic theory’s conceptualization of reality. As was mentioned above, theories and concepts come and go in scientific life, especially in fields of applied philosophy like sociology or economics. Whether the chaos property of some dynamical systems will indeed revise the mainstream paradigm, or whether it will be shown that it is only a marginal curiosity in economic dynamics can be determined only by scientific progress. In any case, chaotic dynam- ics constitute an exciting example of how complicated some dynamical systems may be, although they may at first seem to be qualitatively identical with well-known regular systems. Naturally, this book is not an essay on the purely mathematical aspects of non- linear dynamical systems. It is designed as a survey of recent developments in dy- namical systems theory and its economic applications. It is the aim of the book to familiarize economists with the existing literature in dynamical systems theory, and not to provide a satisfactory overview from a mathematical point of view. Thus, the interested reader will be referred to the genuine mathematical literature for all proofs of the mentioned theorems and for a deeper mathematical understanding as often as possible.

The book is organized as follows: Chapter 1 attempts to demonstrate that the general attitude of dynamical economics toward reality is an inheritance from the mechanistic worldview of the 18th and 19th century. The philosophically more ed- ucated reader who is also familiar with the history of science is cordially requested to excuse the excursion into a basically distinctive field which nevertheless is en- lightening with respect to several of the topics enclosed in this book. Such a discus- sion seems to be mandatory when an attempt is made to evaluate the influence of complex dynamical systems on the determinism/indeterminism controversy dom- inating the science-theoretic literature during the first half of the 20th century. Chapter 1 also attempts to illustrate this worldview by a short survey of assump- tions and methods in standard economic dynamics which generally can be coined linear dynamics. The basic tools for analyzing nonlinear dynamical systems are in- troduced in Chapter 2. It includes topics like the Poincare-Bendixson´ theorem, the uniqueness of limit cycles, and – as an example of a conservative dynamical system – Goodwin’s predator-prey model of the class struggle, which can be trans- formed into a dissipative dynamical system under additional assumptions. Chapter

3 is devoted to a subject which is becoming more and more important in economic

dynamics, namely bifurcation theory. In addition to the renowned Hopf bifurca-

tion, economic examples of other bifurcation types like the transcritical, fold, or flip bifurcation are presented for discrete-time and continuous-time systems. Chapter

4 constitutes one of the two main chapters of this book. It contains an introduc-

tion to discrete-time, one-dimensional, chaotic dynamics and provides examples of these “strange” phenomena from several economic sub-disciplines. The chap- ter concludes with a short outline of the emergence of strange dynamics in two-



and higher-dimensional, discrete-time systems and a discussion of complex tran- sient motion. The mathematically more sophisticated higher-dimensional chaos in continuous-time models is presented in Chapter 5 which should be considered as an outline of future research. It concentrates on standard scenarios like coupled oscillator systems and forced oscillators. It also contains a discussion of spiral-type chaos which might be a very long-lasting transient phenomenon. Chapter 6 deals with the empirically most important question of establishing chaos in observed time series. Chapter 7 then presents an outline of catastrophe theory whose relevance to the advance of dynamical economics may not seem to be obvious but never- theless merits special attention. Catastrophe theory represents a particular tool to model the evolution of economies whose variables can be categorized as slow and fast variables. Catastrophe theory permits to model sudden jumps in the evolution of a variable in a completely endogenous fashion. A few concluding remarks are contained in the final Chapter 8. The book closes with an appendix that contains some material which is either mandatory for an understanding of several concepts introduced in the main text or which supplements some statements. It recalls basic elements in the theory of dynamical systems, including the dynamic properties of linear one- and two-dimensional systems in discrete and continuous time, different approaches to the modeling of lag structures, and the use of operators in express- ing these lag structures. It also contains a few warning remarks regarding the use of numerical simulation techniques in investigating nonlinear differential equations.

Chapter 1 Economic Dynamics, Linearities, and the Classical Mechanistic Worldview N onlinear economic dynamics may

Chapter 1

Economic Dynamics, Linearities, and the Classical Mechanistic Worldview

Linearities, and the Classical Mechanistic Worldview N onlinear economic dynamics may be considered just a

N onlinear economic dynamics may be considered just a collection of models with essentially nonlinear ingredients that require the use of a particular set of

(relatively new) mathematical tools. As such, nonlinear economic dynamics has a rank comparable to that of game theory, optimal control, or many other innovations in economic theory made during the last 50 years. However, nonlinear dynamical systems emerging in several fields have never been evaluated only from an exclusive formal point of view. The potential complexity and impredictability of nonlinear dynamical systems have almost immediately initiated a discussion of basic science- theoretic themes. Popular treaties of the subject occasionally talk of a scientific revolution or employ similar spectacular expressions. However, it seems as if in several examples of these inquiries the scientific environment which is supposed to encounter such a revolution is not always described with a sufficient accuracy. The following remarks do not (and cannot, actually) attempt to provide a completely satisfactory account of the origin of economic theorizing and the extend to which nonlinear dynamics might contribute to a change in the attitude toward economic dynamic processes. The sole purpose of the following notes consists in encouraging further reflections on the role of dynamical systems in the modeling of dynamic economic processes. The first section recalls a few original quotations from the ancestors of mod- ern economic theory (with an emphasis on the dynamic aspects of economic the- ory). The overall imitation of physics’ methodology in the writings of 19th century economists is demonstrated with several quotations from those authors who obvi- ously felt obliged to justify their procedures. As the mechanistic worldview domi-


Chapter 1

nated the basic attitude toward life in those days, a more careful description and evaluation of this worldview and the challenge it encountered at the beginning of this century is presented in the second section. The chapter closes with a few reflec- tions on the resistance observable in the economics profession to a concentration on nonlinear phenomena in economic dynamics.

1.1. Some Reflections on the Origin of Economic Dynamics

Economics in its modern form was introduced as a serious and distinguished sci- ence during the second half of the 18th century. Unlike earlier attempts to un- derstand economic phenomena (usually in the context of political economy like, e.g., mercantilism) the writings of Adam Smith or David Ricardo constitute the first successful approaches toward an abstract explanation of human economic be- havior. One reason why economics emerged as a science in that particular period surely has to do with the expansion of capitalism in the advanced societies of that day and the increasing complexity of trade. It is not surprising that economics as a modern science originated in Great Britain, which not only is considered the homeland of capitalistic production but which also had been the dominant factor in international trade for more than 150 years. Much of the early economists’ inter- est was therefore devoted to the major economic subjects of the day like the effects of international trade on the prosperity of the domestic economy. 1 It cannot have been the political and economic environment of the late 18th and early 19th century alone which stimulated an interest in focusing research on eco- nomic problems and which initiated the development of economics into its present day form (although the development of this science is inherently connected to the social environment). There had been other events with similar importance to the economic development of a political unit which had not initiated a comparable in- terest in economic affairs. Economic considerations of, e.g., the mercantilistic policy in 17th century France and other European countries were intimately connected through absolutistic ideals of improving the welfare of the nation, occasionally in- carnated in the personal welfare of its emperor. Thus, the “economist” of the day was incorporated into the national administration and was given no incentive to dwell upon his own independent individualistic ideas and concepts. This mercantilistic attitude in absolutistic nations came in conflict with the emer- gence, popularization, and final success of the enlightenment movement in the 18th century. The enlightenment’s concentration on individualism, which laid the foun- dations for capitalistic (and political) development in the advanced economies like Britain, arose in an intellectual atmosphere dominated by the writings of Leibniz, Voltaire, Kant, Newton and other enlightenment philosophers. Several of these authors who profoundly reformed modern western thought (some of whom were

1 In many cases, inquiries into international trade represent the renowned work of clas- sical writers; for example, most economists will probably remember David Ricardo mainly for his investigations of comparative cost advantages rather than for his labor value theory.

1.1. On the Origin of Economic Dynamics


probably the last generally educated and interested scholars in modern history) were not only concerned with philosophical questions of Being but also strongly inter- ested in the natural sciences. The enlightenment period of 18th century Europe has gained favorable retrospective interest not exclusively due to its concentration on human affairs, but also from its successes in the investigation of natural phe- nomena. Whereas scientific pioneers like Galileo, Kepler, or Descartes had to recant their ideas or seek refuge, the 18th century was characterized by an openness to enlightening ideas, probably because of the stringency of the results of several authors and experimentalists in the natural sciences. The effects that the writing of Voltaire or Newton had on the academic community of their day can probably not be overestimated. It was in this era of close ties of enlightenment philosophy to advances in the natural sciences and political and economic development in which the writings of the now classical economists were published. As educated academics, A. Smith or later D. Ricardo and J.S. Mill must have been familiar with at least the general ideas of enlightenment philosophy and the advances made in physics. Their work must have been influenced, directly or indirectly, both by the political and social implications of that philosophy, and also through its basic approach toward an understanding of natural phenomena. Abstracting from several spectacular inventions, a major reason for the strong impact of the natural sciences on daily life and the academic community consisted in the fact that physics occurred as being a precise science in the sense that an experiment with a careful description of the environment leads to unambiguous results. If the environment does not change, an experiment’s outcome will remain constant as well. The hypothetical possibility of repeating an experiment infinitely often with the same outcome laid the foundation for determining the physical con- stants and for deriving basic laws of motion underlying the experiment. Once the laws of motion and the physical constants are known, it is possible to predict the out- come not only of the particular experiment from which they are derived, but also of related and qualitatively similar events in general surroundings. If science would not have been characterized by this ability to precisely predicting the outcome of physical processes, the major inventions made in the 18th and 19th century would probably not have been possible and physics may not have had any impact on other sciences at all. At a relatively early stage in the development of classical mechanics the view was expressed that the basic physical laws of motion constitute the essential dy- namic principles of the entire cosmos. In reflecting on the predictability question, Laplace wrote the following, often quoted statement in 1776:

