Optimal Stabilization Policy Under Governmental Risk Aversion

Governmental stabilization policies take account of the underlying risk aversion of its voters. A utility function for the government is defined, one which includes variances of national income changes with respect to its policy instruments—here the budget variable, the bond rate of interest, and the currency-exchange rate. The consequence of this for the optimal set of policies is a target level of national income less than what a risk-neutral government aims at. This applies to an open economy when this is a key-currency country, as it need attend to balance-of-payments effects only insofar as they affect national income. The non-key-currency country, by contrast, must take account directly of balance-of-payments effects and their variance, so it reaches a lower level of utility than the key-currency country.