Panel Data Nonlinear Simultaneous Equation Models with Two-Stage Least Squares using Stata

In this article, we will follow Woolridge (2002) procedure to estimate a set of equations with nonlinear functional forms for panel data using the two-stage least squares estimator. It has to be mentioned that this topic is quite uncommon and not used a lot in applied econometrics, this is due that instrumenting the nonlinear terms might be somewhat complicated.

Assume a two-equation system of the form:

Where the y’s represents the endogenous variables, Z represents the exogenous variables taken as instruments and u are the residuals for each equation. Notice that y2 is in a quadratic form in the first equation but also present in linear terms on the second equation.

Woolridge calls this model as nonlinear in endogenous variable, yet the model still linear in the parameters γ making this a particular problem where we need to somehow instrument the quadratic term of y2.

Finding the instruments for the quadratic term is a particular challenge than already it is for linear terms in simple instrumental variable regression. He suggests the following:

“A general approach is to always use some squares and cross products of the exogenous variables appearing somewhere in the system. If something like exper2 appears in the system, additional terms such as exper3 and exper4 would be added to the instrument list.” (Wooldridge, 2002, p. 235).

Therefore, it worth the try to use nonlinear terms of the exogenous variables from Z, in the form of possible Z2 or even Z3. And use these instruments to deal with the endogeneity of the quadratic term y2. When we define our set of instruments, then any nonlinear equation can be estimated with two-stage least squares. And as always, we should check the overidentifying restrictions to make sure we manage to avoid inconsistent estimates.

The process with an example.

Let’s work with the Example of a nonlinear labor supply function. Which is a system of the form:

Some brief description of the model indicates that for the first equation, the hours (worked) are a nonlinear function of the wage, the level of education (educ), the age (age), the kids situation associated to the age, whether if they’re younger than 6 years old or between 6 and 18 (kidslt6 and kidsge6), and the wife’s income (nwifeinc).

On the second equation, the wage is a function of the education (educ), and a nonlinear function of the exogenous variable experience (exper and exper2).

We work on the natural assumptions that E(u|z)=0 therefore the instruments are exogenous. Z in this case contains all the other variables which are not endogenous (hours and wage are the endogenous variables).

We will instrument the quadratic term of the logarithm of the wage in the first equation, and for such instrumenting process we will add three new quadratic terms, which are:

And we include those in the first-stage regression.

With Stata we first load the dataset which can be found here.

Load up the data (double click the file with Stata open or use some path command to get it ready)

use MROZ.dta

Generate the squared term for the logarithm of the wage with:

gen lwage_sq=lwage *lwage

Then, get ready to use the following command with ivregress, however, we will explain it in detail.

ivregress 2sls hours educ age kidslt6 kidsge6 nwifeinc (lwage lwage_sq  = educ c.educ#c.educ exper expersq age c.age#c.age kidsge6 kidslt6 nwifeinc c.nwifeinc#c.nwifeinc), first

Which has the following interpretation. According to the syntaxis of Stata’s program. First, make sure you specify the first equation with the associated exogenous variables, we do that with the part.

ivregress 2sls hours educ age kidslt6 kidsge6 nwifeinc

Now, let’s tell to Stata that we have two other endogenous regressors, which are the wage and the squared term of the wages. We open the bracket and put

(lwage lwage_sq  =

This will tell to Stata that lwage and lwage_sq are endogenous, part of the first equation of hours, and after the equal, we specify ALL the exogenous variables including the instruments for the endogenous terms, this will lead to include the second part as:

(lwage lwage_sq  = educ c.educ#c.educ exper expersq age c.age#c.age kidsge6 kidslt6 nwifeinc c.nwifeinc#c.nwifeinc)

Notice that this second part will have a c.var#c.var structure, this is Stata’s operator to indicate a multiplication for continuous variables, (and we induce the quadratic terms without generating the variables with another command like we did with the wage).