The present state of the system of nature is evidently a consequence of what it was in the preceding moment, and if we conceive of an intelligence which at a given instant comprehends all the relations of the entities of this universe, it could state the respective positions, motions, and general affects of all these entities at any time in the past or future. Physical astronomy, the branch of knowledge which does the greatest honor to the human mind, gives us an idea, albeit imperfect, of what such an intelligence would be. The simplicity of the law by which the celestial bodies move, and the relations of their masses and distances, permit analysis to follow their motion up to a certain point; and in order to


Chapter 1

determine the state of the system of these great bodies in past or future centuries, it suffices for the mathematician that their position and their velocity be given by observation for any moment in time. Man owes that advantage to the power of the instruments he employs, and to the small number of relations that it embraces in its calculations. But ignorance of the different causes involved in the production of events, as well as their complexity, taken together with the imperfection of analysis, prevents our reaching the same certainty about the vast majority of phenomena. Thus there are things that are uncertain for us, things more or less probable, and we seek to compensate for the impossibility of knowing them by determining their different degrees of likelihood. So it is that we owe to the weakness of the human mind one of the most delicate and ingenious of mathematical theories, the science of chance or probability. 2

In principle everything therefore follows deterministic rules. Either the human incapability or technical restrictions prevent a complete comprehension of actual empirical phenomena. Laplace’s demon represents a universal scientist who is not limited by these technical and mental restrictions. It should be noted that this demon is not a divine being but that in principle every human being can attain to its capabilities. While a more detailed discussion of this attitude toward reality can be found below, this attitude should tentatively be denoted as the mechanistic, deterministic worldview. The tremendous success of this approach in explaining natural phenomena in mechanical, celestial, optical, etc. problems constituted a stimulant for the newly emerging branches of philosophical thinking in the 19th century. The determinis- tic worldview and the attitude toward the predictability problem began to become influential in the social sciences as well. While, as was pointed out by Crutch- field et al. (1986), a direct application of Laplace’s statement on predictions to human affairs implies that no free human will exists at all, the philosophical devel- opment incorporated this idea in a somewhat hidden manner. Hegel’s philosophy of history, and later Marx’s deterministic laws of economic and social development, indicated that in the course of the 19th century a tendency to compare the overall effects of human action with qualitatively the same kind of laws of motion, which had been applied to the natural sciences, emerged. The philosophical attitude of the early 19th century was dominated by an entity called weltgeist which constituted a surrogate for the legislation of the medieval universe: the determinism of classical physics, idealistic philosophy, or Marxian sociology began to replace the theological notion of a divine predestination of human life. If no truly free human will exists, it is possible to generalize individual human behavior and to abstract from singular phenomena based in the isolated minds of human beings. It is therefore possible to describe the actions of an individual according to typical patterns of behavior, provided he/she is not characterized by pathological attitudes toward reality. This idea that individuals behave to some de- gree according to typical patterns constitutes the essential prerequisite in establish- ing economics as a scientific branch. Typical patterns of economic behavior were introduced to economics by means of a rather simple approach; for example, if the rationale of a typical agent consists in maximizing a predetermined utility function

2 Quoted from Crutchfield et al. (1986).

1.1. On the Origin of Economic Dynamics


which lacks psychological or sociological considerations, the fundamental problem of explaining individual economic behavior is replaced by the assumption of indi- viduals acting rationally, i.e., maximizing utility, in a given environment. What has later been termed the axiomatic foundation of economics is basically nothing more than the hypothetical determination of fundamental behavioral laws from which most results in economics follow tautologically, though usually not obviously. This determination of fundamental behavioral patterns by hypotheses circum- vented the basic problem of studying individuals acting within an economy and cleared path toward a precise economic science, which resembles a strong similar- ity with classical physics as the most advanced science in the 18th and 19th centuries. While this similarity of emerging economics to physics was probably only vaguely evident to classical writers until the mid-19th century, the beginning of the mathe- matical formalization of economics in the second half of that century let economics appear either as a transformation of physical methods to problems of human life or as an application of mathematics, with a status equal to physics. The predecessors of modern mathematical economics, e.g., L. Walras, W.S. Jevons, and V. Pareto, were not only aware of the similarity, but propagated the use of the methods of physics in economics. 3 It seems as if the representatives of the Lausanne School considered physics as a scientific idol among applied sciences, which is supported by the fact that some of them were not educated economists, but had their aca- demic origin in mathematics or in the engineering sciences. 4 Walras repeatedly mentioned his aim to structure economics in a manner similar to physics 5 and claimed that the classical and pre-classical writers were already implicitly guided by the same idea:

theory of price determination of economic goods or the pure economic theory appears

Isn’t it true

that all those English economists from Ricardo to J.S. Mill have treated pure economics

like real mathematics? Their sole error

of mathematics by means of common everyday-language and that they could handle it

been concerned

with the development of pure economics as a physico-mathematical science for several

therefore only with difficulties and without complete

was that they attempted to develop this branch

(to have) the character of a real, namely physico-mathematical




years. 6

3 Standard references for questions concerning the relation between physics and eco- nomics include, for example, Georgescu-Roegen (1971) and Mirowski (1988).

4 V. Pareto had a doctoral degree in railroad engineering and, like his predecessor L. Walras in Lausanne, had not published much on economic theory when he got his first academic appointment. However, Debreu’s (1986) statement that Walras and Pareto had published only novels and other belletristic literature before their first appoint- ments is misleading.

5 In a rather enthusiastic fashion, Walras’ German translator, L.v. Winterfeld, compared

Walras appears to me as the Kepler of economics,

who incontestably and for all time proves the laws which once were suspected and expressed by (the)

Walras with the astronomer J. Kepler: “

German scholar

H.H. Gossen in the style of a Kopernikus.” Own translation (H.-W.L.)

from the German preface to Walras (1876)

6 Walras (1874), p. 7. Own translation (H.-W.L.) from Walras (1876).


Chapter 1

In an even more pointed style, Jevons (1871) associated the survival of economics with its use of mathematics:

It is clear that Economics, if it is to be a science at all, must be a mathematical science. 7

I. Fisher wrote in his 1891 doctoral thesis:

Scarcely a writer on economics omits to make some comparison between economics and mechanics. One speaks of a “rough correspondence” between the play of “economic forces”

In fact the economist borrows much of his vocabulary

from mechanics. Instances are: Equilibrium, stability, elasticity, expansion, inflation, contraction, flow, efflux, force, pressure, resistance, reaction, distribution (price), levels,

and mechanical

movement, friction. 8

Walras, like Pareto, Cournot, and other early mathematical economists, at- tempted to develop a logically consistent edifice of thought. They clearly saw the restrictions of abstract thought experiments and therefore insisted on a separation of the categories of pure and applied economics. It is certainly inappropriate to claim that they considered real economies as systems which behave completely anal- ogously to a physical system. Concerning the modeling of economic systems in pure economics, however, physics did not only serve as a paragon of the useful exploita- tion of mathematics as an instrument in developing a logically consistent theory. In addition to the adoption of its formal methodological approach, physics provided the basic qualitative foundations of scientific economics. As was mentioned above, the deterministic, mechanistic worldview of physics in the 19th century dominated not only the internal scientific community but also had a widespread influence on other disciplines and also on the public weltanschauung. Much in the spirit of Laplace’s statement, economic systems were therefore interpreted as systems whose development could be calculated with preciseness if an appropriate degree of in- formation about the structure, the parameters, and the initial values of the systems were provided to the economist. This favoring of a methodological approach derived from physics is most clearly evident in a statement made by J.S. Mill, originally published in 1843, which shows that physics was not only favored by mathematically educated scholars like Walras or Pareto:

The phenomena with which this science is conversant being the thoughts, feelings, and actions of human beings, it would have attained the ideal perfection of a science if it enabled us to foretell how an individual would think, feel, or act, throughout life, with the same certainty with which astronomy enables us to predict the places and the occultation of the heavenly bodies. It need scarcely be stated that nothing approaching to this can


acting, do not depend on causes;

(T)he impressions and actions of human beings are

This is not, however, because every person’s modes of thinking, feeling, and

7 Jevons (1871), p. 3.

8 Cf. Fisher (1961), p. 25. Fisher himself attempted to develop a consistent value theory analogous to the theory of equilibrating water cisterns. He even constructed mechanical devices to illustrate his ideas.

1.1. On the Origin of Economic Dynamics


the joint result of (the) circumstances and of the characters of the individuals: and

, that

the agencies which determine human character are so numerous and diversified,

in the aggregate they are never in any two cases exactly

as many of those effects

which will almost always be

this is sufficient. 9

Inasmuch, however,

are determined,

it is evidently possible to make predictions

For the purposes of political and social science

It must be stressed, however, that the orientation of economics to the paradigms and methods of physics was already being questioned by economists who are nowadays categorized as the founders of deterministic (neo-) classical economics. 10 A. Mar- shall repeatedly drew attention to the idea that the appropriate fellow-discipline in the natural sciences which is most closely analogous to economics (as far as the subject of the field is concerned) is not physics but biology

the forces of which economics has to take account are more numerous, less definite,

less well known, and more diverse in character than those of

like biology, deals with a matter, of which the inner nature and constitution, as well

as the outer form, are constantly

strictly economic relations as those of business credit and banking, of trade unionism or co-

operation, we see that modes of working, that have been generally successful at some times and places, have uniformly failed at others. The difference may sometimes be explained simply as the result of variations in general enlightment, or of moral strength of character and habits of mutual trust. But often the explanation is more difficult. 11

If however we look at the history of such


Other authors searched for analogies with even other disciplines. Menger (1871) described his marginal utility concept “just as a difficult as yet untreated topic in psychology”. 12 Edgeworth (1881) called one of his master pieces “Mathematical Psy- chics”. It should be noted that these influences have not always been uni-directional:

the American psychological school adopted several ideas developed by Edgeworth. This construction of analogies between different sciences is usually called reduc- tionism in the science-theoretic literature. A scientific procedure is called reduction- istic if basic properties of a particular science’s study object are derived with the help of another science’s methodology and existing knowledge. When the statements of classical mechanics are indeed generally valid and if the deterministic worldview prevails, all scientific questions (in all fields) can consequently be treated with the help of the principles of physics. The standard, hierarchical reduction scheme in Table 1.1 which covers only a few interesting sciences is due to Medawar (1969) and

9 Mill (1973), pp. 847f., emphases in original. For the purpose of this little excursion into the history of science, Mill’s Logic can be considered the gap filling contribution between enlightenment philosophy, the methodology of the subsequent development of classical mechanics, and the methodology of economics and other social sciences.

