Professional Documents
Culture Documents
Harjoat S. Bhamra
Imperial College
2015
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 1 / 65
1 Quantitative Easing
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 2 / 65
Quantitative Easing
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 3 / 65
Quantitative Easing
N
X Mt
HtCB = WB,t
CB
+ CB
Wi,t − (1)
Pt
i=1
N
CB CB
X
CB Mt
Ht+dt = WB,t (1 + rt dt) + Wi,t (1 + dRi,t ) − (1 − πt dt) + (Tt − Gt )dt
Pt
i=1
(2)
N
X Mt
dHtCB = WB,t
CB
rt dt + CB
Wi,t dRi,t + πt dt + (Tt − Gt )dt (3)
Pt
i=1
N
X Mt
dHtCB = HtCB rt dt + CB
Wi,t (dRi,t − rt dt) + (rt + πt )dt + (Tt − Gt )dt (4)
Pt
i=1
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 4 / 65
Stochastic Control Theory Hamilton-Jacobi-Bellman Equations and the Stochastic Maximum Principle
t ∈ T = [0, ∞)
We have a 1-d state1 , s, which evolves over time according to the following stochastic law
of motion
ds(t) = f (s(t), c(t))dt + σ(s(t), c(t))dZ (t) (5)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 5 / 65
Stochastic Control Theory Hamilton-Jacobi-Bellman Equations and the Stochastic Maximum Principle
HJB equation
1 00
0 = sup u(s(t), c(t)) − ρJ(s(t)) + J 0 (s(t))f (s(t), c(t)) + J (s(t))(σ(s(t), c(t)))2 (9)
c(t) 2
1
H(s(t), c(t), λ(t), φ(t)) = u(s(t), c(t)) + λ(t)f (s(t), c(t)) + φ(t)σ(s(t), c(t))2 (10)
2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 7 / 65
Stochastic Control Theory Hamilton-Jacobi-Bellman Equations and the Stochastic Maximum Principle
1 00
0 = sup u(s(t), c(t)) − ρJ(s(t)) + J 0 (s(t))f (s(t), c(t)) + J (s(t))(σ(s(t), c(t)))2 (14)
c(t) 2
uc (s(t), c(t)) = J 0 (s(t))fc (s(t), c(t)) + J 00 (s(t))σ(s(t), c(t))σs (s(t), c(t)) (15)
Solving the above equation gives the date-t value of the optimal control in terms of the
date-t state and the derivative of the value function.
To find the value function, substitute the optimal control, c ∗ (t) into the HJB to get a
second order nonlinear ordinary differential equation (no longer need the sup)
1 00
0 = u(s(t), c ∗ (t)) − ρJ(s(t)) + J 0 (s(t))f (s(t), c ∗ (t)) + J (s(t))(σ(s(t), c ∗ (t)))2 (16)
2
How do we solve the above nonlinear ode?
Does not generally have a closed-form solution – need numerical methods
Do not have boundary conditions – need a new concept of what a solution to a
differential equation is – viscosity solution – shall understand this informally when we
study finite difference methods
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 8 / 65
Stochastic Control Theory Bellman’s Principle of Optimality and the Hamilton-Jacobi-Bellman Equation
Principle of Optimality: An optimal policy has the property that whatever the
initial state and initial decision are, the remaining decisions must constitute an
optimal policy with regard to the state resulting from the first decision. (See
Bellman, 1957, Chap. III.3.)
Key conceptual difference relative to Pontryagin’s Maximum Principle
Think of the control a function of the state.