So notice we have c.educ#c.educ which is the square of the educ variable, and c.age#c.age which is the square of the age, and we also square the wife’s income with c.nwifeinc#c.nwifeinc. These are the instruments for the quadratic term.

The fact that we have two variables on the left (lwage and lwage_sq) indicates that the set of instruments will hold first for an equation for lwage and second for lwage_sq given the exact same instruments.

We include the option , first to see what were the regressions in the first stage.

ivregress 2sls hours educ age kidslt6 kidsge6 nwifeinc (lwage lwage_sq  = educ c.educ#c.educ exper expersq age c.age#c.age kidsge6 kidslt6 nwifeinc c.nwifeinc#c.nwifeinc), first

The output of the above model for the first stage equations is:

And the output for the two stage equation is:

Which yields in the identical coefficients in Woolridge’s book (2002, p- 236) also with some slightly difference in the standard errors (yet these slight differences do not change the interpretation of the statistical significance of the estimators).

In this way, we instrumented both endogenous regressors lwage and lwage_sq. Which are a nonlinear relationship in the model.

As we can see, the quadratic term is not statistically significant to explain the hours worked.

At last, we need to make sure that overidentification restrictions are valid. So we use after the regression

estat overid

And within this result, we cannot reject the null that overidentifying restrictions are valid.


Wooldridge, J. M. (2002). Econometric Analysis of Cross Section and Panel Data. Cam-bridge, MA: MIT Press.

Please follow and like us:

Wooldridge Serial Correlation Test for Panel Data using Stata.

In this article, we will follow Drukker (2003) procedure to derive the first-order serial correlation test proposed by Jeff Wooldridge (2002) for panel data. It has to be mentioned that this test is considered a robust test, since works with lesser assumptions on the behavior of the heterogeneous individual effects.

We start with the linear model as:

Where y represents the dependent variable, X is the (1xK) vector of exogenous variables, Z is considered a vector of time-invariant covariates. With µ as individual effects for each individual. Special importance is associated with the correlation between X and µ since, if such correlation is zero (or uncorrelated), we better go for the random-effects model, however, if X and µ are correlated, it’s better to stick with fixed-effects.

The estimators of fixed and random effects rely on the absence of serial correlation. From this Wooldridge use the residual from the regression of (1) but in first-differences, which is of the form of:

Notice that such differentiating procedure eliminates the individual effects contained in µ, leading us to think that level-effects are time-invariant, hence if we analyze the variations, we conclude there’s non-existing variation over time of the individual effects.

Once we got the regression in first differences (and assuming that individual-level effects are eliminated) we use the predicted values of the residuals of the first difference regression. Then we double-check the correlation between the residual of the first difference equation and its first lag, if there’s no serial correlation then the correlation should have a value of -0.5 as the next expression states.

Therefore, if the correlation is equal to -.5 the original model in (1) will not have serial correlation. However, if it differs significantly, we have a serial correlation problem of first-order in the original model in (1).

For all of the regressions, we account for the within-panel correlation, therefore all of the procedures require the inclusion of the cluster regression, and also, we omit the constant term in the difference equation. In sum we do:

  1. Specify our model (whether if it has fixed or random effects, but these should be time-invariant).
  2. Create the difference model (using first differences on all the variables, therefore the difference model will not have any individual effects). We perform the regression while clustering the individuals and we omit the constant term.
  3. We predict the residuals of the difference model.
  4. We regress the predicted residual over the first lag of the predicted residual. We also cluster this regression and omit the constant.
  5. We test the hypothesis if the lagged residual equal to -0.5.

Let’s do a quick example of this steps using the same example as Drukker.

We start loading the database.


Then we format the database for stata with the code:

xtset idcode year

Then we generate some quadratic variables.

gen age2 = age^2
gen tenure2 = tenure^2

We regress our model of the form of:

xtreg ln_wage age* ttl_exp tenure* south, fe

It doesn’t matter whether if it is fixed or random effects as long as we assume that individuals’ effects are time invariant (therefore they get eliminated in the first difference model).

