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Implementing Optimal Control in Cointegrated I(1) Structural VAR Models

This paper examines the feasibility of implementing Linear Quadratic Gaussian (LQG) Control in structural cointegrated VAR models and sheds some light on the two major problems generated by such implementation. The first aspect to be taken into account is the effect of the presence of unit roots on the policymaker's ability to control the overall dynamics of the system. Different control techniques are proposed, depending on whether the policymaker can stabilize the whole system, only part of it or none of it. The second issue involves the structural form of the model. It will be shown in this paper that, in general, a system's features will change when implementing a new control rule. In particular, a controlled system will generally not retain features that should be intrinsically invariant to policy changes (e.g., neutrality of money in the long-run).