Three Essays On Monetary Policy Under Uncertainty

This thesis consists of three papers on monetary policy. The first analyzes how endogenous imperfect exchange rate pass-through affects inflation targeting optimal monetary policies in a New Keynesian small open economy. The paper shows that an inverse relation exists between the pass-through and the insulation of the economy from foreign and monetary policy shocks, and that imperfect pass-through tends to decrease the variability of the terms of trade. The second paper focuses on optimal monetary policy in presence of uncertainty of the structural parameters in an open economy. Comparing CPI and domestic inflation targeting, it shows that the latter implies considerably less variability in the distribution forecast of the economic dynamics. The third paper argues that estimated linear monetary policy rules are weighted averages of the actual rules working in the diverse monetary regimes, where the weights merely reflect the length and not necessarily the relevance of the regimes.

In the first chapter, I propose a new design of Early Warning Systems to detect early warning signals of an impending financial crisis. The problem of EWS is formulated from a policy maker's perspective. Hence the probability threshold is obtained by minimizing the policy maker's welfare loss. This paper employs the Bayesian Quickest Change Detection as the methodology to detect the early warning signals. We show that the BQCD method outperforms the Logit model used in traditional EWS models based on results of simulation exercise and the out-of-sample prediction of the 1997 Asian financial crises. In the second chapter, I investigated the timing of U.S. monetary policy response to the 2007 financial crisis. The LIBOR-OIS spread jumped significantly on Aug 9, 2007, indicating an unusual increase in distress of the financial sector, but it was not until Aug 17, 2007, that the Federal Reserve responded with a 50 basis points of reduction of the primary credit rate after an unscheduled meeting. I further assumed that the policy maker was uncertain about the intensity of the financial crisis, and that monetary policy responded to more severe financial crisis more intensively. In order to increase the accuracy of choosing the right policy regime, waiting for more information may be desirable. I found that for certain specifications of the intensity of the financial crisis, the optimal timing of the Federal Reserve's policy response should be Aug 15, 2007. I concluded that uncertainty about the intensity of the financial crisis played an important role in the timing decision of the policy maker. In the third chapter, I investigated the issue of international monetary policy coordination under uncertainty. The consensus is that international monetary policy coordination is welfare improving, but some argue that the improvement is not significant quantitatively. This paper studied the role of model uncertainty in international monetary policy coordination, and found that considering model uncertainty can enhance welfare gain of coordination.

investigate the global spillover effects of US monetary policy uncertainty in these three essays. In the first chapter, I focus on the impact of uncertainty on the macroeconomic activity of other advanced and emerging economies. I find that an increase in US monetary policy uncertainty reduces output, investment, consumption, exports, and imports in these economies. Such adverse effects are larger in relatively open than closed economies in trade and capital flows. Central banks around the world respond to heightened uncertainty by cutting policy rates, which is further validated by the evidence from central bank minutes. In the second chapter, I examine asset price spillovers from US monetary policy uncertainty to global asset prices. An increase in US monetary policy uncertainty raises sovereign yields and depreciates exchange rates in advanced and emerging economies. A higher level of uncertainty weakens the global transmission of US monetary policy to asset prices. Spillovers from uncertainty to asset prices are larger for the countries with high trade integration, but such effects on sovereign yields are larger only in advanced economies with higher financial integration and the exchange rate peg than the flexible regime. The third chapter investigates how uncertainty about US monetary policy affects cross-border bank flows. I find that an increase in US monetary policy uncertainty reduces cross-border bank lending. In response to higher uncertainty, banks reallocate their portfolio from foreign to domestic borrowers. Such cross-border effects are found to be higher in countries with low capital controls.