Now let’s do the manual estimation of the test. In order to do this, we use a pooled regression of the model without the constant and clustering the regression for the panel variable. This is done of the form:

reg d.ln_wage d.age* d.ttl_exp d.tenure* d.south, noconst cluster(idcode)

The options noconst eliminates the constant term for the difference model, and cluster option includes a clustering approach in the regression structure, finally idcode is the panel variable which we identify our individuals in the panel.

The next thing to do is predict the residuals of the last pooled difference regression, and we do this with:

predict u, res

Then we regress the predicted residual u against the first lag of u, while we cluster and also eliminate the constant of the regression as before.

reg u L.u, noconst cluster(idcode)

Finally, we test the hypothesis whether if the coefficient of the first lag of the pooled difference equation is equal or not to -0.5

test L.u==-0.5

According to the results we strongly reject the null hypothesis of no serial correlation with a 5% level of significance. Therefore, the model has serial correlation problems.

We can also perform the test with the Stata compiled package of Drukker, which can be somewhat faster. We do this by using

xtserial ln_wage age* ttl_exp tenure* south, output

and we’ll have the same results. However, the advantage of the manual procedure of the test is that it can be done for any kind of model or regression.


Drukker, D. (2003) Testing for serial correlation in linear panel-data models, The Stata Journal, 3(2), pp. 168–177. Taken from:

Wooldridge, J. M. (2002). Econometric Analysis of Cross Section and Panel Data. Cam-bridge, MA: MIT Press.

Please follow and like us:

HAC robust standard errors.

While we’re using the time series datasets, often we’re highly likely to find serial correlation and heteroskedasticity in our data. These cases increase the chances to obtain serially correlated errors with non-constant variance.

If we’re purely interested in statistical inferences, we should go for the HAC robust standard errors under the Time Series context. This name as Woolridge appoints refers to:

“In the time series literature, the serial correlation–robust standard errors are sometimes called heteroskedasticity and autocorrelation consistent, or HAC, standard errors.” (Wooldridge, ,p. 432).

We got to appoint that HAC standard errors (also called HAC estimators) are derived from the work of Newey & West (1987) where the objective was to build a robust approach to handle the usual problems of time series associated with serial correlation and heteroskedasticity.

What’s the idea behind these standard errors? Well, we can summarize it as:

  1. We do not know the form of the serial correlation.
  2. Works for arbitrary forms of serial correlation and the autocorrelation structure can be derived from the sample size.
  3. With larger samples, we can be flexible in the amount of serial correlation.

This means, that even when the robust standard error is consistent in the presence of the serial correlation and heteroskedasticity, we still need to figure the lag structure for the autocorrelation. Again, Woolridge helps us to decide this on simple basis:

Annual data = 1 lag, 2 lags. Quarterly data= 4 up to 8 lags. Monthly data = 12 up to 24 lags.

Let’s dig into some formulas to understand the relationship between HAC and OLS.

First, Newey & West standard errors work under the ordinary least squares estimator of the form:

Where X is the matrix of independent variables and Y is the vector of the dependent variable. This leads to establishing that Newey-West estimates in terms of values of the estimators will not differ from the OLS estimates.

Second, Newey & West standard errors modify the role of the estimated variances to include White’s robust approach to heteroskedasticity and also the serial correlation structure.

Consider that estimates of the variance in OLS are given by:

Where Ω is the diagonal matrix containing the distinct variances (for a representation of heteroskedasticity).

Now, White robust estimator is defined by:

Where n is the sample size, and e is the estimated time-period residual with ith row of the matrix of independent variables. Let’s define this as robust estimates with 0 lags (since it is only handling heteroskedasticity).

Now here’s where Newey & West extended the White estimator to include the arbitrary forms of serial correlation with a m-lag structure:

As it is visible, the HAC estimates of the variance now include the heteroskedasticity and a m-lag consistent estimate. K represents the number of independent variables, t the time periods and x is the row of matrix of independent variables observed at time t.

