Optimal Control of Heteroscedastic Macroeconomic Models

Abstract

This paper analyses the implications of heteroscedasticity for optimal macroeconomic policy and welfare. We …nd that changes in the variance structure driven by exogenous processes like GARCH a¤ect welfare but not the optimal feedback rule. However, changes in the variance structure driven by state-dependent processes a¤ect 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 U.S. economy in which changes in volatility are driven by a GARCH process and the rate of in ‡ation

Nonlinear Business Cycle and Optimal Policy: A VSTAR Perspective

“…The federal funds rate responds to shocks more aggressively under the optimal monetary policy than under the actual response. See for examples Sack (2000), Polito and Wickens (2012), Polito and Spencer (2015).…”