The Optimal Control of Heteroscedastic Macroeconomic Models

Vito Polito, Peter Spencer

Research output: Contribution to journalArticlepeer-review

Abstract

This paper analyses the implications of heteroscedasticity for optimal macroeconomic policy and welfare. We find that changes in the variance structure driven by exogenous processes like generalized autoregressive conditional heteroscedasticity (GARCH) affect welfare but not the optimal feedback rule. However, changes in the variance structure driven by state-dependent processes affect both. We also derive certainty-equivalent transformations of state-dependent volatility models that allow standard quadratic dynamic programming algorithms to be employed to study optimal policy. These results are illustrated numerically using a reduced-form model of the US economy in which changes in volatility are driven by a GARCH process and the rate of inflation. Copyright © 2015 John Wiley & Sons, Ltd.
Original languageEnglish
Pages (from-to)1430–1444
Number of pages15
JournalJournal of Applied Econometrics
Volume31
Issue number7
Early online date16 Sep 2015
DOIs
Publication statusPublished - 1 Dec 2016

Bibliographical note

© John Wiley and Sons 2015. This is an author produced version of a paper published in Journal of Applied Econometrics. Uploaded in accordance with the publisher's self-archiving policy.

Keywords

  • Heteroscedasticity GARCH optimal control

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