So with this, it is more clearly to work under the frame of :

Annual data: m=1,2 lags. Quarterly data: m=4,8 lags. Monthly data: 12,24 lags.

Let’s see an example:

generate t = _n
tsset t
regress price weight displ, vce(robust)

Up to this point, this is the White robust standard errors to heteroskedasticity, now let’s estimate the HAC estimator with the equivalent which is 0 lags.

newey price weight displ, lag(0)

As you can see everything is exact in comparison to the White’s robust standard errors. Now let’s start to use the HAC structure under 2 lags.

newey price weight displ, lag(2)

Notice as well that the values of standard errors of the independent variables have changed with this estimation.

I would recommend always to provide estimates of the HAC SE, in order to obtain more comparative estimates and correct inferences.

As a last mention, Greene (2012) states as a usual practice to select the integer approximate of T^(1/4) where T is the total of time periods of time. For example, for our case considering it is annual data, it would be

display (74)^(1/4)

and Stata will display a value, therefore our lags to select would be 3 and 2 (with no specific criteria to select one over the other).


Greene, W. H. 2012. Econometric Analysis, 7th edition, section 20.5.2, p. 960

Newey, W. K., and K. D. West. 1987. A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica 55: 703–708.

Wooldridge, J. 2013. Introductory Econometrics: A Modern Approach, Fifth Edition. South-Western CENGAGE Learning.

Please follow and like us:

The Rise of Behavioral Econometrics..

The lessons from behavioral economics have ameliorated social wellbeing and economic success in recent years. Academics and policymakers now recognize that integrating how individuals behave and make decisions in real-life dramatically improves the effectiveness of public policies and the validity of simple theoretical models. Thus, this area of research has enhanced our understanding of the barriers to decision-making and led to the emergence of a wider and richer theoretical and empirical framework to inform human decision making.

This framework builds on fields such as sociology, anthropology, psychology, economics, and political science. Two of the last four Nobel Prizes in Economics (2017 and 2019) have been awarded to Behavioral and Experimental economists working also on development-related problematics. The wider results from this body of work have been used by academics, governments, and international organizations to design evidence-based policies in a wide range of activities such as finance, tax collection, healthcare, education, energy consumption and human cooperation.

Based on this relevance, the present workshop aims to teach foundations on behavioral economics and how their instruments can help improve social and economic outcomes in problems found in modern public policy. Similarly, the workshop will establish statistical and econometric techniques (and commands) to secure the correct implementation of interventions, and the assessment of their results.

Learn more and register at the upcoming workshop in March 2021 at

Please follow and like us:

Identifying Patterns with Stata Graphs

When we start to analyze any type of economic relationship, it is often said that we always need to graph the data. The importance of this step is having a visual where we can increase the understanding of our current relationships in the data. Sometimes with this, we can improve the mathematical functional form in the econometric modelling to capture better the relationships and dynamics in the data.

I would suggest to first do the following steps:

  1. Scatter your independent variable (in the x-axis) against your dependent variable (in the y-axis)
  2. Observe what kind of linear and non-linear relationships may exists in the graph.
  3. Place the mean values of the variables to have some sort of idea of what kind of data concentrations we might have.
  4. Make your inferences accordingly, and do a matrix with correlations with everything.

To do an example of this, let’s make an example with a Data Generating Process of the form:

And to generate the random sample we will use:

clear all
set obs 100
gen n=_n
set seed 1234
gen x=rnormal()
gen x_sq=x*x 
gen z=rnormal() 
gen y= 1 + (0.5*x)+ (- 0.2*x_sq) + (1.5*z)

Now let’s see a summary of our variables.


Which will have as a result

Skipping n, which is just the individual identificatory variable, we can see the mean values of these variables. Now let’s start to play with some scatter plots.

scatter y x
scatter y z

And we will have two graphs that look like this:

First graph, which is the scatter of y and x doesn’t show any clear relationship, in fact, we might state that there’s no relationship by such dispersion, On the second hand, we find out that there’s a possible linear relationship with y and z.

