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Makin Source: Journal of Money, Credit and Banking, Vol. 10, No. 3 (Aug., 1978), pp. 371-377 Published by: Ohio State University Press Stable URL: http://www.jstor.org/stable/1991515 . Accessed: 28/03/2013 07:14

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University of Wisconsin-Milwaukee. MAKIN is associate professor of economics.theXoptimal control is derivedas a linear feedbackcontrol law that satisfiesthe Riccatiequation. 4.1The purposeof this paper is to develop a procedure. 13] assumethat the coefficientsof a quadraticcost functionalare known. University of JOHNH. Althoughthis applicationof the procedurefor solving the inverseproblemis for the relativelysimpletwo-goal. 9. 1 Kalman states: "It is truly astounding that this relation must be stated in the frequency-domain if it is to be reasonably simple" [5.220. Washington. solves for the coefficientsof a quadraticcost functionalfrom the linear optimal control law andthe lineardynamicsystem. 28 Mar 2013 07:14:03 AM All use subject to JSTOR Terms and Conditions .it is convenient if the relationship betweenthe coefficients of a quadratic cost functionalandthe linearcontrol law is expressedin the frequency domain.50/0 t 1978 OhiO State UniVerSitY PreSS JOURNAL OF MONEY.CREDIT. 11. 55].For purposesof solving the inverseproblem. 12. such an applicationis adequateto illustratethe power of the procedureand does yield. p.using Kalman'sequation in the frequency domain[5]. Obtainingan explicitanalyticalsolution of the Riccatiequationis a difficult task in general.a solutionto the inverseproblem enablesus to identifythe coefficients of a quadratic cost functionalfor whicha given control law is optimal.A Solution to the InverseProblemof OptimalControl A Note by YoshioNiho andJohnH. The inverseproblemof optimal control.In otherwords. nO. to solve the inverseproblemof optimalcontrolfor optimalstabilization policies in a deterministic world.on the other hand.AND BANKING. 2. 3. whichareimpliedby the observed behavior of the policyinstruments.vol. Introduction Investigations of optimal stabilizationpolicies.72. 10. as will be seenbelow. 3 (AUgUSt 1978) This content downloaded from 195. * We wish to thank an anonymous referee for helpful comments.134 on Thu. 10. Basedon this cost functionaland a lineardynamicsystem. Financial assistance from the Graduate School of the University of Wisconsin-Milwaukee is gratefully acknowledged.resultsthatappearto be quitereasonable forthe countriesinvolved. It is then demonstrated that the procedurecan readilybe appliedto the problemof obtainingvaluesforthe relative weightsassignedto goals of internaland externalbalanceby the United States andJapan.two-instrument case. Makin* 1.such as [1. YOSHIONIHO is associate professor of economics. 0022-2879/78/0878-0371$00.

R represents an equilibrium state of the above Riccati differential equation. .Q = rrt and d>(s) = (sI-A).AND BANKING 2. the optimalcontrollaw u*(t)is givenas (see [5. For an infinite time horizon problem.1. .220. 28 Mar 2013 07:14:03 AM All use subject to JSTOR Terms and Conditions . (3) where R is the unique positive definite solution of the following algebraic equation:3 A'R + RA-RBP.72.372 : MONEY. Hence. and K. 2 In order for the integral in (2) to converge. this result was obtained from observations over a relatively short. 3 For a finite time horizon problem. (6) where{M(s)}2= M'(-s)M(s).1B'R+ Q = O. t). Although our estimate of K in section 3 does not satisfy the stability condition. Procedure for SolvingtheInverseProblem of the Optimal Stabilization Policies Consider the problem of minimizing the quadratic cost functional (2). P = DD'. a necessary andsufficient conditionfor a controllaw (5) u(t)=-K'x(t) (S) to be an optimal control law u*(t)is that K satisfiesthe following Kalman's equationin the frequency domainfor all reals (see [5. this result does not necessarily imply the instability of the system for our infinite time horizon problem.and A and B are constantmatrices. p. .Equation (6) relatesQ and P with A. (4) The optimalcontrollaw given by equations(3) and (4) can also be expressed in the frequency domain[5]. 55]).1}2. Here. (1) (2) {u(t)3 J = JBO [X'(t)Qx(t) + u'(t)Pu(t)] dt. R must satisfy the Riccati differential equation R + A'R + RA-RBP- 1B'R + Q = O. subjectto the lineardynamicsystem(1):given x(t) = AX(t)+ BU(t).134 on Thu.1}2 = I + {U'@(s)BD . B. finite time period.2 If the dynamicsystem(1)is completelycontrollable and if x(t) is not identically equal to zero for t E [o. the matrix A-BK must satisfy the Routh-Hurwitz condition for stability. theorem4. Accordingly. 12]) u*(t)=-plB'Rx(t). Assumingthat the same conditionson the system (1)andx(t) aresatisfied.Q and P are positivedefinite. This content downloaded from 195. theorem5]): {I + DK'@(s)BD . R satisfies the algebraic equation (4) (see [5. CREDIT.

