The Design of Simple Optimal Policy Rules for Macroeconomic Stabilization with Application to the National Institute Model of the UK Economy

This study is concerned with the design of simple optimal stabilization rules for the control of real output and inflation when the economy is faced with uncertainty about the nature of unexpected shocks. It begins by underlying the policy design framework for economic systems and discusses the approach towards optimal policy formulation with large-scale models. However, in view of the practical difficulties encountered with solving large nonlinear models, the procedure for finding optimal rules has involved forming reduced size linear approximations and designing alternative rules based on the optimal control of the linear reductions. With linear representations it has also been possible to adopt a stochastic framework for policy design in which the object of policy is not only to maintain the stability of the system but also to achieve the desired long-term objectives when the system is subjected to stochastic shocks. Under this framework, using the National Institute model of the U.K. economy, a variety of simple, decoupled rules are developed with policy instruments, interest rates and tax rates, acting upon indicators such as the level of nominal or real GDP, the price level, the rate of inflation, the nominal or the real exchange rate, and other important variables. Also examined is the robustness of these rules with respect to uncertainty about the nature of underlying shocks, the sensitivity of policy designs to alternative exchange rate specifications, and the usefulness of the exchange rate as an indicator of policy. Some of the optimal rules are appraised by evaluating their performance on the nonlinear model and the results of policy evaluation indicate that these rules are bound to be stabilizing, a picture which conforms with the overall conclusions of policy design. Some implications of the study are finally noted.