Optimal monetary policy in an open macroeconomic model with rational expectation

Chiun-Lin Hwang

ISU General Staff Papers from Iowa State University, Department of Economics

Abstract: This study is concerned with the choice of the optimal control of money supply for a linear stochastic discrete-time model of an open economy with rational expectations. Optimal control theory is applied to the setting of the stabilization policy. The linear and quadratic loss function is assumed to be the government objective function form. 'Optimal' indicates that the expected weighted sum of the squares of deviations of the state variables from the target values (or trend values) is minimized. The objectives of the study are (1) to examine the validity of the 'policy ineffectiveness proposition', (2) to investigate the comparative performances of alternative money supply rules--feedback versus fixed and superior information versus fixed, and (3) to determine whether the structure of the economy is crucial to the effectiveness of the setting of the money supply rule, in the sense that the economy is insulated from random shocks;It is shown that the derived optimal money supply has an effect on the probability distribution of output, price, and other endogenous variables even when public expectations are rational. The variance of endogenous variables will change as alternative money supply rules are applied. It indicates that either the feedback money supply rule or the superior information rule is effective in an economy with rational expectations. The structure of the economy does really matter when choosing the optimal money supply rule of stabilization policy.

Date: 1989-01-01
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