The targetof externalbalance unemployment forthe UnitedStateswas assumedto be a zerovalueof gold lossesand lncreases in short-termliabilitiesto foreigners(a zero liquiditydeficit). Business. if we let x denote the vector of the state variables. For the United States it was assumedthat Y grows at a rate of 0.65annually)5 quarterly rate was at a minimumfor the period underinvestigation the unemployment For Japanit was assumedthat Y grows at a rate of 1.NOTES.5 percent 5 Basedon the notionof "potential" U.4 Quarterly the vectorof the policygoals. Thestatevariables money supplym.08)t[0.it was felt that this variablerepresented hensive target.It is assumedthat 20 percentof lmportsare required and serviceitemsabroad.both in real terms.we estimatethe dynamicsystem (1) and the control law (5). and K.withgivenvaluesof C (seefn. quarterly(8 percentannually)with Y assumedto equal Y in 1964 when the ratewas at a low of 1.72.y' = (Y-Y.e.S. 10) fromequation 7 g(t) andm(t) areobtained fromthe observedvaluesof Y and B and the assumed and the valuesof y(t) that are determined valuesof Y and B.expressedin deviationsfromtheirdesired levels.This assumptionwas made to reflectthe level of imports to maintaina high realrateof growthof GNP. where Let y represent and the Y and B are the internaland externalbalancevariables. Monetary International perannumas proposedby the GNP growingat 3. Departmentof Commerce. For Japan. This content downloaded from 195.we have x' = (g.6 of goods and servicesrequired g.It seemslogicalto end the seriesjust before 4 Data werereadily fromgold and associated the majorexogenousshock resultingfromthe United Statesdeparture policiesbegunin August 1971. and expenditure government arethe policyinstruments.220.9 percent and that Y= Y in the second quarterof 1969when (3.5 percent). If the dynamicsystem is correctlyestimatedand if equation(6)willenableus to inferQ andP fromestimates estimatedu(t)= u*(t).because of the stateddesireof the United Statesoverthe periodunderinvestigation frequently to maintainthe reservecurrencyrole of the dollar. whereG and M are the values of G and M that availableas farbackas 1963. i. B-B).Ito 1971. COMMENTS.94percent (3.AND REPLIES : 373 In order to solve the inverseproblem. the external balancetargetwas assumedto be a tradebalancesurplusgrowingat a rate of 8 percentannually.16percent. balancevariableYwastakento be GNP in realterms. pp. costs of changingthe policy instruments datawereemployedforthe timeperiod1963. to the UnitedStatesandJapan 3. M-M).ly(t).I. of A. 81-83].II.Whereonly one domestic the most compregoal was specified.134 on Thu.m)= (G-G. B.includingas it does a notion of growth and full employment. 28 Mar 2013 07:14:03 AM All use subject to JSTOR Terms and Conditions . In bothcasesthe internal barsimplythe desired(ortarget)levelsof the variables.7Hence.respectively.B= [(real importsin 1964 yen) x (1. (7)as x(t) = C.20] with quarterly to purchaseinputs froma movingaverage. Councilof EconomicAdvisors[14.The data for the United Statesare from The Survey of Current and for Japan are from International Financial Statistics. An Application for solving the inverseproblemof optimal procedure Here we employ the Japanesedata to obtain estimates of the and American with control along domesticand externalbalanceand of the of to goals attached weights relative as impliedby theirobservedbehavior.. figuresobtained 6 For Japan. Fund.

