This thesis develops the small open economy DSGE model and applies Bayesian methods in order to investigate the implications of macroeconomic policy in the face of a number of challenges. In chapter 2, we construct a small open economy DSGE model with non-tradable goods and intermediate sectors under complete financial markets, and identify relative home producer price effects in the dynamics of main variables and optimal allocation. Also, by embedding intermediate sectors, we identify linkages between final and intermediate sectors. In chapter 3, we incorporate financial frictions and a global banking system in a small open economy DSGE model. We show that credit policy appears to be powerful in response to a negative leverage shock since an expansionary monetary policy shock leads to severe costs of capital flight, inflation and a sudden drop in deposits. However, when there is a negative capital quality shock, an expansionary monetary policy shock appears to be more effective than credit policy through lower real interest rates and a sharp depreciation of the terms of trade and the real exchange rate. In chapter 4, we estimate a model with financial frictions and global banking system for Korea and the U.S. using a Bayesian approach. We show that the main driving forces of business cycle fluctuations differ between countries, and that there are substantial frictions in the global banking sector. Therefore, a model analysis and macroeconomic policy without heterogeneous characteristics of each economy and frictions in global banking sector would be severely misleading.

Local fiscal policy needs to take into account particular characteristics of a region and its level of development. Each locality has its own particular combination of resources, capabilities and needs. Firstly, this work estimates the impact of fiscal policy through a number of income and expenditure variables on output per capita growth and employment/unemployment using fixed-effects panel data econometric methodology in 32 states and 2,247 municipalities of Mexico from 1994 to 2010, and country data in 20 Latin American economies during the same period. Secondly, this analysis computes the impact on growth of the 1998 Federal Reform to the Fiscal Coordination System in Mexico, since it is the most significant reform in the decade regarding transfers from central to local governments. Finally, this research discusses the linkage between policy makers’ perception, public finances and the local inhabitants’ opinion regarding public services provided -considering a self-developed survey in the 32 Mexican states and Latinobarómetro surveys from 2008 to 2010. The main result in this research is that local fiscal policy is inaccurate if it does not take into account income and expenditure components simultaneously when analysing the effect of fiscal policy variables on Gross Domestic Product per capita (GDP per capita) and employment/unemployment at a sub-national level. This research intends to be a pragmatic application of fiscal policy management. My work shows that the impact of fiscal policy variables is not equal among the different levels of government. My results are consistent with Devarajan et al. (1996) that find that current expenditure can boost growth in less developed economies, and the relationship between government capital expenditure and growth is negative in developing countries due to misallocations of public spending. The current study shows that the 1998 Federal Reform has a positive effect, particularly on low income localities in Mexico, while some negative effects in more developed municipalities. According to the results of my self-developed survey in Mexico during 2014-2015, government officials considered that fiscal policy had a significant effect on growth (up to 65%) and only (2-5%) thought it was not significant. With respect to the analysis of Latinobarómetro surveys 2008-2010 for localities in Mexico, I utilise an ordered probit regression where the dependent variable reflects the response to questions regarding taxes, confidence and satisfaction of local services and the independent variables in my model are the fiscal variables. In my understanding, there has not been a similar exercise in establishing a relationship between taxpayer’s satisfaction and fiscal policy variables. My results show a lack of confidence in the local government and poor taxpayer satisfaction with municipal services. Overall, my research suggests that 1) policy makers need to account for local population needs and disparities to overcome regional inequalities; 2) a lack of local government capacity building and 3) relevance of institutional framework.

