Optimal Control and Policy Analysis with a Model of a Small Open Economy: The Case of Ireland

Abstract

The Irish economy closely approximates a text-book small open economy (SOE). Consequently, with growing interdependence between nations, Ireland is in an increasingly vulnerable position with respect to changes in external circumstances. One aspect of this is the diminished ability of stabilization policy to protect the Irish economy from undesirable fluctuations. Some of the problems involved in analysing stabilization policy are examined in the light of the properties of the Central Bank's macromodel. In particular, model validation and optimal control techniques are seen as a means of quantifying, in terms that policy makers understand, the relative powerlessness of many policy measures copied from closed economies. The nature of the usual trade-off between such targets as unemployment, inflation, growth, balance of payments and public sector borrowing are explored against the known SOE background of the model. The nonlinear control algorithm and code of Chow is used to perform the control simulations.