The Application of System and Control Theory to Monetary Policy

Abstract

Monetary policy is the process by which the central bank attempts to maintain price stability. Typically, this is done by manipulating the interest rate. This process is executed by the central bank of a country or union. Specifically, the policy makers of a central bank make policy decisions manually, based on advise and experience. The process, of manipulating a variable to get the desired outcome, is a technology where system and control engineers are specialized in. Mostly, they focus on dynamical technological processes. Nevertheless, a new field in system and control theory pledges to widen this variety. Specifically, towards applying these system and control theories to economic processes: Economic engineering. Up to now, very little attention is paid to the possibility of applying system and control theory to monetary policy. This work combines the current model of the European Central Bank (ECB), used to analyze monetary policy in the Eurozone, and the economic-engineering analog that can be used to model economics as if it were a mechanical system. It builds on these two theories by presenting monetary policy as a control problem. Firstly, the analog is extended in order to express money and interest in mechanical terms. With this extension, a first-principles model of the economy is developed. The results of the ECB’s model are analyzed and an alternative is offered by the application of open loop transfer function characteristics. A PID controller is designed and the design conditions are interpreted as policy decisions. Finally, the effects of these design conditions are explained. The model, developed in this thesis, adds to existing models because of its distinction between disturbances and the control input. This contrasts the existing models because they approach both disturbances and control input similar - i.e. so called shocks. The first-principles modeling approach offers the first model that presents the underlying dynamics of the system. These dynamics can now be analyzed in the form of the effects of disturbances. The model offers the possibility to better understand monetary policy. Policymakers can now simulate possible policy actions and the effects on different economic variables, such as wages, GDP and investment.