10 Compare, e.g., Blaug (1978), p. 311, for the resistance to the emerging mathematical methods among well-reputed economists.

11 Marshall (1938), p. 772. Compare also Hodgson (1993) for a recent discussion of Marshall’s attitude toward biology.

12 Menger (1871), p. 94. Own translation (H.-W.L.).


Chapter 1

describes economics as a science which can be treated with biological principles. Biology itself is nothing else than a particular investigation of the working of basic chemical processes and, finally, physics describes the essential relations inherent in all observable phenomena.

A consequent application of this re-

duction scheme implies that the fields 2.-4. do not possess a real right to ex- ist as self-sustained sciences. If the con- stituting properties of a particular field can be described with the help of the methods and qualitative results of sci- ences situated in front of it, this field ob- viously does not possess those essential properties which could justify the dif- ferentiation as a separate science. The subject of reducible sciences appears as a specific application of the more gen- eral science in the scheme.

It might be suspected that the scientific reductionism was a historic phenome-

non that does not have a serious recent relevance. However, modern fields in the natural sciences like molecular biology reduce biological phenomena to chemical processes. Parts of evolutionary economics emphasize the biological principles of natural selection. 13 Finally, if the above mentioned discussion of the analogy be- tween the methodology of physics and economics appears just as a historic anecdote dating back to the last century the reader should compare Jojima (1985), Sebba (1953), or Thoben (1982) for an indication that the discussion is still going on (although this happens to take place somewhere at the outskirts of mainstream economics). Aside from this general recalling of reductionism as a procedure which is not too uncommon in the history of sciences and the few critical remarks that em- phasize analogies to other sciences than physics, Marshall, Menger, Jevons and most contemporaries nevertheless considered physics as the science which can serve as a paragon in respect to both the formal apparatus and the involved worldview in economic theorizing. Marshall’s general understanding of economics as a sub-discipline of natural philosophy and especially Walras’ concentration on the mathematical methodology have, in the scientific spirit of the last century, survived in mainstream economics until today. A majority of the topics covered by modern mathematical economics, especially in the general equilibrium framework, still deal with the same problems which interested classical economists like Walras, and it is this tradition inherited from the classical writers, which still allows one to assign the term “mechanistic worldview” to most economic approaches. Though this term is often quoted (mainly among critics of neoclassical economics) it nevertheless seems useful to investigate it more carefully. It will turn out that the common association

4. Economics

3. Biology

2. Chemistry

1. Physics

The Reduction Scheme in the Deterministic Worldview Source: Medawar (1969), pp. 15ff. Table 1.1

13 Compare also the standard discussion on reductionism in modern evolutionary biology itself. Cf. Dawkins (1987).

1.2. The Deterministic Worldview and Deterministic Theories


of this term with “determinism” in a most general sense cannot cover all facettes of the relevant, basic science-theoretic discussion. Without a more elaborated discus- sion of the relevant terms it seems to be impossible to evaluate the above mentioned statements that nonlinear dynamics tackles basic science-theoretic foundations of several disciplines.

1.2. The Deterministic Worldview and Deterministic Theories

In the light of the discussion in the previous section classical physics has played a prominent role in the emergence of the deterministic worldview. It is thus useful to recall the standard paradigm governing research in physics and most other natural sciences roughly until the end of the 19th century. 14

A physical phenomenon can be isolated from the environment. The study of the isolated (or de-coupled) physical systems and processes (for example in labora- tory experiments) can provide a precise understanding of the problem’s nature. The abstraction from noisy surroundings during this isolation may reveal the pure properties of a physical system.

Laboratory experiments can be repeated as often as desired. In these experi- ments constants can be derived which permit the formulation of laws of nature. These laws have an arithmomorphic character, i.e., they can be formulated in math- ematical terms and follow the standard mathematical rules. 15

The interaction of different isolated phenomena occurs in an additive manner, i.e., it is dominated by the principle of superposition. This implies that “the most gen- eral motion of a complicated system of particles is nothing more than a linear superposition of the motions of the constituent elements.” 16

If it is not possible to properly analyze all constituent elements of a given system, perturbing an existing linear model (which was constructed by superposition) can always explain the originally disregarded phenomena.

The paradigmatic attitude toward the study object expressed by the above list can be called the mechanistic worldview. Georgescu-Roegen (1971) summarizes this paradigm as follows:

a science is mechanistic if, first, it assumes only a finite number of qualitatively different elements, and if, second, it assumes a finite number of fundamental laws relating these elements to everything else in the same phenomenal domain. 17

Other terms can be used in characterizations of the paradigm. West (1985) iden- tifies the procedure expressed in the aforementioned list with a linear science:

14 Cf. West (1985), for a longer discussion.

15 Cf. Georgescu-Roegen (1971), p. 44, for an intensive discussion of the term.

16 Cf. West (1985), p. 70 .

17 Georgescu-Roegen (1971), p. 115.


Chapter 1

Physical reality could therefore be segmented: understood piece-wise and superposed back

Thus the philosophy was to

solve the linear problem first, then treat the remaining interaction (that was not treated quite properly) as a perturbation on the linear solution, assuming throughout that the

perturbation is not going to modify things significantly. 18

again to form a new representation of the original

It can in fact be shown that the majority of the most important theoretical discov- eries in classical physics followed this procedure. The investigations of sound as a wave phenomenon by Newton, Lagrange, and Laplace, or the findings on the vibration of strings by D. Bernoulli, Lagrange, and Euler are good examples how a complex phenomenon was separated into single elements which could be analyzed by means of simple techniques. 19 Classical economic writers incorporated this procedure in analyses of economic behavior. The following items appear as the most important properties of (neo-) classical economic analyses in the present context:

Individual behavior (or the behavior of individuals in an economic unit like a market) can be isolated from the economy as a whole.

Human behavior can be described in terms of general behavioral patterns, such that the analysis may indeed abstract from individual behavior.

Individual human behavior is comparable to the physical laws of motion, it is both regular and predictable. If the environment is known with precision, indi- vidual behavior within that environment is deterministic.

The behavior of a society consists of the additive actions of its members. The principle of superposition implies that the behavior of a society as a whole does not differ from the sum of the individual actions.

This economic worldview implies that an economy can be described by linear (or quasi-linear) functional relations. It abstracts from the presence of unpredictable (irrational) individual behavior, from restrictions in the environment, from non- additive interdependence between different individuals and/or actions, etc. A lot of progress has been made since the days of the classical (neoclassical) writers with respect to the above mentioned and other limitations, but the dynamic aspects of the theory are still more or less characterized by the same concentration on linear relations as was the case during the first formalizations of the development of an economy over time. At the turn of the century physics began to experience a basic revolution (the use of the term seems to be undisputable for a description of that event). Quantum mechanics and later relativity theory constituted a challenge to the dominating classical mechanistic paradigm. It was demonstrated in the subsequent years that classical mechanics was only an approximation to those phenomena that happen

18 West (1985), p. 70

19 Cf. West (1985), pp. 68 ff., for a short survey. It is remarkable that Euler personally rejected the superposition principle though he actually proved its correctness in the case of the wave equation.

1.2. The Deterministic Worldview and Deterministic Theories


to take place on a scale immediately observable by human beings. Heisenberg’s quantum mechanics with the unsharpness relation and Schrodinger’s¨ equations have demonstrated that the best that can be done in many cases is to provide a stochastic description of possible phenomena. 20 The conflict between this newly emerging paradigm and Laplace’s determinism is obvious. The basic indeterminism (in the classical sense) of phenomena on the molec- ular as well as the cosmic layer initiated a long discussion in the science-theoretic literature on the relevance of the mechanistic worldview. When phenomena are essentially indeterministic it can obviously be doubted whether the formulation of deterministic, arithmomorphic laws of nature makes any sense at all. Stochastic descriptions of reality may be considered the only meaningful approach to explana- tions of physical phenomena. Alternatively, it might be supposed that deterministic laws of nature represent good approximations of reality on that scale immediately observable by human beings. It turns out that a rough distinction between deter- minism and indeterminism is not extremely well-suited for a discussion of the rel- evance of the deterministic worldview. Popper (1982) thus distinguished between scientific determinism and a deterministic theory. 21

The doctrine of ‘scientific’ determinism is the doctrine that the state of any closed physical system at any given future instant of time can be predicted, even from within the system, with any specified degree of precision, by deducing the prediction from theories, in conjunc- tion with initial conditions whose required degree of precision can always be calculated (in accordance with the principle of accountability) if the prediction task is given. 22

The scientific determinism can therefore be interpreted as a deterministic worldview which is exclusively based on empirical knowledge collected in the form of scientific activity. In contrast, Popper defines a deterministic theory (a “prima facie deterministic theory”) as follows:


physical theory is prima facie deterministic if and only if it allows us to deduce, from


mathematical exact description of the initial state of a closed physical system which


described in terms of the theory, the description, with any stipulated finite degree of

precision, of the state of the system at any given future instant of time. 23

The distinction of the two terms is useful for two reasons. The scientific deter- minism (i.e., the mechanistic worldview in Georgescu-Roegen’s term and Laplace’s sense) does not necessarily result in the construction of deterministic theories. It

20 Even the motion in (usually) simple devices like mechanical clocks (which occasionally appear as the incarnation of the mechanical approach) might be called indeterministic when the molecular layer is considered instead.

21 The reference originally constituted a postscript to the English translation of his Logic of Scientific Discovery, first published in German in 1934, which has had a major impact on the methodology of all social sciences, including economics.

22 Popper (1982), p. 36. The principle of accountability states that it is possible to determine the required precision of initial points for a desired precision in the predictions.