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 9 / 65
Stochastic Control Theory Bellman’s Principle of Optimality and the Hamilton-Jacobi-Bellman Equation
Z t+dt
J(s(t)) = sup Et e −ρ(u−t) u(s(u), c(u))du (17)
c(u)u≥t t
Z ∞
+ e −ρdt Et Et+dt e −ρ(u−[t+dt]) u(s(u), c(u))du (18)
t+dt
For our infinite horizon problem, where the law of motion for the state does not depend explicitly on time, we can go even further: thinking of the control
as a map from the state to the reals, it so happens that the map is time invariant, i.e. ∀t ∈ T , (cut (s))u≥t , for each u ≥ t, we have cut (s) = c(s)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 10 / 65
Stochastic Control Theory Bellman’s Principle of Optimality and the Hamilton-Jacobi-Bellman Equation
Exploiting the Principle of Optimality reveals a recursive structure for the value function
Z t+dt
J(s(t)) = sup Et Et e −ρ(u−t) u(s(u), c(u))du
c(u)u∈[t,t+dt) t
Z ∞
+e −ρdt sup Et+dt e −ρ(u−[t+dt]) u(s(u), c(u))du (19)
c(u)u≥t+dt t+dt
| {z }
J(s(t+dt))
To derive the HJB equation we just need to indulge in some Stochastic Calculus. First observe
that
Z t+dt
Et e −ρ(u−t) u(s(u), c(u))du = u(s(t), c(t))dt + o(dt) (20)
t
h i
h(t)
h(t) = o(j(t)) ⇐⇒ limt→0 j(t)
=0
The Et is important – it kills off dZ (t) terms!
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 11 / 65
Stochastic Control Theory Bellman’s Principle of Optimality and the Hamilton-Jacobi-Bellman Equation
Hence
Now
and so
J(s(t)) = sup u(s(t), c(t))dt + Et J(s(t + dt)) − ρdtEt J(s(t + dt)) + o(dt) (23)
c(u)u∈[t,t+dt)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 12 / 65
Stochastic Control Theory Bellman’s Principle of Optimality and the Hamilton-Jacobi-Bellman Equation
Now
J(s(t + dt)) = J(s(t)) + dJ(s(t)) (25)
1
= J(s(t)) + J (s(t))Et ds(t) + J 00 (s(t))Et [(ds(t))2 ] + o(dt)
0
(26)
2
1
= J(s(t)) + J 0 (s(t))f (s(t), c(t))dt + J 00 (s(t))(σ(s(t), c(t)))2 + o(dt) (27)
2
(28)
and so
1
0 = sup u(s(t), c(t)) − ρJ(s(t)) + J 0 (s(t))f (s(t), c(t)) + J 00 (s(t))(σ(s(t), c(t)))2 dt + o(dt)
c(t) 2
(29)
In the continuous time limit, we obtain
1 00
0 = sup u(s(t), c(t)) − ρJ(s(t)) + J 0 (s(t))f (s(t), c(t)) + J (s(t))(σ(s(t), c(t)))2 (30)
c(t) 2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 13 / 65
Stochastic Control Theory Stochastic Maximum Principle
For the deterministic case, it was fairly straightforward to see the connection between
Pontrayagin’s Maximum Principle and the Hamilton-Jacobi-Bellman Equation. In the stochastic
case, the mathematics is more challenging, so I give a heuristic overview.
The main idea of interest to us is that the Hamiltonian needs to be adjusted for risk – this is
very intuitive for financial economists. In the deterministic case, the Hamiltonian included the
‘expected return’ given a particular control. In the stochastic case, we need to subtract the
‘variance’.
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 14 / 65
Stochastic Control Theory Stochastic Maximum Principle
Equation (32) is a forward sde, while (33) is a backward sde. If they cannot be uncoupled they
constitute a forward-backward sde (FBSDE) system.
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 15 / 65
Stochastic Control Theory Stochastic Maximum Principle
One way to try and get a solution is to take the conditional expectation of
the backward sde, treat λ as a function of the state and the use Ito’s Lemma
to derive a differential equation for λ.
The differential equation for λ can be used in conjunction with the
Feynman-Kac Theorem to obtain a probabilistic solution for λ
See Ma & Yong (2008) for a thorough treatment of FBSDE’s.
