Optimal Stabilization Paths

Abstract

An optimal stabilization policy is one which brings the economy to a desired point in the best way. What makes optimal stabilization policy in economics so difficult is our limited knowledge of the dynamic system. We may have misspecifiled the dynamic model underlying our optimization process. Even if we are fairly confvldent that the forms of the equations are correct, we are not sure of the numerical values of the coeffvlcients. Moreover, some crucial variables (such as the expected rate of price change) are unobservable; and we may obtain misleading estimates of these variables. Our controls operate through differential rather than through algebraic equations. The unemployment rate and the rate of price change are affected by aggregate demand and by cost factors. Aggregate demand may be affected by real balances and the real value of the federal interest plus non-interest bearing debt. However, our controls may be the rate of monetary expansion and the budget deElcit (surplus), which are the time rates of change of the variables affecting aggregate demand. Consequently, our controls cannot achieve the desired results directly but must work through a dynamic system. Fine tuning, or complete offsets of disturbances, is difficult at best. Another problem which bedevils us is the possibility of multiplicative stochastic