23 Popper (1982), p. 31.


Chapter 1

will become obvious from the material presented in subsequent chapters that dy- namical systems which reflect the deterministic worldview, i.e., equations without any stochastic elements, might not constitute deterministic theories. An example

Scientific Determinism

Deterministic Theory

For each phenomenon:

For each mathematically describable phenomenon:

initial values with infinite precision

initial values with finite precision

prediction with infinite precision

prediction with given mathematical precision

Popper’s Distinction between the Deterministic Worldview and a Deterministic Theory Table 1.2

is the famous three-body problem: although the basic laws of motion are precisely given, the motion of three or more bodies with special mass constellations in space cannot be calculated with an arbitrary precision. Thus, Newtonian mechanics can- not be called a deterministic theory in the sense of Popper’s definition while it certainly reflects a deterministic worldview. 24 Without a distinction between the two terms, Newtonian mechanics should be called indeterministic; obviously, this would contradict the self-assessment of classical authors. Alternatively, even if the deterministic worldview prevails theoretical investigations of particular phenomena do not necessarily have to make use of deterministic theories. The influence of hu- man incapabilities have already become obvious from Laplace’s statement; only his demon is able to comprehend the actually infinite numbers of freedom. Thus, stochastic descriptions of reality may constitute sufficiently accurate approaches to physical phenomena. A second justification for the distinction can be seen in the idea that an inde- terministic worldview is not necessarily irreconcilable with the use of deterministic theories. First, an indeterministic worldview does not exclude the possibility that de- terministic niches exist which can be treated with the help of deterministic theories. Second, a deterministic theory can serve as an approximation of those phenomena which actually should be considered indeterministic. The success of Newtonian mechanics in calculating the motion of known celestial bodies is not diminished by the fact that on the molecular layer the motion is indeterminate. This seems to be particularly relevant for economics when economic models are considered thought experiments instead of precise pictures as close to reality as possible. Popper’s (1982) distinction between scientific determinism and a deterministic theory is useful when classical mechanics and all reduced sciences are considered the standard references for deterministic theories. Popper’s main contribution

1.2. The Deterministic Worldview and Deterministic Theories


in this context probably consists in his provision of incentives to concentrate on stochastic approaches in the social sciences. It does not seem to be quite clear what kind of appearance such stochastic descriptions of economic phenomena should have. However, it seems as if descriptions of, e.g., consumer behavior en- tirely in terms of well-defined preferences and deterministic environments without any stochastic influences contradict Popper’s anticipation of an indeterministic ap- proach to economic phenomena. The critique of the deterministic worldview in economics refers to those parts of mainstream economics whose scientific origins date back to the late 19th century. Indeed, while neoclassical economists were still arguing in terms of mainstream classical mechanics, a new way of thinking eventually emerged in the natural sci- ences which involved a drastically different attitude toward reality. Around the turn of the century, advances made in the natural sciences and mathematics raised an- other doubt to the validity of the mechanistic worldview. While the development of relativity theory or quantum mechanics with its unsharpness relation constituted a challenge to the deterministic worldview, the discovery of mathematical properties of several dynamical systems represented a challenge to the deterministic theory itself. It was shown that problems can emerge in predicting the evolution of dynamical systems which are completely deterministic in the sense that no stochastic elements are involved in the definition of the system. It should be noted that the relevance of new developments in mathematics and physics either went unrecognized by the majority in the physics profession or was considered to be only marginally signifi- cant to mainstream science. Thus, with mainstream science still elaborating on the classical mechanistic paradigm, classical economists should not be discredited for their attempts to adapt the methodology of emerging formal economic theory to well-accepted paradigms. Despite the fact that physics was still dominated by the classical paradigm at the turn of the century, this does not mean that the public was not open to new ideas. In fact, mathematicians like H. Poincar´e had attained a reputation over the decades which initiated an uncountable number of honorary lectures, not only for the mathematical community, but also for a broader public audience. For example, as early as 1908 Poincar´e stated in front of a general audience:

A very small cause which escapes our notice determines a considerable effect that we cannot

fail to see, and then we say that the effect is due to chance. If we knew exactly the laws of nature and the situation of the universe at the initial moment, we could predict exactly

the situation of that same universe at a succeeding moment. But even if it were the case that the natural laws had no longer any secret for us, we could still only know the initial situation approximately. If that enabled us to predict the succeeding situation with the same approximation, that is all we require, and we should say that the phenomenon had been predicted, that it is governed by laws. But it is not always so; it may happen that small differences in the initial conditions produce very great ones in the final phenomenon.

A small error in the former will produce an enormous error in the latter. Prediction becomes

impossible, and we have the fortuitous phenomenon. 25

25 Poincar´e (1952), p. 76. Originally published in Poincar´e (1908), p. 68. I am grateful to D. Farmer for providing this reference to me.


Chapter 1

The very essence of Poincar´e’s statement was not immediately realized in the math- ematics community, though his work not only initiated research in several dynamic phenomena but even still constitutes a challenge to recent mathematicians. Fatou (1919) and Julia (1918) made important observations about the behavior of iter- ated complex maps, but it took nearly fifty years before some of the basic results of Poincar´e’s work were exploited in a pioneering, but generally unnoticed work of E.N. Lorenz (1963). His inspection of a dynamical system in the context of a me- teorological phenomenon impressively demonstrated the conceptual impossibility of precisely predicting a dynamical system’s future development without an abso- lutely precise knowledge of the system parameters and the initial values of the state variables. It was left to the currently renowned work by Ruelle/Takens (1971) and Li/Yorke (1975) to encourage a wide interest in nonlinear dynamics, which sometimes even appears to be a fashionable scientific trend. 26 An immediate consequence of the results obtained in studying nonlinear dy- namical systems consists in the need for a revision of Popper’s distinction between scientific determinism and deterministic theories. Popper’s concept of a determin- istic theory is based on the mathematical properties of basically linear dynamical systems. When nonlinear dynamical systems do not possess the predictability prop- erty known from established linear deterministic systems, deterministic theories (i.e., arithmomorphic theories without any stochastic components) have to be dis- tinguished according to their possible output. Deterministic theories can behave





For each

For linear and quasi-linear systems

For chaotic non- linear systems


initial values with infinite precision

initial values with finite precision

initial values with finite precision

prediction with infinite precision

prediction with given mathe- tical precision

prediction only for short time intervals

A Revision of Popper’s Distinction in the Light of Nonlinear Dynamical Systems Table 1.3

in the way described in the Popperian scheme. When their behavior does not es- sentially differ from the behavior of linear systems they will occasionally be called

26 Of course, this does not mean that in the course of the century there was no mathemat- ical progress in the theory of nonlinear dynamical systems. Indeed, relaxation oscilla- tions, for example, were intensively discussed in the 1920s. The work of Cartwright, Levinson, and Littlewood in the late 1940s actually laid the foundations for the recent analysis of chaotic dynamical systems.

1.3. The Dominance of Linear Dynamical Economics


quasi-linear dynamical systems. However, it cannot be excluded that determinis- tic theories behave in an indeterministic fashion: although the functional form of the systems is completely deterministic (i.e., without any stochastic components), the finite precision in the initial values is responsible for the fact that prediction over more than a very short time interval is impossible. These complex nonlinear dynamical systems thus require a revision of Popper’s scheme (cf. Table 1.3). The theoretical and empirical research in several disciplines, mainly in the nat- ural sciences, has concentrated on the investigation of nonlinear systems during the last two decades. While nonlinear approaches have occasionally been enthusi- astically adopted in some disciplines, economics (at least mainstream economics) seems to be characterized by a general hesitancy in exploiting the (mathematically) new ideas. This may be explained by the fact that linear dynamical systems are the appropriate environment for those economic ideas whose origin dates back to the writings of the 19th century classical economists. On the other hand, nonlinearities have been investigated for a long time in the minds of those economists who have developed a more critical attitude toward the functioning of a market economy. For the reader who is interested in recent developments in the theory of nonlinear dynamical economics, it will probably be surprising which topics had been selected and solved by economic writers like R. Goodwin many years before the scientific community became aware of the impor- tance of those nonlinearities. 27 It is noteworthy, however, that the impetus for the study of nonlinear dynamical systems originated once again in the natural sciences, this time with the sometimes spectacular advances made in the analysis of practical physical or biological phenomena. The following section attempts to explain why mainstream economics still con- centrates on linear models though the foundations of nonlinear economics were laid more than forty years ago.

1.3. The Dominance of Linear Dynamical Systems in Economics

A continuous-time dynamical system is called a linear system when it can be written in the form

(t) = Ax(t) + c,

x, c R n ,

t R,


with x(t) as the n-dimensional vector of state variables at the point in time, t, (t) = dx(t)/dt as the vector of time derivatives of the state variables, A as an n × n matrix of constant coefficients, and c as an n-dimensional column vector of constants. Analogously, a discrete-time dynamical system is called a linear system when it can be written in the form

x t+1 = Ax t + c,

x, c R n ,

t Z,


27 Cf. Harcourt (1984) or Velupillai/Ricci (1988) for honory lectures on Goodwin’s work.


Chapter 1

with x t as the vector of state variables in the discrete period t, and A and c defined as above. The solution of these dynamical systems for low values of n and a brief survey of a few stability criteria are contained in the Appendix A.1. The basic dynamic properties of these systems relevant for this section are the following:

Abstracting from a few exceptional examples, linear dynamical systems possess only single fixed points (equilibria). It follows that global and local analyses of the dynamic behavior coincide.

The fixed points of linear dynamical systems belong to one of the following categories: 1) stable/unstable nodes (monotonic convergence/divergence to/ from the fixed point), 2) stable/unstable foci (monotonic oscillations toward/ away from the fixed point, 3) centers, or 4) saddle points.

Center dynamics occur only for particular, numerically precise parameter constella- tions and usually become relevant only in descriptions of limit cases. Unstable nodes and foci imply the eventual motion of the state variables toward infinity. Thus, if an economist’s task is to model the bounded motion of an economy with the help of linear dynamical system, stable nodes and foci represent the appropriate types of fixed points. Several economic applications (including perfect foresight models, for example) concentrate on saddle points because the motion along the stable manifold (cf. the horizontal dashed lines in Figure A.1.f) represents the unique path toward the fixed point. In the face of the various types of dynamic behavior outlined in the rest of this book linear dynamical systems are thus able to describe only a small number of dy- namic phenomena. As linear systems dominate dynamical economics, the question arises what the reasons for this concentration on a limited set of hypothetically pos- sible dynamic phenomena are. Basically, two possible answers to this fundamental question can be distinguished. 28

i) Compared with some branches of the natural sciences, economics has lagged behind in the technical as well as the methodological aspects of scientific work.

ii) Economics is characterized by a paradigmatically motivated concentration on fixed points (equilibria), to the point that other dynamic phenomena than the stability of these fixed points are ignored though they are at least known to exist in the formal mathematical literature.

In the following, both complexes will shortly be discussed in separate sub-sections though they are actually immanently identical.

ad i)

West (1985) distinguishes five stages of scientific progress: 29

Stage 1:

Verbal description of the subject and the immanent logic of the problem.

28 Of course, other pragmatic reasons cannot be excluded. Compare, for example, the enlightening introduction in Boldrin/Woodford (1990).

29 Cf. West (1985), pp. 3-10.

1.3. The Dominance of Linear Dynamical Economics


Stage 2:

Formal identification of the problem and quantification of the mathe-

Stage 3:

matical relations. Consideration of the dynamic aspects of the mathematical model in the form of linear dynamical systems.

Stage 4: Re-consideration of the basic scientific principles and testing whether models in stage 3 can represent all mentally possible phenomena. Estab- lishment of the need to include nonlinear aspects in dynamical models.

Development of complete nonlinear models, which are indeed able to explain the phenomena outlined in the general reflections in stage 1.

It is possible to assign distinguished economists to the different stages of scientific progress according to this rough classification: the classical writers like Smith, Ricardo, Malthus, etc. dominate the first stage. Stage 2 is occupied by neoclassical economists like Marshall, Walras, Pareto and others, who also bridged the gap to the third stage of scientific progress. The mathematically sophisticated literature on the existence of equilibria and its stability in a general equilibrium framework, dominated by the work of Arrow and Debreu, has to be ascribed to this stage. Stage 4 in the above list already leads to the frontiers of recent research in economics. The recent theoretical attempts to demonstrate the possibly drastic divergence in the behavior of nonlinear models from linear ones raise questions concerning the general validity of the standard linear and mainstream thought experiments. A general, nonlinear, dynamic, economic theory representing stage 5 is there- fore obviously not in sight. While other sciences are also still far away from a complete realization of the programme, it seems as if nonlinear phenomena have already been incorporated into other disciplines with more acceptance than in eco- nomics. It may be argued that it is simply a matter of time until economics adopts those new techniques which become more and more important in other disciplines because economics has always reacted sluggishly to new formal developments. How- ever, in contrast to the situation at the end of the last century, economists usually do not lack a profound mathematical background anymore. While this excuse for investigating mainly linear systems is thus not acceptable anymore, it may be worth- while to elaborate a little bit more on the second justification of the use of linear dynamical systems.

Stage 5:

ad ii)

The concentration on linear dynamical systems in economics is usually justified (if at all) with an excuse. The phenomenon under consideration is actually thought of as being nonlinear just because no convincing argument can be delivered why complex structures like economic systems should be characterized by highly stylized and simple relations in the form of linear equations. However, as linear models can be analyzed much easier than nonlinear ones (at least in low-dimensional cases), actual phenomena are approximated by stylized linear structures. 30

30 Usually, this simplification goes hand in hand with the prospect of future research in which the influence of nonlinearities should be investigated. Compare also Baumol (1987), p. 105, for a discussion of this procedure.


Chapter 1

This simplification can certainly be justified in many cases, especially when the true dynamical structure does not diverge essentially from the assumed linear form. If, e.g., the number of equilibria in a dynamical system is identical in linear and non- linear formulations, if the nonlinear functions diverge only minimally from linear forms, and if the interplay of the different nonlinear functions does not imply phe- nomena which are unobservable in linear systems, the usage of linear functions may indeed lead to a (qualitatively) sufficiently good approximation of the system’s true behavior. However, in higher-dimensional systems it will become increasingly difficult to discriminate between good and bad approximations. Indeed, it may be- come impossible to evaluate the effects of neglecting a special (maybe numerically small) nonlinear term which perhaps can drastically change the dynamic behavior of the system. It may be that some economists are not aware of the potential qualitative differ- ences between linear and nonlinear dynamical systems. One major reason for the concentration on linear systems may, however, have its origin in paradigmatic ideals of the functioning of an economy. If one is (explicitly or implicitly) guided by the classical mechanistic weltanschauung outlined in Sections 1.1 and 1.2, then there is indeed no need to consider anything other than linear systems. The fact that lin- ear dynamical systems behave in a very regular fashion and that the most complex dynamic behavior, namely steady regular oscillations, can be modeled only by as- suming a numerically exact parameter constellation support the basic idea that an economy’s equilibrium is asymptotically stable. In addition, the dynamic behavior is predictable. A model which demonstrates the impossibility of predictions can be considered to be part of a negative theory in economics: when the provision of predictions is regarded a justification for the mere existence of economics sev- eral nonlinear dynamic models will certainly be treated very skeptically (and their destructive effects will be emphasized). Consequently, as can be expected, the different scientific economic schools have developed a different attitude toward nonlinearities in economic models. Linear models have been employed especially by neoclassical and “new” classical writers who, after the (neo-) Keynesian disequilibrium interlude, have concentrated on the investigation of equilibrium economics once again. The assumption of linear dynamical systems in these classical models is often justified by technical reasons:

The predominant technical requirement of econometric work which imposes rational expec- tations is the ability to write down analytical expressions giving agent’s decision rules as functions of the parameters of their objective functions and as functions of the parameters governing the exogenous random process they face. Dynamic stochastic maximum prob- lems with quadratic objectives, which produce linear decision rules, do meet this essential


with such a class of functions, and the class of linear decision rules has just seemed most

Computer technology in the foreseeable future seems to require working

convenient for most

It is an open question whether for explaining the central

features of the business cycle there will be a big reward to fitting nonlinear models. 31

This opinion will probably not be shared by every Rational Expectations theorist but it implicitly uncovers the ignorance of the importance of nonlinear phenom-

1.3. The Dominance of Linear Dynamical Economics


ena. In fact, former schools in equilibrium economics were not all characterized by this limited methodological point of view. The literature that concentrated on the properties of tatonnementˆ processes in a general equilibrium context in the 1950s and 1960s also dealt with nonlinear systems. However, the focus of research did not consist of investigations into the effects of different kinds of possibly in- volved nonlinearities. Nearly all contributions concentrated on the question which assumptions are necessary and/or sufficient to ensure the stability of a general equi- librium. This literature therefore excluded all those effects of nonlinearities which

constitute an essential deviation from the qualitative behavior of linear systems. Or, in other words, only those nonlinearities were considered whose implied behavior

is sufficiently close to that of linear systems.

Concentration on linear dynamical structures implies a conceptual problem which becomes evident in attempts to describe and explain actual time series. These series are obviously not characterized by the regular kind of behavior which is typi- cal in deterministic linear systems; instead, several irregularities in the form of, e.g., different types of noise, different frequencies in oscillating series, etc., seem to be involved. The New Classical Macroeconomics overcomes this problem by introduc- ing stochastic exogenous disturbances in basically linear dynamical structures. 32 An economy isolated from its surrounding is believed to behave in a regular fashion, i.e., if it is displaced from its fixed point it returns toward this state in the form of

a monotonic or regularly oscillating motion. The observed irregularity in actual

economies’ time series can then be explained by the influence of random terms, which do not necessarily have any purely economic meaning. 33 When superim- posed stochastic disturbances take place in every period in discrete-time systems (or at each point in time in continuous-time systems) an interesting phenomenon

can be observed in these systems. When the deterministic part of the model implies oscillations with monotonic decreases in the amplitude, i.e., when the fixed point

is a stable focus, the introduction of the disturbances generates persistent fluctua-

tions. Figure 1.1 attempts to illustrate this phenomenon. A linear, discrete-time, dynamical systems generates the continuously drawn time series of one of the two state variables. The oscillation is dampened and x 1 converges toward its fixed-point value. The dotted line represents the time series generated by the same determin- istic system but with superimposed, normally distributed, stochastic disturbances. The time series displays persistent fluctuations. Remarkably, the system generates up- and downswings of the time series which prevail for several periods; the intro- duction of permanent stochastic disturbances therefore does not simply imply a positive or negative offset of the deterministic time series with the magnitude of the stochastic term. 34

32 Compare also Brock (1991) for a discussion of the standard macroeconomic (macroe- conometric) approach in the New Classical tradition.

33 The observation that the influence of additive random terms in linear business cycle models indeed implies theoretically generated time series which closely resemble actual series dates back to Frisch (1933), Slutzky (1937), and Kalecki (1954).

34 This effect has actually been known for a long time in the economic dynamics literature, cf. Samuelson (1947), pp. 335ff.


