State-variable Form of the Econometric Model, Stochastic Simulation and Control
We want to control the econometric model developed in the previous chapter. In order to employ the technique of optimal control, we have to transform the model into a state-variable form. To be precise, this means to create new state variables to replace those variables that appear in the model with lags of more than one period. We also introduce stochastic simulated error terms in order to have stochastic simulation of the model and to apply results of the stochastic optimal control. After introducing the new state variables and adding their definitional equations to the model, we will end up with a set of first-order linear difference equations, and we will be able to apply the optimal control results directly.
KeywordsCovariance Income Rosen
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