This dissertation studies topics in international macroeconomics. In the first chapter, I develop a heterogeneous agent model of a small open economy and studies how households differ in their responses to aggregate productivity and interest rate shocks. Poor households display stronger consumption responses to an aggregate productivity shock because they are more likely to be constrained in liquid assets. In contrast, rich households display stronger consumption responses to an interest rate shock because they are more likely to be unconstrained in liquid assets. When the economy experiences a sudden stop, defined as transitory contractionary shocks to productivity and the interest rate, the interest rate effect neutralizes the productivity effect. As a consequence, the sudden stop generates consumption-income elasticities that display little variation along the income distribution, similar to a permanent shock. My finding captures the observed behavior of households in the Mexican Peso Crisis of 1994. In the second chapter, I study a small open economy subject to a borrowing constraint which experiences stochastic volatility in its output endowment. I find that volatility shocks induce substantial changes in borrowing by households, in excess of the precautionary savings response. Household responses to volatility shocks increases the standard deviation of borrowing, but not the standard deviation of consumption, suggesting small welfare costs. Stochastic volatility increases the frequency of financial crises in a decentralized economy that overborrowsdue to a pecuniary externality, but not a socially optimal economy. In the third chapter, I introduce income heterogeneity into a small open economy model with an occasionally binding collateral constraint. Income heterogeneity generates poor households that borrow up to the constraint to smooth over their income shock. This differs from representative agent models that require a depressed aggregate state for the representative household to interact with the constraint. As a consequence, the model displays a higher average marginal propensity to consume which generates a higher volatility of aggregate consumption. The model with income heterogeneity fails to generate sudden stops. This occurs as the income shock generates rich households that are able to consumption smooth throughout contractions. In the fourth chapter, I trace the path between a benchmark representative agent model and a benchmark heterogeneous agent model. Heterogeneous agent models typically introduce idiosyncratic income risk, a financial friction in the form of a borrowing or non-negativity constraint, and recalibrate the impatience of households. This paper studies the effect of each term. With the minimal financial friction that households cannot starve, complete markets fail, but income risk has no significant effect on the aggregate response of consumption to an endowment or interest rate shock relative to a representative agent benchmark. Heterogeneity and significant financial frictions generate empirically realistic marginal propensities to consume, but fail to alter the aggregate consumption response. Decreasing the impatience of households is necessary to significantly alter aggregate responses to endowment and interest rate shocks.

The successful launch of the European Monetary Union (EMU) raised an already ever growing interest in the economics of monetary integration and the formation of monetary unions around the world. Following the EMU experience, countries have considered forming a monetary union amongst themselves. The East African Community (EAC), comprising the three original member countries Kenya, Tanzania and Uganda and now including Burundi and Rwanda, is an example of such a group of countries that seek to form a monetary union. This study aims to identify the current level of financial integration amongst the East African countries. In order to do so the study examines whether the pass-through of monetary policy in the five countries has become similar over time. This is to provide an indication of the extent to which the nominal convergence criteria amongst the member countries have been met. The results of the study provide an indication of whether the formation of a monetary union in East Africa is possible. The empirical analysis used in this study included stationarity tests, four tests of co integration and an asymmetric error correction model to investigate whether the pass-through of monetary policy transmission in the five countries has become more similar over the ten year sample period from 1999 to 2008. The analysis uses three interest rates and 6-year rolling windows to identify the extent of macroeconomic convergence that prevails within the EAC, and consequently whether the formation of a monetary union is possible. The results suggest that the magnitude of the convergence amongst the countries remain low and there are significant rigidities in the deposit and lending rates over time, however the passthrough has improved with respect to the lending rate but not the deposit rate. The overall conclusion of the study suggests that an EAC wide monetary union is currently not possible based on the evidence provided from the pass-through analysis.

One of the most important aspects of monetary policy is an understanding of the transmission process: the mechanism through which the monetary policy actions of the Central Bank impact on aggregate demand and prices by influencing the investment and consumption decisions of households and firms. Thus, commercial banks are regarded as conveyers of monetary policy shocks and are expected to adjust retail interest rates in response to policy shocks one-to-one. In practice, commercial banks adjust their retail rates in response to changes in monetary policy with a lag of several months and this delay is often viewed as an impediment on the ability of the Central Bank to steer the economy. Several reasons, such as credit rationing and adverse selection, switching costs, risk sharing, consumer irrationality, structure of the financial system, menu costs and asymmetric information are some of the causes advanced for commercial banks retail rates being sticky. In spite of the important role of pass-through analysis in the monetary policy transmission process, it has received very little attention in Sub-Saharan Africa, especially in Cameroon and Nigeria, which have implemented a series of reforms. To this end, this study gives a comparative analysis of interest rate pass-through in Nigeria and Cameroon using retail rates (lending and deposit) and a discount rate (policy rate) from January 1990 to December 2010 for Nigeria and from January 1990 to June 2008 for Cameroon. The study examines the magnitude and speed of retail rate adjustments to changes in the Central Bank policy rate as well as examining the possibility of symmetric and asymmetric pass-through in both countries. In addition, the study also investigates whether there is pass-through of monetary policy from one country to the other. The empirical analysis employs four different types of co-integration techniques to test the presence of a long run co-integrating relationship between retail and the policy rates in order to ensure that the relationship detected is robust. Three sets of analyses are carried out in the study. Following Cottarelli and Kourelis (1994), the study employed a co-integration technique, firstly, to analyse pass-through for the entire sample, secondly, to analyse symmetric and asymmetric pass-through using a ten year rolling window analysis in an error correction framework. Finally, the policy rates were swapped around to investigate if there are transmissions of impulses from one country to the other. Overall, evidence from the entire sample and rolling window analysis suggests that monetary policy in Cameroon is less effective. This is perhaps one of the reasons why the Banque Des Etats De L’Afrique Centrale (BEAC) is unable to sterilise the excess liquidity of the banking sector in Cameroon. The long run pass-through of 0.72 and 0.71 for the entire sample, and the average long run pass-through for the rolling window of 0.78 and 0.76 for the lending and deposit rates, suggest that monetary policy is highly effective in Nigeria compared to Cameroon. The empirical evidence confirmed asymmetric adjustment in six rolling windows in the lending rate in Nigeria. Three rolling windows indicated that the direction of rigidity is downward, supporting Scholnick’s (1996) collusive pricing arrangement between banks, and the other three suggested that the lending rate is rigid in the upward direction, corroborating Scholnick’s (1996) customer reaction hypothesis. The deposit rate in Cameroon was also found to adjust asymmetrically and the direction of rigidity is downward, supporting Hannan and Berger’s (1991) customer reaction hypothesis. The investigation of impulse transmission between the two countries revealed that only the policy rate in Nigeria exerts some influence on the deposit rate in Cameroon. Policy recommendations are also discussed.