Let’s go and place the means of each variable in the scatter graph, remember that x mean is 0.0078 and y mean is 0.7479, with these values we will have something like this:

scatter y x, xline(.0078032) yline(.747933)
scatter y z, xline(-.0452837) yline(.747933)

According to this, the data appears to be normal distributed (as it should be since we use a random sampling with normal distribution), in other cases, we might find that the mean is allocated in extreme values in either of the axis, which might imply some sort of kurtosis or non-normal distributions.

Now let’s use some linear and non-linear predictions using the not so common lfitci and qfitci. To do this, we type:

twoway (lfitci y x)
twoway (lfitci y z)

And the respective output will be:

If we want to use lines instead of shaded area, we might type

twoway (lfitci y x, ciplot(rline) )
twoway (lfitci y z, ciplot(rline) )

And it will display the same graph, but without shaded areas.

We can extend the same idea with non-linear relationships with a quadratic form using qfitci:

twoway (qfitci y x)
twoway (qfitci y z)

And the output of the graph will be:

Notice that the quadratic relationship is now more visible using the quadratic adjustment for x and y. Therefore, it is a good practice to perform the quadratic adjustment even when the relationship is totally linear like in the case of y and z.

One last type of graphical analysis is using the fractional polynomial, where the syntax is given by:

twoway (fpfitci y x)
twoway (fpfitci y z)

Finally, and to complete the steps we mentioned in this post, let’s do the matrix of correlations. Which is just simply the scatter plots together.

graph matrix y x z

The useful thing to consider with the matrix of correlations is that we can observe not only the scatter plots to a certain variable, but instead we got the scatter plots associated to all the variables we place in the command. Therefore, in regression analysis, this is quite useful to inspect to multicollinearity issues among the independent variables and not only the correlation between the dependent variable.

We can say that similar to x and z, there’s no strong linear correlation since it looks like more like a cloud of dots instead of a linear relationship like it has y and z.

Notice, however, that unless we use a quadratic adjustment, we don’t have it easy to detect the quadratic relationship between y and x, therefore, it is recommended to use the qfitci command to investigate such non-linear relationship.


StataCorp (2020) Graph twoway fpfitci, Recuperated from:

Please follow and like us:

Investigating Non-linear relationships with curvefit using Stata

While modelling specific phenomenon’s in economics, sometimes we might encounter a functional form which may not be linear in the explanatory variables. Assuming, that we still have linearity in the estimators, we have the capability to include in the regression, variables with powers. As an example, consider the following model:

The last equation presents the dependent variable Y as a function of X however, we can see that the polynomial in the model is of second-order degree. A few mentions can be done from here: 1) the model still linear in the parameters β. 2) No multicollinearity can be argued to exists between the regressors in X and the square of X (the model itself in terms of X will be highly correlated) therefore we’re modeling a structure where both of them will move together. 3) The parameters will no longer have a static/basic marginal effect, to find out this marginal effect we need to calculate the derivate of the model, given by:

Which represents that when X increase in one unit, the change in y is the above expression.

Considering the derivate, a turning point is given in the effect of X to Y, and can be found when we equal this derivate to 0 (to find the numerical spot where the slope is equal to 0). And that is done by solving the equation for the value of X:

We clear X and we have:

Let’s see this in practice, first let’s formulate a Data Generating Process -DGP- as follows without any noise or error:

Where X~N(0,1), with Stata let’s generate some random observations and the square variable.

clear all
** Setting observations
set obs 50
gen n=_n
set seed 1234
gen x=rnormal()
gen x_sq=x*x 
gen y= 1 + (0.5*x)+ (- 0.2*x_sq)

After that, let’s scatter y, over x. and using scatter y x we have the next graph:

If we regress this functional form with the next command:

regress y x x_sq

We have the regression totally adjusted to the DGP. But with missing values on lots of statistics (since there is no residual at all!).

Notice also that the linear adjustment for r-squared is 1, meaning it is matching the data perfectly.

