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 https://www3.nd.edu/~esims1/log_linearization_sp12.pdf

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

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A brief example to model the Cobb-Douglas utility function using Stata.

Regarding microeconometrics, we can find applications that go from latent variables to model market decisions (like logit and probit models) and techniques to estimate the basic approaches for consumers and producers.

In this article, I want to start with an introduction of a basic concept in microeconomics, which is the Cobb-Douglas utility function and its estimation with Stata. So we’re reviewing the basic utility function, some mathematical forms to estimate it and finally, we’ll see an application using Stata.

Let’s start with the traditional Cobb-Douglas function:

Depending on the elasticity α and β for goods X and Y, we’ll have a respective preference of the consumer given by the utility function just above. In basic terms, we restrict α + β =1 in order to have an appropriate utility function which reflects a rate of substitution between the two goods X and Y.  If we assume a constant value of the utility given by U* for the consumer, we could graph the curve by solving the equation for Y, in this order of ideas.

And the behavior of the utility function will be given by the number of quantities of the good Y explained by X and the respective elasticities α and β. We can graph the behavior of the indifference curve given a constant utility level according to the quantities of X and Y, also for a start, we will assume that α =0.5 and β=0.5 where the function has the following pattern for the same U* level of utility (example U=10), this reflects the substitution between the goods.

Cobb-Douglas function with U=10 and α =0.5 and β=0.5 . Source: Own Elaboration

If you might wonder what happens when we alter the elasticity of each good, like for example, α =0.7 and β=0.3 the result would be a fast decaying curve instead of the pattern of the utility before.

Cobb-Douglas function with U=10 and α =0.7 and β=0.3 . Source: Own Elaboration

Estimating the utility function of the Cobb-Douglas type will require data of a set of goods (X and Y in this case) and the utility.

Also, it would imply that you somehow measured the utility  (that is, selecting a unit or a measure for the utility), sometimes this can be in monetary units or more complex ideas deriving from subjective utility measures.

Applying logarithms to the equation of the Cobb-Douglas function would result in:

Which with properties of logarithms can be expressed as:

This allows a linearization of the function as well, and we can see that the only thing we don’t know regarding the original function is the elasticities of α and β. The above equation fits perfectly in terms of a bivariate regression model. But remember to add the stochastic part when you’re modeling the function (that is, including the residual in the expression). With this, we can start to do a regressing exercise of the logarithm of the utility for the consumers taking into account the amount of the demanded goods X and Y. The result would allow us to estimate the behavior of the curve.

However, some assumptions must be noted: 1) We’re assuming that our sample (or subsample) containing the set of individuals i tend to have a similar utility function, 2) the estimation of the elasticity for each good, would also be a generalization of the individual behavior as an aggregate. One could argue that each individual i has a different utility function to maximize, and also that the elasticities for each good are different across individuals. But we can argue also that if the individuals i  are somewhat homogenous (regarding income, tastes, and priorities, for example, the people of the same socioeconomic stratum) we might be able to proceed with the estimation of the function to model the consumer behavior toward the goods.

The Stata application

As a first step would be to inspect the data in graphical terms, scatter command, in this case, would be useful since it displays the behavior and correlation of the utility (U) and the goods (X and Y), adding some simple fitting lines the result would be displayed like this:

twoway scatter U x || lfit U x
twoway scatter U y || lfit U y 
Stata graphs for the dispersion of each good (X and Y) relative to the utility. Source: Own Elaboration.

Up to this point, we can detect a higher dispersion regarding good Y. Also, the fitted line pattern relative to the slope is different for each good. This might lead to assume for now that the overall preference of the consumer for the n individuals is higher on average for the X good than it is for the Y good. The slope, in fact, is telling us that by an increase of one unit in the X good, there’s a serious increase in the utility (U) meanwhile, the fitted line on the good Y regarding to its slope is telling us comparatively speaking, that it doesn’t increase the utility as much as the X good. For this cross-sectional study, it also would become more useful to calculate Pearson’s correlation coefficient. This can be done with:

correlate U y x
Correlation Matrix between the variables. Source: Own Elaboration

The coefficient is indicating us that exists somewhat of a linear association between the utility (U) and the good Y, meanwhile, it exists a stronger linear relationship relative to the X good and the utility. As a final point, there’s an inverse, but not significant or important linear relationship between goods X and Y. So the sign is indicating us that they’re substitutes of each other.

Now instead of regressing U with X and Y, we need to convert it into logarithms, because we want to do a linearization of the Cobb-Douglas utility function.

gen ln_U=ln(U)
gen ln_X=ln(x)
gen ln_Y=ln(y)
reg ln_U ln_X ln_Y
Regression with Ordinary Least Squares with constant. Source: Own Elaboration

And now performing the regression without the constant.

Regression with Ordinary Least Squares without the constant. Source: Own Elaboration

Both regressions (with and without the constant) tends to establish the parameters in α =0.6 and β=0.4 which matches the Data Generating Process of the Montecarlo simulation. It appears that the model with the constant term has a lesser variance, so we shall select these parameters for further analysis.

How would it look then our estimation of this utility function for our sample? well, we can start using the mean value of the utility using descriptive statistics and then use a graphical function with the parameters associate. Remember that we got:

And we know already the parameters and also we can assume that the expected utility would be the mean utility in our sample. From this, we can use the command:

sum U y x
Summary of the variables using Stata. Source: Own Elaboration

And with this, the estimated function for the utility level U=67.89 with approximated elasticities of 0.6 and 0.4 would look like this:

Graph of the Curve for the Expect Utility of the Sample, with the parameters estimated with OLS. Source: Own Elaboration

In this order of ideas, we just estimated the indifference curve for a certain population which consists of a set of i individuals. The expected utility from both goods was assumed as the mean value of the utility for the sample and with this, we can identify the different sets of points related to the goods X and Y which represents the expected utility. This is where it ends our brief example of the modeling related to the Cobb-Douglas utility function within a sample with two goods and defined utilities.

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