1.72. we can solve for the coefficientsof the cost functional(9). However. or (c) the cost functional (9) with this discount rate was being minimized. and obtain informationon the coefficientsof the goal-instrument of the controllaw (S)K.whereQ= C'WC. The values for Japan were obtained by estimating a simple open macromodel (not in deviation forms). We employthe followingvaluesfor C:10 the coefficients . 9 The cost functional (2) can be made identically equal to zero by setting G = G and M = M in each period.11 _ ° 0. (b) the future costs were discounted by this rate.and sincethereis no motion of x(t) that makesx'(t)Qx(t) conequalto zero. Hence.374 : MONEY. once we links (7) C. is the best policy. With adjustment costs. however. (7) The controlvariablesare the time the constantcoefficients.thecostfunctional Since the condition for completecontrollabilityis triviallysatisfiedfor the + u'(t)Pu(t) system(8). The cost functionalis assumedto be8 + u'(t)Pu(t)] dt. J = g0 [y'(t)Wy(t) (9) (8) where W= [a2 a2] representsthe weights attachedto the policy goals and into When(7) is substituted the instruments. this policy is not optimal (unless G = G and M = M in the initial period (see [4]) 10 These values for the United States were derived from a model employed to simulate an open macromodel (see [7]). p = [gl p2] the costs of changing in theformof equation(2). rate of change x(t)= u(t).204 _ C .134 on Thu.once C is given. but the system was misspecified. canbe written (9).995 UnitedStates:C = _ 01714 0. in fact.we obtainQ andP in termsof K as PA182 t:2J _ plk2l _plkllk21 + p2k22 + A2kl2k22 k22 k21 plkllk21 plk2l + A2kl2k22 + p2k22 _ Given Q. We assumethe followinggoal-instrument y(t)= Cx(t). 28 Mar 2013 07:14:03 AM All use subject to JSTOR Terms and Conditions . but the cost functional (9) was not being minimized.9equation(6) providesa necessaryand sufficient identically dition for the control law (S) to be optimal. in the instruments.9155-0. This content downloaded from 195. the results with the discount rate equal to S percent did not satisfy the condition that W be positive definite for both the United States and Japan. If there is no cost of adjusting policy instruments.we can obtain W fromQ = C'WC.AND BANKING links: are associatedwith Y and B.2. CREDIT. whereC represents namely.784- 8 We can easily extend the analysis to solve the case where future costs are discounted. this.220.Equatingpowers of s across the equalitysignof equation(6). This implies the following possibilities: (a) the future costs were actually not discounted by this rate.

212708 0.11 Japan Unlted States x1: internal balance °62 interaction external balance OC3: A1: cost of adjusting g .157994 The relativeweightsof the cost functional(9) obtainedwith these values of K and C are given in Table 1. This is not particularly surprising since the Bank of Japan has controlled the money supply largely by lending policy rather than by means of open market operations. g(t) and m(t). AND REPLIES : 375 Similarly. All of the coefficients are found significant at the 5 percent level.317497 0.B2: cost of adjusting m 1 -0. the home countryperceived relativeimportanceassignedto the externalbalancegoal for Japan perhaps reflectsthe crucialrole played by importsof goods and servicesas inputs to economyduringthe periodunder of the Japanese the high level of performance 1l The time rate of change is approximated by a discrete change of a variable over a period. The lending policy represents a somewhat arbitrary restriction on the quantity of funds available to banks and our evidence that it is a relatively costly policy procedure is consistent with the views of some Japanese economists.by regressingthe time rate of change for each of the instruments.347 0. This content downloaded from 195. 28 Mar 2013 07:14:03 AM All use subject to JSTOR Terms and Conditions .173 0.g(t) and m(t).12 is considerably cost of adjustingboth instruments TABLE 1 ANDCOSTS WEIGHTS POLICY RELATIVE FOR ADJUSTMENTS OFPOLICY ANDJAPAN STATES UNITED THE 1963.3 1 -0. indicating a higher cost of changing instrument values.562 0. 8] ). COMMENTS.the implied higherin Japan.0 26.119354 -0.16184 K= Jcapun: .the domesticgoal gets the heaviestweightin both sector goal gets a heavierweight relative countries.338 2.Three main observations emergefromTable 1.on theirlevels. The smaller absolute values of K for Japan suggest that adjustments to deviations from targets are accomplished more slowly.317 0.0.. 1 The value of . The relative wetightsobtained guaranteethat both W and P are positive definite.220. They are normalizedon the weightassignedto the domestic goal and adjustedfor the scale of each of the other targets or instrumentsrelative to the domestic goal.we obtain the followingvalues of K for the controllaw (5):1l United States K = 0 573263 -1. First.second. (see [6. and third. the international to the domesticgoal in Japanthan in the United States.B2 reported in Table 1 for Japan indicates that the cost of adjusting monetary policy is approximately thirteen times the cost of adjusting government expenditure.33606 * 0. relative to the importance of goals.1.134 on Thu.NOTES.432 to in view of the primaryresponsibility The first resultis hardlysurprising The higher fornationaleconomicpolicymanagers.515337 .72.I-1972. in Japan.