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 16 / 65
Stochastic Control Theory Stochastic Maximum Principle
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 17 / 65
Stochastic Control Theory Stochastic Maximum Principle
Start by noting that at the optimum, where c(t) = c ∗ (s(t)), the HJB becomes the following ode
0 = H(s(t), c ∗ (s(t)), J 0 (s(t)), J 00 (s(t))) − ρJ(s(t)) (36)
Differentiate the ode wrt to s(t) and use the fact that Hc (s(t), c ∗ (s(t)), J 0 (s(t)), J 00 (s(t))) =0
=0
z }| { ∂c ∗ (s(t))
∗ 0 00
0 = Hs (s(t), c (s(t)), J (s(t)), J (s(t))) + Hc (s(t), c ∗ (s(t)), λ(t), φ(t)) (37)
∂s(t)
+ Hλ (s(t), c ∗ (s(t)), J 0 (s(t)), J 00 (s(t))) J 00 (s(t)) (38)
| {z }
=f (s(t),c ∗ (t))
∂λ(t)
Remember the identification λ(t) = J 0 (s(t)), which implies ∂s(t)
= J 00 (s(t))
∂λ(t) 1 ∂ 2 λ(t)
0 = Hs (s(t), c ∗ (s(t)), λ(t)) + f (s(t), c ∗ (t)) + σ(s(t), c ∗ (t))2 − ρλ(t) (40)
∂s(t) 2 ∂s(t)2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 18 / 65
Stochastic Control Theory Stochastic Maximum Principle
Noting that
∂λ(t) 1 ∂ 2 λ(t)
dλ(t) = ds(t) + (ds(t))2 (41)
∂s(t) 2 ∂s(t)2
1 ∂ 2 λ(t)
∂λ(t)
= f (s(t), c ∗ (t)) + 2
σ(s(t), c ∗ (t))2 dt (42)
∂s(t) 2 ∂s(t)
∂λ(t) ∗
+ σ(s(t), c (t))dZ (t), (43)
∂s(t)
we obtain
dλ(t)
0 = Hs (s(t), c ∗ (s(t)), λ(t)) + Et − ρλ(t) (44)
dt
and hence by treating λ(t) as a function of s(t) and using Ito’s Lemma
∂λ(t)
σ(s(t), c ∗ (t))dZ (t) = Hs (s(t), c ∗ (s(t)), λ(t))dt + dλ(t) − ρλ(t)dt (45)
∂s(t)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 19 / 65
Applying the Stochastic Maximum Principle to the CIR Model Model Outline
Model
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 20 / 65
Applying the Stochastic Maximum Principle to the CIR Model Model Outline
Underlying economics I
Yt = Ct + It (50)
The rate of output is sum of the consumption rate and the investment flow
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 21 / 65
Applying the Stochastic Maximum Principle to the CIR Model Model Outline
Underlying economics II
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 22 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
where µ = A − 21 σ 2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 23 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
HJB equation
where
e (1−γ)ct 1
H(kt , ct , Λt , Φt ) = + (µ − e ct −kt )Λt + σ 2 Φt (59)
1−γ 2
FOC for c
Hc = 0 (60)
(1−γ)c c−k
e =e Λ (61)
−γc −k
e =e Λ (62)
k−γc
Λ=e (63)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 24 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
1 1
e c = e γ k Λ− γ (64)
Differentiate HJB eqn wrt k
∂c ∗ ∂Λ ∂Φ
0 = Hc + Hk + HΛ + HΦ − ρΛ (66)
∂k ∂k ∂k
∂Λ ∂Φ
0 = Hk + HΛ + HΦ − ρΛ (67)
∂k ∂k
dΛ
0 = H k + Et − ρΛ (68)
dt
dΛ = (ρΛ − Hk )dt + ΦσdZ (69)
(70)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 25 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
∂Λ
where Φ = ∂k . Last step – used Ito’s Lemma
dΛ = ρ − e −(1− γ )k Λ− γ Λdt + ΦσdZ
1 1
(71)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 26 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
Deriving FBSDE I
forward-backward sde (FBSDE) system
forward sde
1
1 k
− 1− γ t
−γ
dkt = µ − e Λt dt + σdZt , given k0 (72)
backward sde
1
∂Λt
1 k
− 1− γ −γ
dΛt = ρ−e t
Λt Λt dt +Φt σdZ , Φt = , lim e −ρT E0 [ΛT ] = 0
∂kt T →∞
(73)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 27 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
Deriving FBSDE II
Change of variables: λ = ln Λ
forward sde
−1
1 k
− 1− γ
dkt = µ−e t
Λt γ dt + σdZt , given k0 (74)
backward sde
2 !