Monetary Policy Economics has grown substantially over the recent years. The presentation of a simple monetary policy rule by Professor John Taylor stimulated an enormous amount of research on monetary policy and in particular on the formulation and implementation of the monetary policy rules. Economists have evaluated monetary policy rules and regimes i.e. their feasibility, viability etc. from various dimensions. However research on many of the issues related to monetary policy is still pending. This thesis is organized in the form of a series of essays on monetary policy. This particular field of economics is so dynamic that adhering to a single model or topic for the completion of one's thesis may not prove to be very fruitful. Models and topics intensively examined by researchers have changed rapidly over the recent years. We now no longer see the ad hoc econometric models (which were frequently used in the past) for the evaluation of the monetary policy rules. To keep up with the existing literature and also to examine monetary policy from more than one dimension, I decided to organize this thesis as a collection of essays. I evaluate various monetary policy rules in these essays using simulations, empirical estimation etc. In the context of a closed economy (using simulations) in one essay I examine the viability and preferability of the Taylor rule, nominal income targeting rules and inflation targeting rules. In another two essays in the same context I examine the performance of the monetary policy rules in response to fiscal and asset price bubble shocks. In the open economy context (using simulations) I examine the performance of domestic/CPI inflation targeting rules. In another essay for a closed economy I use a mixture of (empirical) estimation and simulation for examining the impact of shocks in an inflation targeting regime. The essays which are exclusively empirical in nature include one in which I examine the preferences of the policy makers (in terms of the policy regimes) using regime switching policy rules. Another paper in the same category examines the effectiveness of inflation targeting in the UK using a VAR framework. In an open economy context I examine the optimal policy rules in a small estimated macro-econometric model. In a multi-country setting a short paper examines the policy rules (using simulations only) in a two country framework. A final essay examines the determinacy and E-stability of the equilibrium under the Taylor rule and the nominal income targeting rule in a New Keynesian framework. Most of the essays in the thesis utilize some sort of a small dynamic general equilibrium framework for the evaluation of the policy rules. Each essay is designed to be independent from every other essay, so as to be individually accessible to the reader. I very much hope that the essays prove to be useful contributions to the existing literature on monetary policy and will help in stimulating further research on monetary policy.

This thesis offers three empirical essays on the effects of structural reforms. Although these essays can be regarded as three self-contained studies, they are linked by the idea that structural reforms are characterised by significant interactions. Chapter 1 studies the interplay of trade openness, capital account liberalisation, and reform of the banking sector in a panel of 90 countries for the period 1973-2005. The estimation of flexible functional forms through nonlinear least squares, as well as of linear equations based on Taylor expansions and other related specifications, consistently produced a meaningful result. It is suggested that these three policies are complementary; the very same reform may generate very different growth outcomes depending on how policies are advanced in the other domains. Chapter 2 looks at financial deepening in the same group of countries by analysing the interaction between banking liberalisation and capital account liberalisation. The two reforms have a significant effect on domestic credit to the private sector when they coexist concurrently. In methodological terms the paper makes use of a standard multiplicative interaction term; in addition a more flexible version of the term is introduced. A supermodularity test is also implemented. Chapter 3 revisits the period of early post-communism transition to study the implications of the interplay between privatisation and liberalisation of prices for economic growth (more specifically, for the attenuation of the so-called "transformational recession"). It is suggested that privatisation should be implemented in a context of totally freed prices. Privatising in a context where an important share of prices is still the object of administrative decisions is associated with a negative contribution to economic performance.

The inflation equation, more commonly known as the Phillips curve, lies at the heart of modern macroeconomic modeling. This Keynesian relationship between inflation and unemployment discovered by Phillips (1958) soon became widely adopted by policymakers in the 1960's. However, its empirical shortcomings led to competing theories such as the natural rate hypothesis by Friedman (1968), who alongside Phelps (1967) and Lucas (1972), condemned its implications of money non neutrality. More recently, the specification has adapted to capture nominal inertia led by the New Keynesian school of Fisher (1977) and Taylor (1980), as an answer to the classical result of neutrality. The Phillips curve remains as a relationship of interest to capture the aggregate behaviour of the supply side in the economy, connecting the labour market and the pricing decisions of firms. This Thesis consists of three self contained works, each of which are set out within their own chapter but connected by the employment of the theoretical framework of this inflation equation. They attempt to answer three specific economic questions related to inflation dynamics and labour market frictions. The first analysis concerns itself with the labour market policy of the working hours restriction; specifically with the question of how this labour market policy affects unemployment in the long run. I find weak evidence of a fall in unemployment shortly after the announcement of this policy. Secondly, whether or not one can capture the different characteristics displayed by the labour markets of the US and EU using labour market frictions in the determination of inflation dynamics. Our findings lead us to the conclusion that it is indeed possible to capture these characteristics when analyzing a Phillips curve specified in terms of unemployment. Lastly the question of whether aggregate prices are better represented by controlling for heterogeneity. The results obtained lead us to infer that controlling for heterogeneity of this kind does indeed affect the dynamics of the macro model and does not wash out in the aggregate.

