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The main objective of the thesis is to analyse the suitability of inflation targeting, a monetary policy regime which focuses on the achievement of the price stability, for the emerging market economies. The performance of inflation targeting countries is compared to the performance of non-inflation targeting countries which use other monetary policies such as the monetary aggregate target or exchange rate anchor. Regressions, using the difference-in-differences estimation approach, are run to assess the contribution of the inflation targeting framework to the development of economic variables such as the CPI, GDP, national interest rate etc. Economic outcomes of the financial crisis period (2007- 2010) are crucial part of the thesis. The convenience of the inflation targeting framework for the emerging market economies is derived. This holds also for the severe situations such as the crisis since it lowers the volatility of the main variables of the interest. Keywords: inflation targeting, monetary economics, monetary policy, emerging market economies, difference in differences estimation, financial crisis

Thesis advisor: Susanto Basu / This dissertation consists of three essays that study macroeconomic modeling and its application with a particular focus on monetary economics. In Chapter 1, I develop a New Keynesian model with heterogeneous workers whose wage settings are subject to downward nominal wage rigidity (DNWR) to address two puzzles of inflation dynamics: the missing deflation during the Great Recession and the excessive disinflation afterward. I demonstrate that DNWR introduces a time-varying wedge between the output gap and the marginal cost of producing one unit of output, which makes the observed Phillips curve flatter during recessions. Endogenous evolution of cross-sectional wage distribution generates various dimensions of non-linearities, while the presence of the zero lower bound (ZLB) of the nominal interest rate further reinforces the mechanism. Consequently, the model can quantitatively account for the inflation dynamics during and after the Great Recession under plausible parameter values that are consistent with micro evidence. In Chapter 2, I study welfare-maximizing monetary policy rule in the heterogeneous agent New Keynesian model with DNWR that is developed in Chapter 1. The optimal monetary policy rule responds strongly to output to address the inefficiency generated by DNWR, while responsiveness to inflation plays a minor role in welfare. Moreover, monetary policy can improve social welfare by responding more aggressively to a contractionary shock than to an expansionary one to offset the asymmetry stemming from DNWR. In the presence of the ZLB, on the other hand, alternative policy rules such as forward guidance and price-level targeting can partly offset the adverse effects of it by committing to a future low interest rate policy. I also investigate the optimal steady-state inflation rate. In Chapter 3, which is coauthored with Dongho Song and Jenny Tang, we propose a method of introducing theory-driven priors into the estimation of the vector autoregression (VAR). Our methodology is more flexible than existing methods in that it allows a researcher to incorporate prior beliefs on a subset of variables in theoretical models that are of key interest while remaining agnostic about other variables in the VAR. We apply to the problem of exchange rate forecasting for the British pound versus the US dollar. By imposing different combinations of priors informed by uncovered interest rate or purchasing power parity, we find that substantial gains are realized at longer forecast horizons. / Thesis (PhD) — Boston College, 2018. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.