1 ∂λt ∂λt
1 k
− 1− γ 1λ
2 t −γ t
dλt = ρ− σ −e e dt + σdZ
2 ∂kt ∂kt
(75)
−ρT λT
lim e E0 [e ]=0 (76)
T →∞
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 28 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
FBSDE
forward sde
1 k
− 1− γ 1λ
t −γ t
dkt = µ−e e dt + σdZt , given k0 (77)
backward sde
2 !
1 ∂λt ∂λt
1 k
− 1− γ 1λ
−γ
dλt = ρ− 2
σ −e t
e t
dt+ σdZ , lim e −ρT E0 [e λT ]
2 ∂kt ∂kt T →∞
(78)
Ansatz: λt = a0 + a1 kt
dkt = µ − e −(1− γ )kt e − γ (a0 +a1 kt ) dt + σdZt
1 1
(79)
1 2 2 −(1− γ1 )kt − γ1 (a0 +a1 kt )
dλt = ρ − a1 σ − e e dt + a1 σdZ (80)
2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 29 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
1
ρ − a12 σ 2 − a1 µ = (1 − a1 )e −(1− γ )k− γ a1 k e − γ a0
1 1 1
(81)
2
Two possibilities
RHS is function of k ⇒ no solution for most parameter values
RHS is constant ⇒ a1 = 1 − γ &
−1a 1 1 1
e γ 0 = ρ+ 1− A − γσ 2 (82)
γ γ 2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 30 / 65
Applying the Stochastic Maximum Principle to the CIR Model Solution
1 1 1
λt = −γ ln ρ+ 1− A − γσ 2 + (1 − γ)kt (83)
γ γ 2
−γ
1 1 1 2
Λt = ρ+ 1− A − γσ Kt1−γ (84)
γ γ 2
and
dKt 1 1 1 2
= (A − ρ) + 1 − γσ dt + σdZt , given K0 (85)
Kt γ γ 2
2
K =K e γ [ 1
(A−ρ)+ (1− )
1 1
γ 2 γσ ]t e − 21 σ2 t+σZt (86)
t 0
Z ∞
Jt = sup Et f (Cu , Ju )du (88)
(Cu )u≥t t
where
c
f (c, v ) = ρ(h−1 (v ))1−γ u (89)
h−1 (v )
x 1−γ
h(x) = (90)
1−γ
1
1− ψ
x −1
u(x) = 1
(91)
1− ψ
s.t.
dKt = (It − δKt )dt + σKt dZt , (92)
where
It + C t = Y t (93)
and
Yt = AKtα (94)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 32 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
HJB Equation
HJB equation
1 2 2 00
sup f (Ct , Jt ) + J 0 (Kt )(AKtα − δKt − Ct ) + σ Kt J (Kt ) (95)
Ct 2
FOC (drop excessive notation, such as t-subscript and K -argument)
1
− γ− ψ 1
−ψ
ρ(h−1 (J)) C = J0 (96)
Make a transformation
e (1−γ)g (k)
J= (97)
1−γ
k = ln K (98)
Note that while J 0 = ∂K J, g 0 = ∂k g , so we obtain
J 0 = e (1−γ)g −k g 0 (99)
00 (1−γ)g −2k 00 0 2 0
J =e (g − (γ − 1)(g ) − g ) (100)
C
f (C , J) = ρe (1−γ)g u (101)
eg
The HJB reduces to the following nonlinear second order ode
1
0 = ρu C ∗ e −g + Ae −(1−α)k − δ − C ∗ e −k g 0 (k) + σ 2 (g 00 − (γ − 1)(g 0 )2 − g 0 ), (102)
2
where C ∗ denotes the optimal consumption rate. From the FOC, we can see that
C ∗ = [ρe k (g 0 )−1 ]ψ e (1−ψ)g (103)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 33 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
ρψ [e k e −g (g 0 )−1 ]ψ−1 ρψ
= − (107)
ψ−1 ψ−1
C ∗ e −g g 0 ρψ
= − (108)
ψ−1 ψ−1
The ode can thus be rewritten as
1 1
0 = βψ − (ψ − 1) Ae −(1−α)k − δ + σ 2 + C ∗ e −g ∂k − (ψ − 1)σ 2 ∂kk g (109)
2 2
1 2 0 2
+ σ (γ − 1)(ψ − 1)(g ) (110)
2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 34 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
k̂ = k − k|dss (111)
Observe that
e −(1−α)k = e −(1−α)(kdss +k̂) = e −(1−α)kdss [1 − (1 − α)k̂] + O(k̂ 2 ) (112)
and
∗
C ∗ e −g = e c −g
= e cdss −gdss + [c ∗ − g − (cdss − gdss )]e cdss −gdss + O([c ∗ − g − (cdss − gdss )]2 )
