Essays On Optimal Monetary Policy And Financial Frictions

The objective of this dissertation is to understand the role of financial frictions in the transmission of shocks and their effect on the monetary policy transmission mechanism. To accomplish the task, we develop Dynamic Stochastic General equilibrium models with financial frictions. In the first chapter, we develop a model to analytically determine the appropriate price index to target in the presence of financial frictions (where a fraction of households are constrained to consume their wage income each period). The analysis suggests that in the presence of financial frictions, a welfare-maximizing central bank should adopt flexible headline inflation targeting-i.e. a headline inflation target but with some weight on the output gap. These results are particularly relevant for emerging markets, where the share of food expenditures in total consumption expenditures is high and a large proportion of consumers are credit constrained. In the second chapter, we develop a small open economy model with macrofinancial linkages. The model includes a financial accelerator - entrepreneurs are assumed to partially finance investment using domestic and foreign currency debt - to assess the importance of financial frictions in the amplification and propagation of the effects of transitory shocks to productivity, interest rates and net worth of firms. We use Bayesian estimation techniques to estimate the model using India data. The model is used to assess the importance of the financial accelerator in India and to assess the optimality of the current monetary policy rule. In the third chapter, we develop a small open economy New Keynesian model with financial frictions and an active banking sector for India. We find that the presence of a monopolistic banking sector with sticky interest rate setting attenuates the shocks. However, if the interest rates are flexible it results in the amplification of shocks. We also find that an unexpected reduction in bank capital can have a substantial impact on the real economy and particularly on investment. Use of nonmonetary policy tools result in greater volatility as compared to when central banks use traditional monetary tightening.

The great recession that started in 2007, has not only changed the perspective of the macroeconomic literature about the role of financial frictions within the canonical New Keynesian (henceforth, NK) monetary models but also has rekindled the debate about sources of business cycle fluctuations. This dissertation, comprising of three self-contained essays, makes theoretical and empirical contributions to the emerging strands of literature incorporating financial frictions in the NK monetary models. The first essay (Chapter 2) of this dissertation extends traditional optimal monetary policy analysis to NK models with capital and financial frictions. In the case of a negative productivity shock, the chapter finds that: 1) a standard inflation targeting rule dominates the Taylor rule in both NK models without capital and with capital as it approximates the welfare level associated with the Ramsey policy; 2) in the NK model with capital and with financial frictions, the relative performance of the economy under standard inflation targeting is much better compared to alternative policies because it approximates Ramsey monetary policy. In the case of a financial shock, the chapter shows that the inflation targeting rule provides a welfare level that is close to the welfare level achieved under optimal monetary policy under commitment. In addition, Ramsey policy under commitment performs well in response to a financial shock, compared to alternative monetary policy regimes, by aggressively minimizing the impact of financial constraints on the interest rate spread. The second essay (Chapter 3) estimates the importance of financial shocks in business cycle fluctuations for the US economy using structural VAR models. In that chapter, financial and non-financial shocks are identified with a minimum set of sign restrictions based on the two competing NK models: the standard NK model augmented with a financial accelerator and the NK model augmented with financial intermediaries. Estimation results show that a financial shock, emanating both from entrepreneur's net worth and financial intermediaries net worth, is prominent in explaining fluctuations in real output and interest rate spread. As far as the relative importance of these two financial shocks is concerned, the following results stand out. A financial shock related to the demand side is relatively the major driver of output fluctuations in both time horizons while financial shocks related to financial intermediaries explain a moderate variation in output fluctuations in both time horizons. In addition, financial shocks related to financial intermediaries account for a relatively larger share of interest rate spread fluctuations at both time horizons compared to a financial shock related to the demand side. The third essay (Chapter 4) extends Gertler and Karadi's model (2011) into a two-sector setting. The Two-Sector Financial Accelerator model not only helps to incorporate the differences in the leverage ratios of commercial and investment banks but also introduces additional shocks that capture some features of the sub-prime financial crisis in the simulated economy. The results also show that output recovery would remain slow in the simulated economy as long as the relative price of non-consumption goods is not recovered to its trend.