This thesis is structured around three essays individual essays and two collaborative pieces of work that examine the relationship between the macroeconomy, financial markets and the term structure of interest rates. Chapter I is an overview- of the most important literature that examines the relationship between the macroeconomy and the term structure of interest rates. I present a small empirical exercise that estimates the unobserved factors of the yield curve with two popular methodologies to fit the yield curve which includes a dynamic Nelson·Siegel model and an affine·term structure model in the form of a three factor Cox, Ingersoll and Ross model and I demonstrate that the factors from each methodology are very similar and that they are correlated with macroeconomic variables. I also show by means of a simple macro-finance model that there are statistically significant relationships between the yield curve factors and the macroeconomic variables that are consistent with the results from the other literature. In Chapter 2 I estimate a fully-fledged macro-finance yield curve model of both the nominal and real forward curve for the UK from 1993 to 2008. The model is able to accommodate a larger number of macroeconomic variables than previously seen in other literature. I use the model to estimate the supply effects from debt issuance on both forward rates and so gauge the impact of Quantitative Easing on forward rates; I find that 10 year nominal interest rates on average are lower by 46 basis points which can largely be explained by the portfolio balance channel, the liquidity premium channel and the signalling channel but there is no statistical impact on the real rates. Chapter 3 presents a way to introduce heterogeneous expectations in a dynamic stochastic general equilibrium model to price the expected path of the short-term interest rate in which different types of agents possess different models that price forward rates. The results suggest with heterogeneous expectations that even a simple three equation New Keynesian model which allows for a certainty equivalent forward curve to be priced from the short-term interest rates, can better match the second moments of US output and inflation and forward rates from 1975 to 2012. The introduction of heterogeneous expectations can also help to explain one of the well known term structure puzzles: the excess volatility puzzle. In Chapter 4, after outlining some of the monetary developments associated with Quantitative Easing (QE), we measure the impact of the UK's initial 2009·10 QE Programme on bonds and other assets. First, we use a macro-finance yield curve both to create a counterfactual path for bond yields and to estimate the impact of QE directly. Second, we analyse the impact of individual QE operations on a range of asset prices. We find that QE significantly lowered government bond yields through the portfolio balance channel - by around 50 or so basis points. We also uncover significant effects of individual operations but limited pass through to other assets. Chapter 5 assesses some of the issues arising from unconventional monetary policy in three separate DSGE models with financial frictions. We find that it is possible to correct for the effects at the zero lower bound in DGSE models by offsetting the liquidity premium embedded in long-term bonds. By adopting counter-cyclical subsidies to bank capital as well as the creation of central bank reserves to reduce the costs of the loan supply.

Effects of Monetary Policy on the $/£ Exchange Rate. Is There a 'Delayed Overshooting Puzzle'? (Review of International Economics, 20(3), 443-467, 2012, with H.-M. Krolzig) The determination of the $/£ exchange rate is studied in a small symmetric macro econometric model Including UK-US differentials in inflation, output gap, short and long-term interest rates for the four decades since the breakdown of Bretton Woods. The key question addressed is the possible presence of a 'delayed overshooting puzzle' in the dynamic reaction of the exchange rate to monetary policy shocks. In contrast to the existing literature, we follow a data-driven modelling approach combining (i) a VAR based cointegration analysis with (ii) a graph-theoretic search for instantaneous causal relations and (iii) an automatic general-to-specific approach for the selection of a congruent parsimonious structural vector equilibrium correction model. We find that the long-run properties of the system are characterized by four cointegration relations and one stochastic trend, which is identified as the longterm interest rate differential and that appears to be driven by long-term inflation expectations as in the Fisher hypothesis. It cointegrates with the inflation differential to a stationary 'real' long-term rate differential and also drives the exchange rate. The short-run dynamics are characterized by a direct link from the short-term to the long-term interest rate differential. Jumps in the exchange rate after short-term interest rate variations are only significant at 10%. Overall, we find strong evidence for delayed overshooting and violations of UIP in response to monetary policy shocks.