(113)
= [1 − (cdss − gdss )]e cdss −gdss + (c ∗ − g )e cdss −gdss + O([c ∗ − g − (cdss − gdss )]2 ) (114)
From
C ∗ e −g = [ρe k e −g (g 0 )−1 ]ψ , (115)
we have
c ∗ − g = ψ[ln ρ + k − g − ln ∂k̂ g ] (116)
and so
C ∗ e −g = [1 − (cdss − gdss )]e cdss −gdss + ψ[ln ρ + k − g − ln ∂k̂ g ]e cdss −gdss (117)
∗ 2
+ O([c − g − (cdss − gdss )] ) (118)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 35 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
1
0= βψ − (ψ − 1) Ae −(1−α)kdss (1 − (1 − α)k̂) − δ + σ 2 + C ∗ e −g ∂k (120)
2
1
− (ψ − 1)σ 2 ∂kk g (121)
2
1
+ σ 2 (γ − 1)(ψ − 1)(g 0 )2 (122)
2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 36 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
Numerical Solution I
For the numerical solution, I shall solve for J, but use k = ln K as the underlying state variable.
(this turns out to be better than (g , k) and (J, K ))
∂K J = e −k ∂k J (123)
∂KK J = −e −2k ∂k J + e −2k ∂kk J (124)
The HJB equation thus becomes
1 1
sup f (C , J) + Ae −(1−α)k − δ + σ 2 − Ce −k ∂k J + σ 2 ∂kk J (125)
C 2 2
The FOC is
1
− γ− ψ 1
−ψ
ρ(h−1 (J)) C = e −k ∂k J (126)
Hence
1
−ψ γ− ψ
ρψ (h−1 (J)) C −1 = e −ψk (∂k J)ψ (127)
1
ψ γ− ψ
−1 −ψ −ψk ψ −1
C =ρ e (∂k J) (h (J)) (128)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 37 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
Numerical Solution II
1
1− ψ 1 −1
ρ[h−1 (J)]1−γ [C h−1 (J)] ψ − 1]
f (C , J) = 1
(129)
1− ψ
1 )
−(γ− ψ 1
1− ψ
ρ[h−1 (J)] C − ρ[h−1 (J)]1−γ
= 1
(130)
1− ψ
Ce −k ∂k J − ρ(1 − γ)J
= 1
(131)
1− ψ
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 38 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
Ce −k ∂k J − ρ(1 − γ)J
1 1
1
+ Ae −(1−α)k − δ + σ 2 − Ce −k ∂k J + σ 2 ∂kk J (132)
1− ψ
2 2
The optimal control C is a function of the first derivative of the value function, so using
the upwind approximation
C U (n) = C F (n)I{D F (n)>0} + C ss (n)I{D F (n)<0,D B (n)>0} + C B (n)I{D B (n)<0} (136)
Here we are making use of the steady-state, which we are essentially using as a boundary
condition.
For the second derivative
J(n + 1) − 2J(n) − J(n − 1)
∂kk J = (141)
(∆k)2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 40 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
J(n + 1) − J(n)
0 =f (n) + D F (n) · I{D F (n)>0} (142)
∆k
B J(n) − J(n − 1)
+ D (n) · I{D B (n)>0} (143)
∆k
1 2 J(n + 1) − 2J(n) − J(n − 1)
+ σ , (144)
2 (∆k)2
where
C U (n)e −k ∂kU J(n) − ρ(1 − γ)J(n)
f (n) = f (C U (n), J(n)) = 1
(145)
1− ψ
and
C U (n) = C F (n)I{D U (n)>0} + C ss (n)I{D U (n)<0,D B (n)>0} + C B (n)I{D B (n)<0} (146)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 41 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
J(n)i+1 − J i (n)
=f (n) + x(n)J(n − 1) + y (n)J(n) + z(n)J(n + 1) (153)
∆
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 42 / 65
Applying HJB Equation to Solve Stochastic Growth Model Solution
In matrix form, it is clear that we can obtain J i+1 directly from J i without matrix inversion.