The dissertation consists of three essays studying the effects of monetary and fiscal policy. The first chapter, ''Policy Uncertainty and Government Spending Effects'' (joint with Shu-Chun Yang), studies government spending multipliers in a low nominal interest rate environment. Using a fully nonlinear New Keynesian model, this chapter shows government spending multipliers can decrease when 1) the initial debt-to-GDP ratio is higher, 2) the tax rate is higher, 3) debt maturity is longer, and 4) monetary policy is more responsive to inflation. When monetary and fiscal policy regimes can switch, policy uncertainty also reduces spending multipliers. If higher inflation induces a rising probability of switching to a regime where monetary policy actively controls inflation and fiscal policy raises future taxes to stabilize government debt, the multipliers can fall much below unity.The second chapter is a joint work with Zhao Han and Xiaohan Ma and studies how dispersed information impacts inflation, inflation expectations, and the Phillips curve by analytically solving a price-setting problem with nominal rigidity and informational frictions. The analytical representations enable us to recover the underlying parameters with data from the Survey of Professional Forecasters (SPF) and quantify the effects of dispersed information. The estimation results show dispersed information plays an important role in generating persistent inflation forecast errors and non-zero nowcast errors, as observed in the SPF data, but the effects of higher-order expectations on the Phillips curve are quantitatively small.The last chapter derives the optimal monetary policy when firms only have limited capacity to process information. The result shows marginal cost of attention is the key to determining the trade-off between the central bank's dual mandates. When the marginal cost is low, monetary policy aiming at stabilizing the output gap attracts attention from the private sector and generates inefficient price dispersion; Increasing the marginal cost of attention can eliminate the trade-off. A comparison between a rule-based policy and a discretionary policy confirms welfare gain from commitment. Firms pay extra attention to the policy signal when it is discretionary, which generates more price dispersion and harms welfare.

The three essay are concerned with the uncertainty and risks that pervade the economy, influence investors and affect policymakers. The first essay shows that monetary policymakers consider events and contingencies to make decisions, and concludes that short-lived regime switches corrupt the descriptive power of linear Taylor-type rules, although these describe well the contours of the Fed's behaviour. The second essay focuses on the role of global and domestic factors for macroeconomic fluctuations in Brazil. The estimates of a VAR model reveal that global risk aversion is an important determinant of the volatility of Brazilian series and affects the monetary policy transmission channel. The third essay builds on the idea that, contrary to the predictions of IRBC models, the degree of international consumption smoothing is low. After a review of the literature addressing the puzzle, it investigates the relationship between external debt and consumption smoothing in a sample of developing countries.

Abstract: My dissertation grapples with the issues of model uncertainty in macroeconomics, and analyzes its consequences for monetary policy. It consists of three essays. In the first essay (Chapter 1), "Monetary Policy under Misspecified Expectations", I examine policy choices for the central bank that faces uncertainty about the process of expectation formation by economic agents. The economy contains both "rule-of-thumb" agents who base their expectations on recent observations and agents who have rational expectations. The central bank is uncertain about the fraction of the rule-of-thumb agents. This uncertainty concern enables me to partially rationalize the over cautious policy stance of the Fed: empirically observed policy in the past two decades involves much weaker responses than optimal policies derived from various micro-founded models. It is well understood that when the economy is more forward-looking, the central bank displays more aggressive responses to inflation and output. But the uncertainty-averse central bank evaluates policies by the performance in the worst case. In my economy this has a high fraction of agents that are backward-looking. The best policy the central bank chooses thus involves moderate responses. That is to say, this minimax policy moves closer toward actual less responsive policy. In the second essay (Chapter 2), "Phillips Curve Uncertainty and Monetary Policy", I investigate the effect of model uncertainty on policy choices employing a more general approach, which nests the minimax and Bayesian approaches as limiting cases. The central bank is uncertain about whether the economy has a sticky price Phillips curve or a sticky information Phillips curve. I argue that how the central bank chooses a policy depends both on its perception of uncertainty environment and on its attitude towards uncertainty. I find that as the central bank either becomes more uncertainty-averse or considers sticky information more plausible, the response to inflation decreases and to output increases. The third essay (Chapter 3) is entitled "Optimal Simple Rules in RE Models with Risk Sensitive Preferences". This paper provides a useful method to solve optimal simple rules under risk sensitive preference in macro models with forward looking behavior. An application to a new Keynesian model with lagged dynamics is offered and risk sensitive preference is found to amplify policy responses.