An application of optimal control theory in economics: optimal fiscal and monetary policies in Iran

In this paper, the stochastic optimal control algorithm (OPTCON) is used to calculate optimal fiscal and monetary policies under fixed, flexible and crawling peg exchange rate regimes for the third five year Iranian development plan (2000–2004). The results of the study show that in the absent of active monetary policy instruments, the government expenditures are greater and the optimal tax revenues are lower than the proposed values in Iran third development plan. However, under a flexible exchange rate regime, the optimal values of government expenditures are lower and the optimal values of tax revenues are greater than that proposed in Iran’s third development plan. The study also shows that using optimal macroeconomic policies lead to lower fluctuations in major macroeconomic variables. The main conclusion seems to be is that only under the flexible exchange rate regime, the macroeconomic goals of the plan can be achieved, the flexible exchange rate regime being recommended as a policy instrument for Iran’s fourth five year development plan.