In matrix form
(I − ∆A) J i+1 = ∆ f + J i (156)
We must invert the matrix I − ∆A to obtain tje updated solution – this is why the method
is implicit.
Which method to use? Implicit methods are more stable in the sense that they converge
more rapidly for a given step-size, ∆.
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 43 / 65
Basic New Keynesian Model with Risk Model
Model I
Representative household
Z ∞
Nu1+ϕ
−δ(u−t)
Et e ln Cu − du (157)
t 1+ϕ
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 44 / 65
Basic New Keynesian Model with Risk Model
Model II
Ct (i)dt is the quantity of good i consumed by the household over the interval
[t, t + dt).
Can show that:
nominal expenditure on consumption aggregates nicely
Z 1
Pt C t = Pt (i)Ct (i)di (160)
0
where
1
Z 1 1−
Pt = Pt (i)1− di (161)
0
−
Pt (i)
∀i ∈ [0, 1], Ct (i) = Ct (162)
Pt
Model III
Lagrangian
!
∞
N 1+ϕ ∞
Z Z
Wt
L = Et e −δt
ln Ct − t dt − κ Λt Ct − Nt dt (164)
0 1+ϕ 0 Pt
FOC’s
consumption
Wt
e −δt Ntϕ = κΛt (166)
Pt
Implications of FOC’s
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 46 / 65
Basic New Keynesian Model with Risk Model
Model IV
SDF process
−1
Cu Λu
e −δ(u−t) = (167)
Ct Λt
consumption-labor
Wt
Ntϕ Ct = (168)
Pt
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 47 / 65
Basic New Keynesian Model with Risk Model
real firm value is the above nominal value dividend by Pt , the aggregate price
index
Nominal profit flow function
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 48 / 65
Basic New Keynesian Model with Risk Model
" 1− #
Pt (j) Wt Pt (i)
Πt (j) = − Pt Yt (172)
Pt At Pt Pt
" 2 #
∞
Λ$u
Z
Wu − 1 µu
sup Et Pu Yu xu1− − xu −1
Pt − θ du (173)
µt t Λ$t Au 2 xu
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 49 / 65
Basic New Keynesian Model with Risk Model
x is the state variable, which is the price of the good produced by the firm
µ, the rate of change of the state variable, is the control
assuming price is locally deterministic, i.e. no volatility
Rewrite objective function
" 2 #
∞
Λ$u Pu Yu
Z
Wu − 1 µu
Pt Yt sup Et xu1− − xu −1
Pt − θ du
µt t Λ$t Pt Yt Au 2 xu
(175)
" 2 #
Z ∞
Λu Yu Wu − 1 µu
Pt Yt sup Et xu1− − x −1
Pt − θ du (176)
µt t Λt Yt Au u 2 xu
Λu Yu
With log utility over intermediate consumption, Λt Yt = e −δ(u−t)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 50 / 65
Basic New Keynesian Model with Risk Model
" 2 #
Z ∞
−δ(u−t) Wu − 1 µu
Yt sup Et e xu1− − xu −1
Pt − θ du (177)
µt t Au 2 xu
Value function
" 2 #
Z ∞
−
Ru
ks ds Wu − 1 µu
Jt = sup Et e t xu1− − xu −1
Pu − θ du (178)
µt t Au 2 xu
Hamiltonian
2
Wt − 1 µt dJt
H= xt1− − x −1
Pt − θ + Et (179)
At t 2 xt dt
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 51 / 65
Basic New Keynesian Model with Risk Model
HJB equation
FOC wrt µ
Hµ = 0 (181)
µ
Jx = θ 2 (182)
x
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 52 / 65
Basic New Keynesian Model with Risk Model
∂µ
0 = Hµ + Hx − kJx (183)
∂x
0 = Hx − kJx (184)
" 2 #
1− Wt − −1 1 µt d
0 = ∂x xt − xt Pt − θ − kJx − Et Jx (185)
At 2 xt dt
Define Φ = Jx
W dΦ
0 = ( − 1)x − − 1 P −1 + θµ2 x −3 + Et − δΦ (186)
− 1 Ax dt
µ
Φ=θ (187)
x2
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 53 / 65
