Thesis advisor: Pablo Guerron-Quintana / The dissertation consists of three independent chapters that study nonlinear effects in international finance and macroeconomics. The implications of presence of nonlinear effects are examined both in the context of a puzzle in international financial markets, a constrained policy within a closed economy, and are also ap- proached as a general problem in macro and macroeconometric modeling. I quantify the role of nonlinear effects in these contexts, and make a case for the application of nonlinear modeling techniques.The first chapter of the dissertation titled “Sovereign Default Risk and Currency Returns” is solo-authored. Many currencies exhibit non-zero average returns with respect to US dollar, in an apparent violation of textbook uncovered and covered interest parities. I first show that in the cross-section of countries foreign currency returns are positively related to the sovereign default risk, and then reconcile this finding with the standard theory via the “peso problem”. Market players collect premium for bearing the risk of sharp devaluation in case of default. Since defaults are rare in the data, default premium manifests itself in higher currency returns. To formalize the link between default risk and currency returns, I discipline quantitatively a model “with default” based on Arellano (2008) for a set of developing countries. I then use the implications of this model to construct an econometric model for cross-section of currency returns that I estimate using extended Fama and MacBeth (1973) method. I find strong evidence supporting the “peso problem” explanation: credit default swaps’ spreads serving as proxy for the risk of default explain around 25% of the cross-country variation of average currency returns. I also estimate that the market participants expect a 50% depreciation of national currency upon default. The second chapter is titled “Nonlinear Dynamic Factor Model in Application to Financial and Macroeconomic data”, and is joint work with Pablo Guerron- Quintana and Molin Zhong. Through the lens of a nonlinear dynamic factor model, we study the role of exogenous shocks and internal propagation forces in driving the fluctuations of macroeconomic and financial data. The proposed model 1) allows for nonlinear dynamics in the state and measurement equations; 2) can generate asymmetric, state-dependent, and size-dependent responses of observables to shocks; 3) and can produce time-varying volatility and asymmetric tail risks in predictive distributions. We find evidence in favor of the nonlinear factor model over its linear counterpart in applications that include interest rates with zero lower bounds, credit default swap spreads for European countries, and nonfinancial cor- porate credit default swap spreads in the U.S. We extract a shadow interest rate comparable to those in the literature. The results hint to an important role for a nonlinear internal propagation element to exogenous shocks during periods of tur- bulence such as the European debt crisis and the Great Recession. This nonlinear term allows the model to forecast better during the early stages of the Covid-19 crisis. The third chapter is titled “Local Government spending and business cycle” and is based on a solo-authored paper. Local government revenues and spending in the United States are procyclical due to constitutional constraints of states and municipalities. As a result, the local government policies can act as amplifiers of the business cycle. This paper introduces fiscal policy conducted by local governments to an otherwise standard New Keynesian closed economy model to assess quantitatively the contribution of spending policies into the business cycle. The procyclical nature of local government spending generates an amplification mechanism that accounts for around 15% of fluctuations in output and hours worked. / Thesis (PhD) — Boston College, 2022. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.