Optimal financial policies in an open economy : the UK case
The object of this study is to examine the 'monetary instrument 1 problem, at both theoretical and empirical levels, using a framework in which 'domestic 1 and 'external 1 monetary policy are analysed concurrently. Our theoretical analysis generalises and extends some of the propositions on the stabilising properties of alternative financial policies in the case of a small open economy, subject to both internal and external shocks. An econometric model of the -U.K. economy is built to test these propositions. To get our results, we make use of an optimal control framework which employs an objective function depicting the desires of the policy makers, to yield optimal paths for the target variables as well as the policy variables. Most of the results are of the open-loop deterministic type, although we also approximate a closed-loop stochastic system by perturbing the system with certain shocks and optimizing again. Among the pegging regimens considered, the one involving targets for foreign reserves and the monetary aggregate seems to be preferable. However, the analysis also reveals that the policy makers should not adhere to the optimal rule, but should allow the paths of the intermediate targets to alter in response to new information as it becomes available. Since the quantitative results are model specific, the study should be regarded as demonstrating a methodology for the design of policy, rather than as offering actual policy guidance.