Now confirming that coefficients are 0.5, -0.2 and 1 for the constant. Let’s confirm that the turning point of the model is in:

Solving and changing the parameter’s we have that:

The slope of the curve where it turns to be 0 it should be allocated in X=1.25, with an image in Y=1+0.5(1.25)-0.2(1.25^2)= 1.3125 after that, there’s a decreasing effect in Y given changes in X.

Let’s redo the graph but marking those points.

scatter y x, yline(1.3125) xline(1.25)

We allocated the exact point where the input of x variable is enough to create a decreasing effect on the dependent variable (specifically at x=1.25, y=1.3525) and moving to x>1.25 we have decreasing effects on y, where areas before this point it was positive.

Within this context, let’s introduce to curvefit command.

This package created by Liu wei (2010) and it is good to investigate this kind of nonlinearities, let’s look it in action.

curvefit y x, function(1)

By placing the variables of interest (y as dependent and x as an independent), we need to specify the behavior of the polynomial, as the examples show, function(1) equals a first-order polynomial (a single straight line equation). With the following output.

As you can see, it gives estimates of the coefficients (b0 as the constant with b1 as the slope) and the basic statistic of the number of observations (N) and the adjusted r-squared. The graph displayed is:

Which is a linear model. A simple regression with first-order power in X. let’s try another function (the quadratic function). We type:

curvefit y x, function(4)

Which gives the following output:

Where b0 is the constant parameter, b1 would equal to the X without any power, and finally, b2 is the parameter associated with X^2. Giving an R^2 adjusted of 1, represents the goodness fit of the model of 100%. With the associated graph:

As you can see, the curve provides estimates pretty decent of the structure of the data given different types of mathematical models.

Here’s the complete list of what kind of functions it can be modeled.

function(string) The following are alternative Models correspond with the values of the sting: 

. string = 1 Linear: Y = b0 + (b1 * X) 
. string = 2 Logarithmic: Y = b0 + (b1 * ln(X)) 
. string = 3 Inverse: Y = b0 + (b1 / X) 
. string = 4 Quadratic: Y = b0 + (b1 * X) + (b2 * X^2) 
. string = 5 Cubic: Y = b0 + (b1 * X) + (b2 * X^2) + (b3 * X^3) 
. string = 6 Power: Y = b0 * (X^b1) OR ln(Y) = ln(b0) + (b1 * ln(X)) 
. string = 7 Compound: Y = b0 * (b1^X) OR ln(Y) = ln(b0) + (ln(b1) * X) 
. string = 8 S-curve: Y = e^(b0 + (b1/X)) OR ln(Y) = b0 + (b1/X) 
. string = 9 Logistic: Y = b0 / (1 + b1 * e^(-b2 * X)) 
. string = 0 Growth: Y = e^(b0 + (b1 * X)) OR ln(Y) = b0 + (b1 * X) 
. string = a Exponential: Y = b0 * (e^(b1 * X)) OR ln(Y) = ln(b0) + (b1 * X) 
. string = b Vapor Pressure: Y = e^(b0 + b1/X + b2 * ln(X)) 
. string = c Reciprocal Logarithmic: Y = 1 / (b0 + (b1 * ln(X))) 
. string = d Modified Power: Y = b0 * b1^(X) 
. string = e Shifted Power: Y = b0 * (X - b1)^b2 
. string = f Geometric: Y = b0 * X^(b1 * X) 
. string = g Modified Geometric: Y = b0 * X^(b1/X) 
. string = h nth order Polynomial: Y = b0 + b1X + b2X^2 + b3X^3 + b4X^4 + b5*X^5 … 
. string = i Hoerl: Y = b0 * (b1^X) * (X^b2) 
. string = j Modified Hoerl: Y = b0 * b1^(1/X) * (X^b2) 
. string = k Reciprocal: Y = 1 / (b0 + b1 * X) 
. string = l Reciprocal Quadratic: Y = 1 / (b0 + b1 * X + b2 * X^2) 
. string = m Bleasdale: Y = (b0 + b1 * X)^(-1 / b2) 
. string = n Harris: Y = 1 / (b0 + b1 * X^b2) 
. string = o Exponential Association: Y = b0 * (1 - e^(-b1 * X)) 
. string = p Three-Parameter Exponential Association: Y = b0 * (b1 - e^(-b2 * X)) 
. string = q Saturation-Growth Rate: Y = b0 * X/(b1 + X) 
. string = r Gompertz Relation: Y = b0 * e^(-e^(b1 - b2 * X)) 
. string = s Richards: Y = b0 / (1 + e^(b1 - b2 * X))^(1/b3) 
. string = t MMF: Y = (b0 * b1+b2 * X^b3)/(b1 + X^b3) 
. string = u Weibull: Y = b0 - b1*e^(-b2 * X^b3) 
. string = v Sinusoidal: Y = b0+b1 * b2 * cos(b2 * X + b3) 
. string = w Gaussian: Y = b0 * e^((-(b1 - X)^2)/(2 * b2^2)) 
. string = x Heat Capacity: Y = b0 + b1 * X + b2/X^2 
. string = y Rational: Y = (b0 + b1 * X)/(1 + b2 * X + b3 * X^2) 
. string = ALL refers to a total of above models (Attention: it's uppercase!) nograph Curve Estimation without curve fit graph.