Chapter 1

x 1 Time Persistent Oscillations in a Stochastic Linear Dynamical System Figure 1.1
x 1
Persistent Oscillations in a Stochastic Linear Dynamical System
Figure 1.1

It can be argued that assuming these linear structures with superimposed sto- chastic influences is justified when actual time series do not suggest a falsification of this hypothesis. However, it was demonstrated by Blatt (1978, 1980, 1983) that statistical procedures may be misleading in discriminating between linear and nonlinear structures. Suppose that a time series is generated by a linear dynamic model with stochastic influences. It can be expected that a linear regression will fit the data extremely well. On the contrary, suppose that a time series is gener- ated by a deterministic nonlinear model. It is not immediately clear that a linear regression will reject the hypothesis of a linear structure with stochastic influences. Blatt (1983) performed the following experiment: 35 consider the discrete-time, multiplier-accelerator model of Hicks (1950) with ceiling and floor. 36 The model is nonlinear because the ceiling (the maximal growth path) and the floor (the min- imal growth path determined by autonomous investment) constitute upper and lower bounds to the endogenous fluctuations. It is crucial to the nonlinear ver- sion of the Hicks model that the endogenous (linear) fluctuations are exploding. Blatt assumed the following parameter specifications in the endogenous part of the Hicks model, i.e., the second-order difference equation

Y t = C 0 + I 0 + (c + β)Y t1 βY t2

= 25.0 + (0.75 + 1.5)Y t1 1.5Y t2 ,


with c as the marginal propensity to consume and β as the accelerator. The values of the parameters in (1.3) imply exploding oscillations. A time series generated by the deterministic nonlinear model, i.e., equation (1.3) with upper and lower bounds, was investigated by postulating the linear stochastic equation

Y t = A + (c + β)Y t1 + βY t2 + u t .


35 Compare also Brock (1988b) for a discussion of Blatt’s results.

36 Cf. Gabisch/Lorenz (1989), pp. 49ff., for a description of the model.

1.3. The Dominance of Linear Dynamical Economics


Surprisingly, this linear lagged model fits the data of the nonlinear model suffi- ciently well. Standard statistics for the model are

Y t = 28.5 + (0.713 + 0.887)Y t1 .887Y t2

(R 2 = 0.92, DW = 2.17, H = 0.56)


with H as the alternative Durbin statistics. The estimated value of the accelerator β is lower than 1, indicating that the economy is inherently stable though the underlying dynamical system (1.3) is unstable. An inspection of the statistics does not leave much room for rejecting the linear structure of the time series, even when the principles of critical rationalism are kept in mind. It can be suspected that similar econometric investigations of actual time series suggested the presence of linear stochastic structures in a multitude of cases and that the presence of nonlinearities has probably been rejected too many times. Nonlinear approaches to economic dynamics have been investigated mainly by economists who felt uncomfortable with the classical paradigm of equilibrium eco- nomics. Most contributions to nonlinear economic dynamics in the postwar era are therefore credited to authors usually assigned to post-Keynesianism, neo-Keynes- ianism, neo-Ricardianism, etc., though these contributions did not always make use of the mathematical advances in dynamical systems theory of the day. However, it would be misleading to attribute research in nonlinear economic dynamics ex- clusively to these schools. Nonlinearities have played a particular role in several fields dominated by neoclassical writers. For example, oscillating control trajecto- ries were known to exist in nonlinear optimal control theory long before the profes- sion became aware of the potential relevance of nonlinearities in other fields. Most interestingly, recent work on the effects of nonlinearities in the standard domain of mathematical economics, namely the general equilibrium analysis, is becoming more and more important. Oscillatory motion of economic variables has almost always been identified with fluctuations observable in capitalist, market-oriented, Western economies. The idea that phenomena like investment cycles could have been an empirical fact in the former socialist East European countries usually did not come to mind. However, recent work by Brody/Farkas´ (1987) and Simonovits (1991a,b) indicates that such cycles were at least theoretically possible in socialist economies. It seems as if the emergence of oscillatory behavior in dynamic economic systems cannot be excluded per se in models of various economic schools.

Chapter 2 Nonlinearities and Economic Dynamics I f the world is not linear (and there

Chapter 2

Nonlinearities and Economic Dynamics

Chapter 2 Nonlinearities and Economic Dynamics I f the world is not linear (and there is

I f the world is not linear (and there is no qualitative reason to assume the con- trary), it should be natural to model dynamic economic phenomena in the form

of nonlinear dynamical systems. However, there will not always exist an advan- tage in such a modelling. It depends crucially on the kind of nonlinearity in a model and sometimes on the subject of the investigation whether techniques ap- propriate to nonlinear systems provide new insights into the dynamic behavior of an economic system. Nonlinearities may be so weak that linear approximations do not constitute an essential error in answering qualitative questions about the sys- tem, e.g., whether or not the system converges to an equilibrium state. While this is certainly true for many low-dimensional systems, the effects of nonlinearities in higher-dimensional systems cannot always be anticipated with preciseness, implying that linear approximations should be treated with skepticism especially when the nonlinearities obviously diverge from linear structures. Unfortunately, the techniques for analyzing nonlinear dynamical systems are far less developed than for linear models. In detail, it is usually not possible to solve a nonlinear dynamical system anymore, i.e., to provide an explicit expression that delivers the value of a variable at a specific point in time when an initial value is given. 1 What is left to an analysis of nonlinear systems is the description of the qual- itative behavior in the sense that it is occasionally possible to determine under what conditions a dynamical system exhibits a closed orbit or displays related dynamic phenomena. Occasionally it is also possible to exclude the occurrence of some phenomena typical for nonlinear dynamical systems. In these cases linear approx-

1 It should be noted that the same is actually true for high-dimensional linear systems where computational difficulties usually preclude the determination of a solution.

2.1. Preliminary Concepts


imations can provide a sufficiently precise description of the dynamical properties of a given nonlinear system. This chapter deals mainly with the concept of closed orbits in a dynamical sys- tem. Although it is exclusively defined for the two-dimensional case, the Poincare-´ Bendixson theorem has become one of the most popular tools in analyzing non- linear dynamical systems. The power of this tool will be demonstrated through the presentation of economic examples from standard Keynesian business-cycle theory and simultaneous price-quantity adjustment processes. As the Poincare-Bendixson´ theorem does not exclude the existence of multiple closed orbits, a separate sec- tion is devoted to the question of the uniqueness of these cycles. An example of a so-called conservative dynamical system is provided through a presentation of Goodwin’s (1967) model of the class struggle, which in terms of dynamical systems theory is an example of a so-called predator-prey system. The chapter closes with a short section on relaxation oscillations, i.e., a particular type of dynamic behavior that emerges when the adjustment speed of one of the state variables is very large, and a few remarks on the irreversibility phenomenon observable in dissipative dynamical systems.

2.1. Preliminary Concepts

In this chapter, only continuous-time dynamical systems will be discussed. 2 Most of the following concepts can be transformed to the case of discrete-time dynamical systems. Consider the n-dimensional, ordinary differential equation system defin-

ing the motion of the state variables x i , i = 1,



x˙ 1





f 1 (x 1 ,

x˙ n = f n (x 1 ,


n ),


n ),


or, in vector notation,

= f(x),

x W R n ,


with W as an open subset of R n and a dot over a variable denoting the operator

d/dt. The functions f i , i = 1,

equation systems like (2.1.1) describe vector fields in W, i.e., for each x W the dynamical system unambiguously determines the direction and the speed of change of that point. Figures 2.1.a and 2.1.b depict two examples of vector fields in the plane. A solution curve, trajectory, or orbit is defined as Φ t x(0) , i.e., when a certain

are usually assumed to be C . Differential


2 A discussion of the advantages and disadvantages of different time concepts will be avoided in this book. Cf. Gandolfo/Martinengo/Padoan (1981) for a discussion.

3 The dependence of the variables on t will be ignored for notational convenience.


Chapter 2

2.1.a 2.1.b

Stylized Vector Fields in R 2 Figure 2.1

2.2.a 2.2.b

A Solution Curve and the Flow of a Dynamical System Figure 2.2

x(0) is given, Φ t x(0) provides the values of x at t (cf. Figure 2.2.a). The flow Φ t (x): R n R n of system (2.1.2) describes the future development of all x(0) W (cf. Figure 2.2.b with t 0 , t 1 , and t 2 as distinct points in time, t R). Central in the discussion of nonlinear dynamical systems is the notion of an at- tractor. There exist subtle differences between different definitions of an attractor in the literature; the following definition should be understood as a working def- inition. An attractor is an example of an invariant set with specific properties. A set D R n is invariant for the flow Φ t (x) of a system like (2.1.1) if Φ t (x) D for x D t R. 4

4 A set is called a positive invariant set if it is invariant for t 0. If it is invariant for t < 0, it is said to be negatively invariant. Cf. Wiggins (1990), p. 14.

2.1. Preliminary Concepts


Definition 2.1: 5 A closed invariant set A W is called an attracting set if there is some neighborhood U of A such that Φ t (x) U t 0 and Φ t (x) A when t → ∞ for all x U.

A repelling set is defined by letting t → −∞ in Definition 2.1. An attracting set is therefore a set to which trajectories starting at initial points in a neighborhood of the set will eventually converge. The set of all initial points which are attracted by A is called the basin of attraction of A.

Definition 2.2: Let U be a neighborhood of an attracting set A. The basin of attraction B(A) is the stable manifold of A, i.e., B(A) = t0 Φ t (U).

The shaded areas in Figures 2.3.a and 2.3.b depict basins of attraction for the cases in which the attractor is a single point (cf. 2.3.a) and in which the attractor is a closed curve (cf. 2.3.b). The basin of attraction is delimited by its basin boundary.

2.3.a 2.3.b

Basins of Attraction of Attracting Sets A Figure 2.3

In most parts of this book the term “attracting set” will be identified with an “attractor”. However, it should be noted that the expressions can be distinguished. An attractor can be defined as a topologically transitive attracting set. 6 Attracting sets can often be detected by locating a trapping region (cf. Wiggins (1990), p. 43):

5 Cf. Guckenheimer/Holmes (1983), p. 34, or Wiggins (1990), p. 43.

6 A closed invariant set is said to be topologically transitive if, for any two open sets U,

∅ ∀ t>t 0 , cf. Wiggins (1990), p. 45,

and Ruelle (1989), p. 151f. Examples showing that an attractor may be only a subset

of an attracting set can be found in Eckmann/Ruelle (1985), p. 623. Compare also Wiggins (1990), pp. 44f.

V A there exist t 0 > 0 such that Φ t (U) V =


Chapter 2

Definition 2.3: A closed, connected set D is a trapping region if Φ t (D) D t 0 or, equivalently, if the vector field on the boundary of D is pointing toward the interior of D.

The intersection t>0 Φ t (D) of all trajectories in D is then an attracting set. Trap- ping regions can be identified with the help of Lyapunov functions which will be introduced later in this section.

