The superiority of “optimal control” over simulation in policy analysis

AbstractThe simulation approach to policy analysis usually concentrates on policy multipliers as a measure of the thrust of economic policy. However, this measure is inadequate for one branch of economic policy, namely, fiscal policy. The reason is that the effectiveness of fiscal policy depends, via the government budget constraint, on the method of finance. It is argued in this paper that for this very reason the conventional way of calculating simulation-based dynamic multipliers introduces a bias towards the no-crowding-out thesis. This bias arises even in models of monetarist persuasion. Furthermore, it is shown that this bias can be removed by utilizing multipliers based on optimal control. We illustrate this proposition by providing numerical results using a large-scale U.K. econometric model of international monetarist persuasion (the London Business School model, LBS). Section 1 builds up a framework through which policy optimization can be compared and evaluated to policy simulations. In Section 2 we derive and compare policy multipliers obtained through policy simulations and optimal control. Section 3 provides a numerical example with the findings being summarized in Section 4