Optimal Macroeconomic Policies in a Financial and Economic Crisis

In this paper, we study the optimal reactions of fiscal and (to some extent) monetary policy upon a financial and economic crisis like that of the last two years. We consider the case of a small open economy that is part of the Economic and Monetary Union (EMU), namely Slovenia. Using an econometric model of the Slovenian economy, we simulate the effects of a global crisis under the assumption of no-policy reactions, i.e. assuming macroeconomic policies being conducted in the form of “business as usual”. Next, we investigate the optimal reaction of fiscal policies under the assumption that Slovenian policy-makers behave as maximizing an objective function. We use a new version of the algorithm OPTCON for the optimal control of nonlinear econometric models to obtain optimal paths of fiscal policies under different assumptions about monetary policy design by the European System of Central Banks. We show that optimal policies call for an active countercyclical role of fiscal policies, but also a strong policy reaction of European monetary authorities is called for if excessive unemployment and a sharp decline of real GDP are to be avoided.