Stochastic optimal control, international finance and debt

We use stochastic optimal control-dynamic programming (DP) to derive the optimal debt/net worth, consumption/net worth, current account/net worth, and endogenous growth rate in an economy – which could be a country, region or sector within a country. Unlike the literature that uses an intertemporal budget constraint or the Maximum Principle, the DP approach does not require perfect foresight or certainty equivalence. Our results are generalizations of the Merton model, and are explained graphically within a mean–variance context. Two examples are provided to illustrate the usefulness of our technique in predicting debt crises.