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Stochastic optimal control, international finance and debt

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  • Fleming, Wendell H.
  • Stein, Jerome L.

Abstract

We use stochastic optimal control-dynamic programming (DP) to derive the optimal foreign debt/net worth, consumption/net worth, current account/net worth, and endogenous growth rate in an open economy. Unlike the literature that uses an Intertemporal Budget Constraint (IBC) or the Maximum Principle, the DP approach does not require perfect foresight or certainty equivalence. Errors of measurement and the effects of unanticipated shocks are corrected in an optimal manner. We contrast the DP and IBC approaches, show how the results of the dynamic programming approach can be interpreted in a traditional simple mean-variance/Tobin-Markowitz context, and explain why our results are generalizations of the Merton model.
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Suggested Citation

  • Fleming, Wendell H. & Stein, Jerome L., 2004. "Stochastic optimal control, international finance and debt," Journal of Banking & Finance, Elsevier, vol. 28(5), pages 979-996, May.
    • Handle: RePEc:eee:jbfina:v:28:y:2004:i:5:p:979-996
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    References listed on IDEAS

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    1. repec:bla:ausecp:v:40:y:2001:i:4:p:417-36 is not listed on IDEAS
    2. Maurice Obstfeld & Kenneth S. Rogoff, 1996. "Foundations of International Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262150476, April.
    3. Stein, Jerome L & Paladino, Giovanna, 2001. "Country Default Risk: An Empirical Assessment," Australian Economic Papers, Wiley Blackwell, vol. 40(4), pages 417-436, December.
    4. Giancarlo Gandolfo, 2016. "International Finance and Open-Economy Macroeconomics," Springer Texts in Business and Economics, Springer, edition 2, number 978-3-662-49862-0, June.
    5. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867–1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1.
    6. Stein, Jerome L. & Paladino, Giovanna, 1997. "Recent developments in international finance: A guide to research," Journal of Banking & Finance, Elsevier, vol. 21(11-12), pages 1685-1720, December.
    7. Jerome L. Stein & Giovanna Paladino, 2001. "Country Default Risk: An Empirical Assessment," Australian Economic Papers, Wiley Blackwell, vol. 40(4), pages 417-436, December.
    8. Milton Friedman, 2001. "Friedman on Friedman," Rivista di storia economica, Società editrice il Mulino, issue 1, pages 127-132.
    9. Jerome L. Stein, 2003. "Stochastic Optimal Control Modeling of Debt Crises," CESifo Working Paper Series 1043, CESifo.
    10. Ettore F. Infante & Jerome L. Stein, 1973. "Optimal Growth with Robust Feedback Control," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 40(1), pages 47-60.
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