A, and

Consider an initial point that does not belong to an attractor, i.e., x(0)

suppose that the trajectory starting at x(0) eventually approaches the attractor. The part of the trajectory Φ t (x(0)) which is not yet on the attractor is called a transient. Transients may exhibit wild behavior in the initial phase of the convergence toward an attractor.

2.4.a 2.4.b

Wandering and Non-Wandering Points Figure 2.4

The motion on transients and on attractors can also be distinguished by intro- ducing the notion of wandering and non-wandering sets. 7 A point x(0) is non-wan- dering under the flow Φ t (x) if for any neighborhood U x(0) , there exists a t 0 0 such that Φ t (U) U = for t>t 0 , i.e., a trajectory starting in an arbitrary neighbor- hood of x(0) eventually returns to this neighborhood. The set of non-wandering points is called the non-wandering set. The wandering set is the complement of the non-wandering set. Examples of non-wandering sets are asymptotically stable fixed points and stable limit cycles (to be introduced below). Points on transients and on trajectories diverging from repellers are examples of wandering sets. Figure 2.4.a shows an example of a wandering point x(0). In order to be a non-wandering point, any neighborhood U of the initial point must fulfill the above mentioned require- ment in the definition of such a point. However, it is trivial to find a neighborhood (the shaded area) with the property that a trajectory leaving the neighborhood never returns to this set. Thus, x(0) in Figure 2.4.a is a wandering point. Figure

2.1. Preliminary Concepts


2.4.b shows an example of a non-wandering point. The motion takes place on the closed curve in a continuous fashion, i.e., all points on the curve are subsequently visited by the trajectory starting at x(0). Thus, when the trajectory on the closed curve leaves the neighborhood U (shaded area) it will eventually return to this neighborhood. Obviously, this is independent of the seize of U. Thus, the point x(0) in Figure 2.4.b (and any other point in the closed curve as well) is an example of a non-wandering point.


Two types of regular attractors have found particular attention, namely fixed-point attractors and closed orbits. They will briefly be described in the following.

1. Fixed Point Attractors. For a long time, economics has concentrated on a special kind of attractor, namely fixed-point (or equilibrium-point) 8 attractors. A survey of some techniques to establish the stability of fixed points in linear dynamical systems is contained in Appendix A.1. In considering nonlinear systems, the local and global stability properties of a fixed point must be distinguished. 9

Local Stability of Fixed Points

Let x = (x

two local stability concepts are the most relevant local concepts for economics:




n ) be a fixed point of (2.1.1) with = 0 = f(x ). The following

The fixed point is locally stable (locally Lyapunov stable) if for every ε > 0 there exists a δ > 0 such that for all |x(0) x | ≤ δ one has |Φ t x(0) x | ≤ ε t.

The fixed point is asymptotically stable if it is stable and if there exists a δ > 0 such

that for |x(0) x | ≤ δ one has lim

t |Φ t (x(0) x | = 0.

The two stability concepts are illustrated in Figure 2.5. In order to be locally Lya- punov stable a trajectory starting in a neighborhood of the fixed point x (deter- mined by δ and indicated by the light grey-shaded area in Figure 2.5.a) is required to stay in a neighborhood determined by ε (dark grey-shaded area). As the ε – neighborhood can be larger than the δ – neighborhood a trajectory is allowed to move away from x for a while but must not leave the ε – neighborhood. The local- asymptotic-stability concept is depicted in Figure 2.5.b. A trajectory starting in a δ

8 The term “equilibrium” as a description of a fixed point of a dynamical system will be avoided as often as possible in the course of the book. The term is mostly used in its economic meaning and indicates the congruence of supply and demand in a market and/or the identity of planned and actual individual actions.

9 Compare also Hahn (1984), pp. 748ff., and Takayama (1974), p. 356, for a detailed discussion of various stability concepts.


Chapter 2

2.5.a 2.5.b

Lyapunov Stability and Asymptotic Stability Figure 2.5

– neighborhood of x converges toward the fixed point; the Euclidian distance be- tween points Φ t x(0) on a trajectory and the fixed point decreases for increasing values of t.

2.6.a 2.6.b 2.6.c

Linear Invariant Subspaces and Nonlinear Manifolds Figure 2.6

The local behavior of a nonlinear dynamical system near a fixed point can be investigated by inspecting the behavior of the linear part of the system. This is true for the following reason. Consider the nonlinear system (2.1.2) and assume that it can be decomposed into a linear part and a nonlinear part, i.e.,

= Ax + g(x),


where A is an n × n – matrix of constant coefficients and g(x) is a nonlinear vector- valued function. It is demonstrated in the appendix that it is possible to determine invariant eigenspaces for the linear part of (2.1.3), i.e., = Ax. Assume that the stable and unstable eigenspaces are described by the linear curves E s and E u , respectively, in Figure 2.6.a and 2.6.b. In nonlinear systems, the analogs of the linear invariant subspaces E s and E u will be called the nonlinear, local (with respect to a fixed point x ), invariant manifolds

2.1. Preliminary Concepts


W s and W u , respectively. Let U R n be a neighborhood of a fixed point x . Then the nonlinear manifolds are defined as: 10

W s = {x U | Φ t (x) x

W u = {x U | Φ t (x) x


t → ∞



t → −∞


Φ t (x) U t 0}

Φ t (x) U t

0}. (2.1.4)

An important property of these nonlinear local manifolds is depicted in Figure

2.6.a. The manifold W s is tangent to the subspace E s at the fixed point x , and the manifold W u is tangent to the subspace E u at this fixed point. Furthermore,

it follows from the Hartman-Grobman theorem 11 that the flow of the nonlinear system

(2.1.2) is equivalent with the flow of the linear system = Ax in a neighborhood of

a fixed point x . The meaning of “equivalence” will be discussed in greater detail in Chapter 3. For the moment it suffices to say that two systems are equivalent if the trajectories of the linear and nonlinear systems have the same orientation and move into the same direction at analogous initial points. Figures 2.6.b and 2.6.c attempt to illustrate this equivalence. Invariant subspaces E s and E u are shown in Figure 2.6.b; the local manifolds W s and W u are depicted in 2.6.c. In a neighborhood U (indicated by the shaded area) the trajectories move into similar directions. It is impossible that a trajectory in Figure 2.6.c moves into a completely different direction than the analogous trajectory in Figure 2.6.b. As it is possible to analyze the local behavior of a nonlinear dynamical system in the neighborhood of a fixed point x with the help of the linear part in (2.1.3), it is desirable to isolate this linear part. The Taylor expansion of a C m function f : R R at a point x is defined as

f(x) = f(x ) +


df(x )





d 3 f(x )




(x x ) +


d 2 f(x )




(x x ) 2

(x x ) 3 +



d m f(x )





x ) m .


In a linear Taylor expansion only the first two terms are considered and all remaining terms are dropped. The linear Taylor expansion of a differential equation system (2.1.1) (or (2.1.2)) yields

x˙ = f(x ) + J |x=x (x x ),


with J |x=x as the Jacobian matrix of partial derivatives evaluated at x . When x is

a fixed point, f(x ) is, of course, equal to zero.

10 Cf. Guckenheimer/Holmes (1983), pp. 13f., for details. The negative time direction has been chosen because otherwise it would not have been possible to express the origin of a diverging trajectory.

11 Cf. Guckenheimer/Holmes (1983), p. 13, for details.


Chapter 2

The properties of the Jacobian matrix, defined as

J |x=x


∂f 1

∂x 1

∂f 2

∂x 1




∂f n

∂x 1

∂f 1

∂x 2

∂f 2

∂x 2




∂f n

∂x 2




∂f 1

∂x n

∂f 2

∂x n


∂f n

∂x n



and its eigenvalues are analogous to those of the coefficient matrix A in linear dynamical systems (cf. (A.1.3) in Appendix A.1). For example, if the real parts of the eigenvalues of (2.1.7) are negative, then the fixed point is locally asymptotically stable. When one (or more) of the eigenvalues of the Jacobian matrix J, evaluated at the fixed point x , equals zero or has zero real parts (i.e., when one of the linear invariant subspaces is a center subspace (cf. Appendix A.1.3)) the above mentioned analogies between the eigenspaces and the local nonlinear manifolds do not hold anymore. When there are such zero roots it is not possible anymore to analyze the local behavior of a nonlinear dynamical system by inspecting the behavior of its linear part. In such cases it is necessary to calculate the center manifold and to investigate the dynamic behavior restricted to this manifold. An introduction to center manifold theory is contained in the Appendix A.2.

Global Stability of a Fixed Point

The distinction between the local and global stability of a fixed point is a necessity in studying nonlinear dynamical systems. While local stability in a linear system also implies global stability, nonlinear dynamical systems can be characterized by multiple fixed points which (in continuous-time systems) are alternatively locally asymptotically stable and unstable. The concept of global asymptotic stability is defined in analogy to the local asymptotic stability with the modification that δ can be arbitrarily large:

The fixed point is globally asymptotically stable if it is stable and lim t |Φ t x(0) x | = 0 for every x(0) in the domain of definition of (2.1.1). A useful tool in investigating the global stability of a fixed point is the concept of a Lyapunov function. 12

Theorem 2.1 (Lyapunov (1949)): Let x be a fixed point of a dif- ferential equation system and let V : U R be a differentiable function defined on some neighborhood U W R n of x such that:

12 Cf. Hirsch/Smale (1974), pp. 192ff., and Guckenheimer/Holmes (1983), pp. 4f. Ex- tensive treatments of the usage of Lyapunov functions can be found in Hahn (1967) and Lasalle/Lefschetz (1961).

2.1. Preliminary Concepts




(x ) = 0 and V (x) > 0 if x =

x , and


(x) 0 in U − {x }.



Then x is stable. Moreover, if



(x) < 0 in U − {x },



then x is asymptotically stable.