My essays that are captured in two chapters of my dissertation focus on shadow banking system, collateralized debt arrangement and monetary policy. The first chapter studies the role of shadow banking in the recent financial crisis, the relationship between shadow banking and traditional banking, and it investigates the monetary policy reaction to overcome the financial frictions associated with the scarcity of collateral or shortages of safe assets that naturally led to the liquidity constraints. On the other hand, the second chapter studies the role of housing as a collateral or as a medium of exchange and it explores how the private liquidity, in the context of home-equity loans, and public liquidity work together to overcome the limited commitment frictions. In the first chapter, a Lagos-Wright model with costly-state verification and delegated monitoring financial intermediation, and a risk-sharing framework of banking is constructed. Lack of memory and limited commitment imply collateralized credit arrangements. In contrast to the traditional banking system, shadow banking system is not subject to the capital requirements. The relative use of shadow funded credit versus traditional bank loans entails the advantages of working outside the oversight of the bank regulations, but drawbacks of having information and transactions cost in funding entrepreneurs. I have five main findings: First, an entrepreneurial credit can help address the need for collateral. Second, the shadow funded credit shifts from risky to safer borrowers and loan creation capacity of the shadow banking sector shrinks when the economic outlook gets worse. Third, the traditional bank can fulfill the role of providing credit that shadow banks had played before the crisis, but can do it only to a certain extent. Fourth, to the extent that collateral backed by entrepreneurial credit mitigates the limited commitment friction in the traditional banking sector, the optimal monetary policy shifts nominal interest rate towards zero lower bound. Lastly, the quantitative easing program can be welfare increasing by reinforcing the shadow funded credit versus traditional banking lending if the credit frictions in the shadow banking sector are sufficiently small. The second chapter studies the role of home-equity loan and government debt in an environment with financial frictions. I construct a Lagos-Wright model in which private transactions must be secured under limited commitment and lack of record-keeping. Housing can be useful to support credit since it serves as collateral. It also gives direct utility as shelter and serves as a medium of exchange when the economy is inefficient. I show that when there is no efficiency loss due to exchange of housing, posting collateral is not optimal since collateralizable wealth is limited. In the state of efficiency loss, the collateral might be useful and the asset therefore bears a liquidity premium. However, once collateral becomes scarce - as it did during the financial crisis- then it amplifies the frictions and the buyer trades the asset to make up for the weak incentives associated with collateral. I show that the world is always non-Ricardian and therefore government debt implies higher welfare. As well, government debt enhances the private debt to the extent that posting collateral is always optimal. In equilibrium, full pledgeability of private collateral, in addition to government debt, completely rules out the efficiency loss arising from exchange of asset. Money and private banks are introduced. I show that as inflation imposes a tax on consumption, interest rate on cash loans imposes a tax on housing collateral. Finally, an increase in inflation raises the housing price near Friedman Rule.

The dissertation, which consists of two chapters, is devoted to exploring the role of informational friction in monetary economics and finance.Chapter I: COUNTERFEITING, SCREENING AND GOVERNMENT POLICY.In this chapter, I construct a search theoretic model of money in which counterfeit money can be produced at a cost but agents can screen for fake money also at a cost. Counterfeiting can occur in equilibrium when both costs and the inflation rate are sufficiently low. Optimal monetary policy is the Friedman rule. However, the rationale for the Friedman rule in an economy with the circulation of counterfeit money differs from the conventional mechanism that holds in the model when counterfeiting does not occur. I also study optimal anti-counterfeiting policy that determines the counterfeiting cost and the screening cost.Chapter II: CENTRAL BANK PURCHASES OF PRIVATE ASSETS: AN EVALUATIONIn this chapter, I develop a model of asset exchange and monetary policy, augmented to incorporate a housing market and a frictional financial market. Homeowners take out mortgages with banks using their residential properties as collateral to finance consumption. Banks use mortgages and government liabilities as collateral to secure deposit contracts, but they have an incentive to fake the quality of mortgages at a cost. Quantitative easing (QE) in the form of central bank purchases of mortgages from private banks has effects on the composition of assets in the economy, and on the incentive structure of the private sector. When the incentive problem is severe, the central bank can unambiguously improve welfare by purchasing mortgages. However, when it is not severe, the central bank's mortgage purchases cause a housing construction boom and sometimes can lower exchange in the economy, hence reducing welfare.

Lastly, I show the optimal monetary policy is rule-based Odyssean forward guidance, which is a state-contingent commitment that specifies how the central bank reacts to both the actual shock and the noise in its own information.

The first chapter of this thesis, joint with Angela Abbate analyses the importance of the risk-taking channel for monetary policy. To answer this question, we develop and estimate a quantitative monetary DSGE model where banks choose excessively risky investments, due to an agency problem which distorts banks’ incentives. As the real interest rate declines, these distortions become more important and excessive risk taking increases, lowering the efficiency of investment. We show that this novel transmission channel generates a new and quantitatively significant monetary policy trade-off between inflation and real interest rate stabilization: it is optimal for the central bank to tolerate greater inflation volatility in exchange for lower risk taking. The second chapter develops a quantitative model of sovereign default with endogenous default costs to propose a novel answer to the question why governments repay their debt. In the model domestic banks are exposed to sovereign debt. Hence sovereign default causes large losses for the banks, which translate into a financial crisis. The government trades these costs off against the advantage of not repaying international investors. Besides replicating business cycle moments, the model is able to generate not only output costs of a realistic magnitude, but also endogenously predicts that default is followed by a period during which no new foreign lending takes place. The duration of this period matches empirical estimates. The third chapter outlines a method to reduce the computationally necessary state space for solving dynamic models with global methods. The idea is to replace several state variables by a summary state variable. This is made possible by anticipating future choices that depend on one of the replaced variables. I explain how this method can be applied to a simple portfolio choice problem.

