Flexible and fixed target stabilisation in an open economy

Abstract

The underlying theme of this study is to examine and compare the effectiveness and consequences of implementing two alternative stabilisation techniques in an open economy. The study incorporates an applied extension of recent theoretical stabilisation developments. In particular, the familiar optimisation or flexible target technique is compared with the new dynamic Tinbergen or fixed target technique. Essentially, the fixed target approach allows the policy-maker to exactly achieve a set of targets over a specified time horizon when he has more targets than instruments as long as he is prepared to anticipate the target path. On the other hand, the flexible target approach imposes the constraint of compromising all targets when the number of targets exceeds the number of instruments. In order to compare the two techniques, a simple open model of the Australian economy is constructed and estimated. The model assumes a fixed exchange rate and allows for an endogenous money supply and interaction and feedback between the income, monetary and open sectors. The interrelationship between sectors complicates the use of policy and the carrying out of flexible and fixed target simulation experiments gives insight into this problem. Uncertainty is stressed throughout the study and it is found that additive uncertainty can seriously affect the mix of policy required, given a specific set of objectives. In particular, it is shown that a significant switch in the emphasis on the use of instruments can occur when we move from a situation of certainty to uncertainty. The switching effects are especially important in an internal and external balance framework. In addition, problems of instrument instability in an open economy are examined and specific problems faced by the applied control theorist are identified along with suggested solutions. The applied experiments mainly focus on the targets of internal and external balance coupled with monetary targets such as the rate of interest and the money supply. The optimal achievement of monetary targets is also examined in some detail with the general conclusion that the supply of money is the appropriate target to aim for. One general conclusion is clear from the internal and external balance experiments and the monetary experiments. The achievement of target configurations which include targets from different sectors and given a fixed exchange rate regime, requires a rigorous and strong use of both monetary and fiscal policy and indeed, the exact achievement of a target or targets under these conditions places considerable stress on the instruments. This feature results in the fixed target technique being vastly inferior to the flexible target technique given the model and the designated target paths set out in this study.