Note that the neighborhood U W can be chosen arbitrarily large. Thus, a fixed point is globally asymptotically stable if the conditions (i) - (iii) are fulfilled for the entire domain of definition of a system like (2.1.2). The choice of the appropriate Lyapunov function in economic applications is not always obvious. Good candidates in different fields are welfare functions, the national product, or arbitrary constructions which resemble the notion of potentials in physics. 13

2. Cyclical Attractors. The present monograph does not focus on the question of (global or local) stability of a fixed point but on dynamic phenomena other than the (possibly complicated) convergence to a fixed-point attractor. The following discussion concentrates on attractors in the form of closed orbits. A point x is said to be in a closed orbit if there exists a t = 0 such that Φ t (x) = x. If a closed orbit is an attractor it will be called a limit cycle in the following.

Definition 2.4: A closed orbit Γ is called a limit cycle if there is a tubu- lar neighborhood U(Γ ) such that for all x U(Γ ), any flow Φ t (x) ap- proaches the closed orbit.

), any flow Φ t ( x ) ap- proaches the closed orbit. A Limit Cycle

A Limit Cycle Figure 2.7

13 Cf. Chapter 7 for the role of potentials in catastrophe theory.


Chapter 2

An example of a limit cycle in R 2 is depicted in Figure 2.7. Trajectories starting at initial points in the closed orbit will stay on the cycle forever. Trajectories starting at initial points in the neighborhood U(Γ ) of the closed orbit will approach the cycle in a spiraling fashion.


In higher-dimensional systems (n 3) more complicated attractors are possible. Several complicated attractors will be introduced in Chapter 4 and 5. In nonlinear dynamical systems more than a single fixed point can exist. In fact, the existence of a multiplicity of fixed points can be viewed as the origin of various kinds of complicated dynamic behavior. It is thus important to know the number of fixed points when a nonlinear dynamical system with potentially complicated behavior is to be investigated. The Poincar´e index is a helpful tool for this purpose. 14

Poincar´e index is a helpful tool for this purpose. 1 4 The Determination of the Poincare´

The Determination of the Poincare´ Index of a Contour Figure 2.8

Suppose that a two-dimensional, continuous-time dynamical system generates a vector field as in Figure 2.8. 15 The fixed point in the center of the vector field is obviously unstable. The Poincare index of the contour D (i.e., the closed curve encircling the fixed point) is determined in the following way: Mark the points of intersection of D with the vector field and note the orientation of each single vector. Start somewhere on D, e.g., at the intersection point # 1, and move along D in a counterclockwise manner, i.e., with positive orientation. Obviously, during the journey on D the orientations of the vectors change. After a full 2π motion, the vector orientation is again the same as that at the beginning but it may have changed by 360 0 or by 360 0 (i.e., in a counterclockwise or clockwise manner)

14 Cf. Andronov/Chaikin (1949) and Milnor (1965) for detailed treatments of index theory. Economically motivated discussions can be found in Dierker (1974) and Varian


15 The higher-dimensional (n 3) analog of index theory is degree theory. Cf. Chow/Hale (1982) for details.

2.1. Preliminary Concepts


during the wandering on the contour. In Figure 2.8 a counterclockwise change in the orientation of the vector field can be observed but there exist dynamical systems with a clockwise change. When a single, complete, counterclockwise rotation of the vector field can be ob- served during the counterclockwise motion along D the Poincare´ index of the con- tour is defined to be I P = 1. Each additional rotation of the vector field increases the index by 1. The Poincare´ index is the number of complete counterclockwise ro- tations of the vector field during a single counterclockwise motion along D. When a clockwise rotation can be observed it contributes a value of 1 to the count, i.e., for a single clockwise rotation during a counterclockwise motion along D the Poincare´ index is I P = 1. 16

2.9.a: I P = 1 2.9.b: I P = 1 2.9.c: I P = −1
2.9.a: I P = 1
2.9.b: I P = 1
2.9.c: I P = −1
2.9.d: I P = 1

Poincare´ Indices of Different Dynamical Systems Figure 2.9

16 When the vector field rotated by 2πk with k as an integer during a single counterclock- wise motion along D, the Poincare´ index is therefore identical with k.


Chapter 2

In Figure 2.8 the contour D encloses a fixed point. It is, of course, possible to determine the Poincare´ index of a contour without a fixed point in its interior but the index is typically calculated for the purpose of investigating the number of fixed points in a specific dynamical system. The Poincar´e index I P (x ) of a fixed point is obtained by calculating the index of a contour D that encircles a single, isolated fixed point x . Figures 2.9.a – 2.9.c illustrate the determination of the indices for different kinds of fixed points. Instead of drawing the entire vector field it suffices in most cases to consider a few trajectories and their (tangential) vectors at the points of intersection of the trajectory and the contour D. The stable node (2.9.a) and the stable focus (2.9.b) have indices I P = +1, while the saddle point in 2.9.c has an index I P = 1. 17 Figure 2.9.d illustrates the determination of the index of a closed orbit. Applying the same technique as above uncovers that a closed orbit has a Poincare´ index of I P = +1. 18 The importance of Poincare´ indices becomes obvious by the fact that the index of a contour D is equal to the sum of the indices of the objects encircled by the curve. 19 Figures 2.8 and 2.9.a-c depict the case where the contour D and the en- circled fixed points have the index I P = +1. Similarly, a contour without fixed points in its interior has index I P = 0. Assume that it is known that a dynamical system generates a closed orbit. Take the orbit itself as the contour D. As its index

is I P = +1 it follows that the orbit must encircle at least one fixed point. When

the index of a known fixed point (calculated by drawing a contour in a sufficiently small neighborhood of the point) is, e.g., I P = 1 then it follows that there must

be additional fixed points encircled by the closed orbit. 20 For example, the saddle

loop in Figure 2.10 has an index of I P = +1 and the index of the saddle fixed point

B is I P = 1. Thus, there are additional fixed points (points A and C in Figure

2.10 with indices I P (A) = 1 and I P (C) = 1). However, the argument cannot be applied in the reverse way: when the sum of the known fixed points encircled by a closed orbit equals +1, one cannot be sure that all fixed points are indeed known.

17 The Poincare´ index of some fixed points can also be determined analytically. Let J be the Jacobian of a dynamical system evaluated at the fixed point x . Then the index is

I P (x ) = +1 1



det(J) > 0; det(J) < 0.

If det(J) = 0, the index has to be calculated by the method described above, cf. Varian (1981). Compare also the formula provided in Wiggins (1990), p. 35.

18 The reader may verify that this is true independent of the orientation of the motion on the closed curve.

19 This follows from the Poincare-Hopf´ theorem; cf. Guillemin/Pollack (1974), pp. 132ff., or Varian (1981), p. 100.

20 When all fixed points are hyperbolic (cf. Section 3.1) then the number of fixed points is odd. When this number is 2n + 1, n fixed points are saddles and n + 1 are either sinks or sources.

2.2. The Poincar´e-Bendixson Theorem


2.2. The Poincare-Bendixson´


In most economic applications, especially when dealing with nonlinear dynamical systems, it is desirable to establish results on the global behavior of dynamical sys- tems. Unfortunately, the global character of the results must be compensated by compromising in respect to the dimension of the dynamical system; this restric- tion arises because it is possible to completely categorize the global behavior of a dynamical system only in the two-dimensional case. The Poincare-Bendixson´ theorem employs the notion of a limit set which has not been mentioned yet.

Definition 2.5: 21 An ω – limit set of a point x W is the set of all points W with the property that there exists a sequence t i → ∞ such that lim i Φ t i (x) = . The α – limit set is defined in the same way but with a sequence t i → −∞.

in the same way but with a sequence t i → −∞ . A Saddle Loop

A Saddle Loop Figure 2.10

In R 2 , three different types of limit sets can be distinguished: 22

Fixed point attractors.

Limit Cycles.

Saddle loops, i.e., fixed points and the trajectories connecting them.

The first two types of limit sets have already been discussed. An example of a saddle loop (or homoclinic orbit) is depicted in Figure 2.10 (it is also possible to have only a

21 The letters α and ω constitute an asses’ bridge: the letters are the first and last letters of the Greek alphabet, respectively. The α – limit set represents the set of points where the motion starts; the ω – limit set contains all points where the motion ends. Cf. Wiggins (1990), pp. 41f., for an explanation why the sequence {t i }, i → ∞, is considered instead of t → ∞.

22 Cf. Guckenheimer/Holmes (1983), p. 45.


Chapter 2

single loop). The associated dynamical system has two unstable fixed points (A and C) and a saddle as a third fixed point (B). The ω - limit set in this example consists of the union of the two loops (i.e., the trajectories that leave the saddle and return to it 23 ) and the saddle point. Saddle loops can occur in a variety of constellations of multiple fixed points and can enclose closed orbits. 24 The subject of the Poincar´e-Bendixson theorem is to provide sufficient conditions for the existence of limit cycles in particular sub-areas of the plane. 25

2.2.1. The Existence of Limit Cycles

Consider the two-dimensional differential equation system

x˙ 1

x˙ 2 = g(x 1 , x 2 ),


f(x 1 , x 2 ),


and assume that an initial point x(0) = x 1 (0), x 2 (0) is located in an invariant set D R 2 .

(0) is located in an invariant set D ⊂ R 2 . A Limit Cycle in

A Limit Cycle in a Compact Set D Figure 2.11

When the set contains limit sets, basically all three types of limit sets mentioned

theorem discriminates between these

above are possible. The Poincare-Bendixson´ different types:

23 These specific trajectories are also known as separatrices.

24 Cf. Guckenheimer/Holmes (1983), p. 46.

25 A complete discussion of the theorem can be found in Hirsch/Smale (1974), Chapter 11, to which the interested reader is strongly referred. Further presentations can be found in Arrowsmith/Place (1982), pp. 109ff., Boyce/DiPrima (1977), Chapter 9, and Coddington/Levinson (1955), Chapter 16. A concise overview is contained in Varian (1981).

2.2.1. The Existence of Limit Cycles


Theorem 2.2 (Poincar´e-Bendixson): A non-empty compact limit set of a C 1 dynamical system in R 2 , which contains no fixed point, is a closed orbit.