This thesis has undertaken a comprehensive theoretical and empirical analysis of the relationship between public spending and economic growth in a neoclassical framework. The focus of the analysis has been to underline two different rules that determine the allocation of public resources across different categories of expenditure. The first rule considers the effective needs of each category and their productivity, relative to the other categories and to private capital. This allows the effect of each category of expenditure on the growth rate of the economy, when productive, to be determined. Following this line of argument, the standard model (a model which only includes this rule) pre- dicts a non-linear relationship between the components of public spending and economic growth, justifying both positive and negative impacts of these components on the economy’s growth rate. When applied to the defence sector, this model can show that the contradictory results found in the literature for the relationship between military burden and economic growth may be explained by an excessive amount of resources attributed to this sector, when its productivity level is lower than that of the other parts of the public sector. A second rule that drives public allocation decisions is not linked to any economic considerations, but to the possibility for the politician can collect bribes by misallocating public resources. As pointed out by many researchers, it is easier to collect bribes from infrastructure projects or highly sophisticated defence equipment than textbooks or teachers’ salaries. In other areas, such as health, this picture is less clear-cut, as opportunities to collect bribes may be abundant in the procurement of hospital buildings, but more limited in the payment of doctors’ and nurses’ salaries. This differential impact of corruption can be used to explain the non-linearities that emerge in the standard model. The underlying conjecture is that, since corruption has a nega- tive impact on growth and given that politicians may favour less productive public sectors, the complementarities between these two mechanisms may explain the low growth rates in those countries in which corruption is more endemic. A related contribution in the thesis is to consider the way corruption is introduced into estimated of growth equations. While several recent papers have considered the underlying causes and consequences of corruption, little (and only recent) attention has been given to the methodological question of how ”corruption” is measured by international organisations and whether there construction of indices may bias empirical results and suggestions for policy. The final part of the thesis considers these issues.

This thesis seeks to make three related contributions to our understanding of the causes and implications of downward nominal wage rigidity, the nature of money illusion on behalf of workers, and the theoretical treatment of irreversibility in factor demand and wage setting. Chapter 1 seeks to contribute to the literature on downward nominal wage rigidity (DNWR) along two dimensions. First, I formulate and solve an explicit model of wage- setting in the presence of worker resistance to nominal wage cuts - something that has previously been considered intractable. In particular, I show that this resistance renders wage increases (partially) irreversible. Second, using this model, one can explain why previous estimates of the macroeconomic effects of DNWR have been so weak despite remarkably robust microeconomic evidence. In particular, one can show that previous studies have neglected the possibility that DNWR can lead to a compression of wage increases as well as decreases. Thus, the literature may have been overstating the costs of DNWR to firms. Using micro-data for the US and Great Britain, I find robust evidence in support of the predictions of the model. In the light of this evidence, Chapter 1 concludes that increased wage pressure due to DNWR may not be as large as previously envisaged, but that the behavioural implications of DNWR in respect of the reaction of workers to nominal wage cuts remain significant. Chapter 2 then contrasts the implications of two proposed models of downward nominal wage rigidity - those based on the form of market contracts (MacLeod and Malcomson [1993]; Holden [1994]), and that based on money illusion explored in Chapter 1. In particular, I identify a method of distinguishing between these two foundations empirically, by observing how the distribution of wage changes varies with the rate of inflation. I find evidence that at least part of the observed rigidity cannot be easily explained by contract models, but can be explained in the context of a model with money illusion. Finally, Chapter 3 extends some of the theoretical developments of Chapter 1 with respect to models of irreversibility. In particular, Chapter 3 presents analytical results for models of dynamic factor demand in the presence of irreversibility in discrete time. It builds on previous work on irreversibility in the investment (Dixit and Pindyck [1994]) and labour demand (Bentolila and Bertola [1990]) literatures which use a continuous time. Brownian framework. I show that, whilst there are parallels between the discrete time models and their continuous time counterparts, the analytics in discrete time allow a more general treatment, principally by allowing the relaxation of the assumption of shocks following a unit root. I then explore the effects of relaxing this assumption on optimal factor demand.

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