This package can be installed using:

ssc install curvefit, replace.


Liu Wei (2010) “CURVEFIT: Stata module to produces curve estimation regression statistics and related plots between two variables for alternative curve estimation regression models,” Statistical Software Components S457136, Boston College Department of Economics, revised 28 Jul 2013.

Please follow and like us:

Log-linearisation in Short

Log-linearisation in Short with an example

There exist many different types of models of equations for which there exists no closed form solution. In these cases, we use a method known as log-linearisation. One example of these kinds of models are non-linear models like Dynamic Stochastic General Equilibrium (DSGE) models. DSGE models are non-linear in both parameter and in variables. Because of this, solving and estimating these models is challenging.

Hence, we have to use approximations to the non-linear models. We have to make concessions in this, as some features of the models are lost, but the models become more manageable.

In the simplest terms, we first take the natural logs of the non-linear equations and then we linearise the logged difference equations about the steady state. Finally, we simplify the equations until we have linear equations where the variables are percentage deviations from the steady state. We use the steady state as that is the point where the economy ends up in the absence of future shocks.

Usually in the literature, the main part of estimation consisted of linearised models, but after the global financial crisis, more and more non-linear models are being used. Many discrete time dynamic economic problems require the use of log-linearisation.

There are several ways to do log-linearisation. Some examples of which, have been provided in the bibliography below.

One of the main methods is the application of Taylor Series expansion. Taylor’s theorem tells us that the first-order approximation of any arbitrary function is as below.

We can use this to log-linearise equations around the steady state. Since we would be log-linearising around the steady state, x* would be the steady state.

For example, let us consider a Cobb-Douglas production function and then take a log of the function.

The next step would be to apply Taylor Series Expansion and take the first order approximation.

Since we know that

Those parts of the function will cancel out. We are left with –

For notational ease, we define these terms as percentage deviation of x about x* where x* signifies the steady state.
Thus, we get

At last, we have log-linearised the Cobb-Douglas production function around the steady state.

Sims, Eric (2011). Graduate Macro Theory II: Notes on Log-Linearization – 2011. Retrieved from

Zietz, Joachim (2006). Log-Linearizing Around the Steady State: A Guide with Examples. SSRN Electronic Journal. 10.2139/ssrn.951753.

McCandless, George (2008). The ABCs of RBCs: An Introduction to Dynamic Macroeconomic Models, Harvard University Press

Uhlig, Harald (1999). A Toolkit for Analyzing Nonlinear Dynamic Stochastic Models Easily, Computational Methods for the Study of Dynamic
Economies, Oxford University Press

Please follow and like us: