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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. Stein, Jerome L & Paladino, Giovanna, 2001. "Country Default Risk: An Empirical Assessment," Australian Economic Papers, Wiley Blackwell, vol. 40(4), pages 417-436, December.
    2. Stein, Jerome L & Paladino, Giovanna, 2001. "Country Default Risk: An Empirical Assessment," Australian Economic Papers, Wiley Blackwell, vol. 40(4), pages 417-436, December.
    3. Ettore F. Infante & Jerome L. Stein, 1973. "Optimal Growth with Robust Feedback Control," Review of Economic Studies, Oxford University Press, vol. 40(1), pages 47-60.
    4. repec:spr:sptbec:978-3-662-49862-0 is not listed on IDEAS
    5. Giancarlo Gandolfo, 2016. "International Finance and Open-Economy Macroeconomics," Springer Texts in Business and Economics, Springer, edition 2, number 978-3-662-49862-0, March.
    6. 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, January.
    7. 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.
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    Cited by:

    1. Haluk Yener & Thanasis Stengos & M. Ege Yazgan, 2017. "Analysis of the seeds of the debt crisis in Europe," The European Journal of Finance, Taylor & Francis Journals, pages 1589-1610.
    2. Stein, Jerome L., 2007. "United States current account deficits: A stochastic optimal control analysis," Journal of Banking & Finance, Elsevier, vol. 31(5), pages 1321-1350, May.
    3. Haluk Yener & Thanasis Stengos & M. Ege Yazgan, 2015. "Survival Maximizing Leverage of an Economy: The Case of Greece," Working Paper series 15-17, Rimini Centre for Economic Analysis.
    4. Belloc, Marianna & Federici, Daniela, 2010. "A two-country NATREX model for the euro/dollar," Journal of International Money and Finance, Elsevier, vol. 29(2), pages 315-335, March.
    5. Eckhard Platen, 2005. "On The Role Of The Growth Optimal Portfolio In Finance," Australian Economic Papers, Wiley Blackwell, vol. 44(4), pages 365-388, December.
    6. Abutaleb, Ahmed S. & Hamad, Marwa G., 2012. "Optimal foreign debt for Egypt: A stochastic control approach," Economic Modelling, Elsevier, vol. 29(3), pages 544-556.
    7. Stein, Jerome L., 2010. "A tale of two debt crises: a stochastic optimal control analysis," Economics - The Open-Access, Open-Assessment E-Journal, Kiel Institute for the World Economy (IfW), vol. 4, pages 1-24.
    8. Jerome L. Stein, 2004. "Optimal Debt and Equilibrium Exchange Rates in a Stochastic Environment: an Overview," CESifo Working Paper Series 1363, CESifo Group Munich.
    9. Stein, Jerome L., 2011. "The crisis, Fed, Quants and stochastic optimal control," Economic Modelling, Elsevier, vol. 28(1-2), pages 272-280, January.
    10. Mariam Camarero & Jesús Peiró-Palomino & Cecilio Tamarit, 2017. "External imbalances and growth," Working Papers 2017/02, Economics Department, Universitat Jaume I, Castellón (Spain).
    11. Rey, Serge, 2009. "L’apport du NATREX à la modélisation des taux de change d’équilibre : théorie et application au dollar canadien," L'Actualité Economique, Société Canadienne de Science Economique, vol. 85(2), pages 131-181, juin.
    12. Kwamie Dunbar, 2009. "Stochastic Business Cycle Volatilities, Capital Accumulation and Economic Growth: Lessons from the Global Credit Market Crisis," Working papers 2009-36, University of Connecticut, Department of Economics.
    13. repec:spr:eurase:v:7:y:2017:i:2:d:10.1007_s40822-017-0066-0 is not listed on IDEAS
    14. Haluk Yener & Thanasis Stengos & M. Ege Yazgan, 2014. "Analysis of The Seeds of Debt Crisis in Europe," Working Paper series 24_14, Rimini Centre for Economic Analysis.

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