Modelling Economic Policy Responses with an Application

There is a range of formal approaches to the modelling of policy responses. This paper will give a very short summary of the broad approaches, which are currently used, then a new approach will be proposed. The main objective of this paper is to explain the motivation and workings of a new algorithm, which allows the calculation of optimal feedback rules designed to minimise the variance of the models responses to economic shocks. This algorithm is tractable even when the model being used is very large. We will place the new algorithm in context by very briefly outlining the development of the treatment of policy formation in econometric models. We will then outline the new algorithm. We will then present an illustration of how the algorithm can be used to calculate optimal feedback rules under various game structures (Nash or co-operative for example).