This thesis investigates monetary policy within the New Keynesian framework in dynamic macroeconomics. It includes three original research papers. The first paper examines the rules and transmission mechanisms of monetary policy in one of the fast growing economies in the 21st century, China, by extending a standard New Keynesian dynamic stochastic general equilibrium model with financial frictions and investment-specific shocks in order to capture some of the Chinese characteristics and applying a Bayesian estimation strategy to real-time data. It offers a new way of empirically examining the rule of China's monetary policy and indicates a structural break of the neutral technology development that may have caused the slowing down of GDP growth since 2010. The second paper revisits optimal monetary policy in open economies, in particular, focusing on the noncooperative policy game under local currency pricing in a theoretical two-country dynamic stochastic general equilibrium model. Quadratic loss functions of noncooperative policy makers and welfare gains from cooperation are obtained in the paper. The results show that noncooperative policy makers face extra trade-offs regarding stabilizing the real marginal costs induced by deviations from the law of one price under local currency pricing. As a result of the increased number of stabilizing objectives, welfare gains from cooperation emerge even when two countries face only technology shocks, which usually leads to equivalence between cooperation and noncooperation. Still, gains from cooperation are not large, implying that frictions other than nominal rigidities are necessary to strongly recommend cooperation as an important policy framework to increase global welfare. The third paper focuses on the noncooperative policy game specified by choice of policy instrument for implementing optimal monetary policy in a two-country open economy model similar to the one in the second paper. It examines four options of policy instruments including the producer price index inflation rate, the consumer price index inflation rate, the import price inflation rate and the nominal interest rate. It shows that choosing different policy instruments generally leads to different equilibria and, in particular, choosing the nominal interest rate results in equilibrium indeterminacy. In addition, the welfare ranking of these policy instruments depends on a country's degree of openness which is measured as the weight assigned to imported goods in the consumers' utility function. In less open countries, domestically produced goods carry a relatively higher weight in the consumers' utility function. For these less open countries, choosing the producer price index inflation rate induces a larger welfare cost from noncooperation than choosing the consumer price index inflation rate would. Choosing the consumer price index inflation rate in turn causes a larger welfare cost than choosing the import price inflation rate. Conversely, the reverse is true when countries are more open. This result sheds light on the important role that policy instrument choice plays in determining the equilibrium outcomes, to which policy makers should pay special attention when implementing optimal monetary policy under noncooperation.

The three chapters in this dissertation analyze the unconventional monetary policy tools that were utilized in response to the global financial crisis of 2007-2009. Chapter 1 examines the degree of misspecification in a mainstream DSGE model with unconventional monetary policy using the DSGE-VAR approach. The findings indicate that this type of model exhibits a high level of misspecification. For instance, estimation results point to the data favoring an unrestricted vector autoregression model over a DSGE model with unconventional monetary policy. Thus, policymakers should exercise caution when using new macroeconomic models that incorporate unconventional monetary policy. Chapter 2 examines the link between expectations formation and the effectiveness of central bank forward guidance. In a standard New Keynesian model, agents form expectations about future macroeconomic variables via either the standard rational expectations hypothesis or a more plausible theory of expectations formation called adaptive learning. The results show that the efficacy of forward guidance depends on the manner in which agents form their expectations. During an economic crisis (e.g. a recession), for example, the assumption of rational expectations overstates the effects of forward guidance relative to adaptive learning. Specifically, the output gap is higher under rational expectations than adaptive learning. Thus, if monetary policy is based on a model with rational expectations, which is the standard assumption in the macroeconomic literature, the results of forward guidance could be potentially misleading. Chapter 3 investigates the effectiveness of forward guidance while relaxing two standard macroeconomic assumptions: rational expectations and frictionless financial markets. A standard DSGE model is extended to include the financial accelerator mechanism. The results show that the addition of financial frictions amplifies the differences between rational expectations and adaptive learning to forward guidance. During a period of economic crisis (e.g. a recession), output under rational expectations displays more favorable responses to forward guidance than under adaptive learning. These differences are exacerbated when compared to a similar analysis without financial frictions. Thus, monetary policymakers should consider the way in which expectations and credit market frictions are modeled when examining the effects of forward guidance.