Basic New Keynesian Model with Risk Model
W dΦ
0 = ( − 1) − 1 P −1 + θπ 2 P −1 + Et − δΦ (188)
− 1 AP dt
Φ = θπP −1 (189)
Wt
Pt = (190)
− 1 At
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 54 / 65
Basic New Keynesian Model with Risk Model
π
dΦ = θd (191)
P(
2 )
dP dP dP
= θP −1 dπ − π − dπ +π (192)
P P P
dΦ = θP −1 dπ − π 2 dt
(193)
Hence obtain real wage rate in terms of technology level and inflation
−1 Wt dπt
− 1 + Et − δπt = 0, (194)
θ − 1 Pt At dt
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 55 / 65
Basic New Keynesian Model with Risk Model
Bond Pricing
it = rt + πt (195)
Real interest rate
rt = δ + µY ,t − σY2 ,t , (196)
dYt
Et = µY ,t dt (197)
Yt
" 2 #
dYt
Et = σY2 ,t dt (198)
Yt
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 56 / 65
Basic New Keynesian Model with Risk Equilibrium
Summary
From household’s FOC’s
−1
Cu Λu
e −δu = (199)
Ct Λt
W t
Ntϕ Ct = (200)
Pt
From firm’s FOC’s
−1 Wt dπt
− 1 + Et − δπt = 0, (201)
θ − 1 Pt At dt
From bond pricing
it = rt + πt (202)
rt = δ + µY ,t − σY2 ,t (203)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 57 / 65
Basic New Keynesian Model with Risk Equilibrium
W N ϕC N ϕ NA
= = = N 1+ϕ = e (1+ϕ)(y −a) (204)
PA A A
and so
−1 (1+ϕ)(yt −at ) dπt
e − 1 + Et − δπt = 0, (205)
θ −1 dt
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 58 / 65
Basic New Keynesian Model with Risk Equilibrium
− 1 (1+ϕ)xt dπt
0= e − 1 + Et − δπt , (206)
θ dt
where
Y
x = ln X = ln
, (207)
Yn
where Y n is natural output flow, i.e. output flow in the economy with no
price adjustment costs (θ = 0)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 59 / 65
Basic New Keynesian Model with Risk Equilibrium
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 60 / 65
Basic New Keynesian Model with Risk Equilibrium
FBSDE
− 1 (1+ϕ)xt ∂πt
dπt = δπt dt − e − 1 dt + dZx,t lim Et [e −δ(T −t) πT ] = 0
θ ∂xt T →∞
(212)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 61 / 65
Basic New Keynesian Model with Risk Equilibrium
Make nominal interest rate rule depend on current inflation and output gap
it = v (πt , xt ) (213)
Obtain a system of stochastic differential equations to pin down outgap and
inflation
forward sde for output gap
1 2
dxt = (v (πt , xt ) − r n − πt + σx,t )dt + σx dZx,t , x0 given (214)
2
backward sde for inflation
− 1 (1+ϕ)xt ∂πt
dπt = δπt dt − e − 1 dt + dZx,t lim Et [e −δ(T −t) πT ] = 0
θ ∂xt T →∞
(215)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 62 / 65
Basic New Keynesian Model with Risk Equilibrium
1 2
dxt = (a + (φπ − 1)π + φx x − r n + σx,t )dt + σx dZx,t , x0 given (216)
2
− 1 (1+ϕ)xt ∂πt
dπt = δπt dt − e − 1 dt + dZx,t lim Et [e −δ(T −t) πT ] = 0
θ ∂xt T →∞
(217)
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 63 / 65
Basic New Keynesian Model with Risk Equilibrium
Summary
Quantitative Easing
Some Stochastic Control Theory!
Derived Basic New Keynesian Model with Risk
Still need to apply Basic New Keynesian Model with Risk
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 64 / 65
Basic New Keynesian Model with Risk Equilibrium
Next Steps
Harjoat S. Bhamra Lecture 2: Central Banks, Monetary Policy and Risk 2015 65 / 65