AND BANKING investigation. of course.220.it is particularly useful to see what the actions of policy makersimply about their desires.S. Concluding Failureto achievepolicytargetsmaybe dueeitherto inabilityor to unwillingaction. as an alternative appealing hereis extremely developed Thoughthe procedure to the potentiallymisleadingapproachof attemptingto ascertainthe desires of policy makersthroughdirect questioning. herefor solvingthe developed procedure the resultstoo literally. of K inappropriate. Our approach ness on the part of policy makersto take appropriate such causesof policy failure.Properspecification upon policy goals is. This content downloaded from 195. of the goal-instrument fromspecifications and uncertainty if even functional objective the possibilityof misestimationof the weights in policy makers may actually be viewed as attemptingto minimize the cost viewed functionalgiven by equation(9). Gregory.thus makingour estimates which cautionagainsttaking Despite these qualifications. "OptimalStochastic Control of LinearEconomic Systems. be mutuallyinconsistenttargets.134 on Thu. 28 Mar 2013 07:14:03 AM All use subject to JSTOR Terms and Conditions .13 (February 1972). 3 (August 1970). . Credit.it is importantto bear in mind some of the limitationsof the particularform of the solution to the inverse of the model describing problemthat we have employed.Also." International of Money.receiving. CREDIT.necessaryto the impactof policy instruments estimatesof the weightsin the objectivefunctionalof the policy obtainaccurate lags maker.72.Sincethe systememployedin theirpaperomitspossibledistributed a exists there links. parameters by the structural and upon directobservationof what the policy makerdoes.K(t) in the control law is no longer constant. as implied based only upon information of the economicsystemwithinwhichhe operates. if optimizationis appropriately employed horizon time infinite the over than over a finitetime horizon.The implied relative weight attached to the goal of external balancefor the United States suggeststhat the goal of ending the growth of the short-termU.as it did. in fact. "Optimal Control of Linear Economic Systems with Finite Time Review.A solution to the inverseproblemof optimal control providessuch information about what the policy makercan do. Economic Horizon. liabilities in foreign hands was taken seriously in the 1963-71 period. 16-25."Journal 2.376 : MONEY.In cases providesa meansto beginto disentangle wherethereexist heavy demandson the limitedresourcesof policy makersto obtain what may. our numerical for the investigator tool a useful represents control optimal of problem inverse the implications upon based makers policy of objectives true the seekingto judge say. they what of value face the upon than do rather of what they LITERATURE CITED 1.rather here. Chow. andBanking. nearlyone-thirdof the weight given to a domesticgoal of output growth and full employment. 291-302. Remarks 4.

137-48. S. 7. 8."Optimal Policiesfor EconomicStabilization. 11. February1974. 13. Kinyuron[Monetary Markets and Policy].525-62. 6.S." Econometrica. "Optimal Stabilization Policiesfor Deterministic and Stochastic Linear Economic Systems.Jerome. and Stephen Turnovsky. "WhenIs a LinearControlSystemOptimal?' Journal of Basic Engineering.and EttoreInfante."Mimeographed. John. "Optimal Macroeconomic PolicyAdjustmentunderConditions of Risk. Credit. Makin. "TheStability Properties of Optimal Economic Policies. Kalman."Optimal Stabilization Paths. Councilof Economic Advisors. 4 (February 1972). Keizaijiten [Annalsof Economics]. . COMMENTS. 58-71. 10. 4. Sengupta."Journalof Economic Theory. and Banking. "Problems of EconomicPolicy from the Viewpointof OptimalControl.Tokyo. 28 Mar 2013 07:14:03 AM All use subject to JSTOR Terms and Conditions .Robert. 1964. U.Rudolf.January 1965. ' Review of Economic Studies. University of Wisconsin-Milwaukee. 5. . 79-95. I.51-60.86 (March1964). 12. 63 (December 1973).AND REPLIES : 377 3." American Economic Review. 40 (January 1973). 37 (January 1970).127-46. 1962. 5 (February 1973). "OptimalStabilization Policy with a QuadraticCriterion Function.529-60. 14. Kurebayashi.134 on Thu. Tokyo." AmericanEconomic Review. Nakayama."Journalof Money. 9." Review of Economic Studies. EconomicReport of the President.220. Henderson. 64 (March1974).825-37. This content downloaded from 195. Stein. 41 (May 1973).Jati Kumar. Turnovsky.NOTES. Stephen. Pindyck. Dale.72. "Alternative ExchangeRate ManagementSystems:A Simulation Study.

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