Thesis advisor: Susanto Basu / Thesis advisor: Ryan Chahrour / This dissertation consists of three independent chapters analyzing the sources of business cycles and the role of monetary policy. Taking both closed- and open-economy perspectives, I study the importance of expectations for the empirical identification of economic and policy shocks, the nature of business cycle fluctuations, and the optimal conduct of monetary policy. The first chapter is titled ``International Spillovers and the Exchange Rate Channel of Monetary Policy,'' and is joint work with Vito Cormun. Motivated by the observation that exchange rate fluctuations largely influence small open economies, we propose a novel approach to separately identify the effects of domestic and external shocks on exchange rates and other macroeconomic variables, thereby uncovering a set of new empirical findings. A first finding is that external shocks account for most of exchange rate fluctuations. Relatedly, the bulk of external shocks is strongly correlated with measures of global risk aversion and uncertainty (e.g. the VIX), and a country’s net foreign asset position largely explains the exposure of its exchange rate to external disturbances. A second finding is that domestic and external disturbances generate very different comovement patterns between interest rates and exchange rates. In particular, unlike domestic shocks, external shocks are associated with large and significant deviations from uncovered interest parity. As a result, an econometrician that fails to properly distinguish between sources of exchange rate fluctuations is bound to obtain puzzling estimates of the exchange rate effects of domestic monetary policy shocks. These empirical findings have profound implications for models of small open economy and exchange rate determination. In particular, they favor theories in which exchange rates are jointly determined by the risk-bearing capacity in financial markets as well as the extent of a country’s financial imbalances. For this reason, we develop a model of the international financial sector that satisfies these features, and embed it in an otherwise standard general equilibrium two-country small open economy model. The key mechanism of the model consists of risk averse traders in the foreign exchange markets that require a premium to hold the currency risk of the small open economy. We show that the proposed model is able to reproduce all the empirical findings documented in the empirical analysis, including the cross-country differences in exposure to external shocks, the role of a country’s net foreign asset position, the different responses of interest rates, exchange rates, and currency excess returns across different shocks, as well as the emergence and resolution of the so-called exchange rate response puzzle across different identification approaches. The second chapter is titled ``Should Central Banks Target Investment Prices?'' and is joint work with Susanto Basu. The question posed in the title is motivated by the observation that central banks nearly always state explicit or implicit inflation targets in terms of consumer price inflation. To address the question, we develop an otherwise standard dynamic general equilibrium model with two production sectors. One sector produces consumption goods, while the other produces investment goods. In this context, we show that if there are nominal rigidities in the pricing of both consumption and investment goods and if the shocks to the two sectors are not identical, then monetary policy faces a tradeoff between targeting consumption price inflation and investment price inflation. In a model calibrated to replicate the estimated processes of sectoral total factor productivities as well as a set of unconditional business cycle moments, ignoring investment prices typically leads to substantial welfare losses because the intertemporal elasticity of substitution in investment is much higher than in consumption. Based on the model's predictions, we argue that a shift in monetary policy to targeting a weighted average of consumer and investment price inflation may produce significant welfare gains, although this would constitute a major change in current central banking practice. The third chapter is titled ``Information Acquisition and Self-Fulfilling Business Cycles,'' and is sole-authored work. To study the implications of imperfect information on economic fluctuations, I develop an otherwise standard Real Business Cycle model with endogenous information acquisition, which generates countecyclical firm-level uncertainty and endogenously procyclical productivity, as empirically documented in the literature. The main contribution of this chapter is the observation that this model displays aggregate increasing returns to scale and, potentially, an indeterminate dynamic equilibrium. In fact, an aggregate representation of the model is observationally equivalent to earlier theories of endogenous fluctuations based on increasing returns to scale, but its microeconomic foundations are consistent with empirically observed firm-level returns to scale. In a model calibrated to replicate a set of moments of the empirical distribution of firm-level productivity, self-fulfilling fluctuations are possible. In addition, a Bayesian estimation of the model suggests that non-fundamental shocks explain a significant fraction of aggregate fluctuations. / Thesis (PhD) — Boston College, 2019. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.

This thesis includes three interconnected essays which, building on the work by Hart and Zingales (2011), lay down the foundations for a new theory of financial intermediation. The first essay explains the Hart and Zingales (HZ) framework and shows that their results are not general. In the HZ model, there is a lack of simultaneous double coincidence of wants, and future income is not pledgeable. This implies that agents need money to trade. However, holding money entails an opportunity cost that leads to a waste of resources. Because of this inefficiency, pecuniary externalities have welfare consequences that private price-taking agents fail to internalize. I find that HZ's result, whereby the market produces inefficiently high levels of liquidity, cannot be generalized, because the conflict between private and social incentives to create money depends on agents' preferences. In the second essay I construct a framework that explains the transactions, precautionary and speculative demand for money. Again, the welfare analysis indicates that, depending on individuals' preferences, the market may produce inefficiently high or low levels of liquidity. The results also evidence that the speculative demand for money exists only when households are risk averse in their wealth. In that case, private and social incentives to hold money are stronger, but the market produces insufficient means of payment relative to the social optimum. The third essay introduces active financial institutions, and examines the role played by moral hazard in the provision of and demand for liquidity. Limited liability and the non-contractibility of bank investment policy induce highly levered financial institutions to invest in an inefficient gambling asset. I find that, when the probability that banks gamble is non-zero, the primary goal of public intervention is to address the moral hazard problem by restricting the creation of liquidity. Several policies to address this inefficiency are discussed and analyzed.

The rst chapter co-authored with Tatiana Damjanovic studies optimal mon- etary policy in a New Keynesian model at the zero bound interest rate where households use cash alongside house equity borrowing to conduct transactions. The amount of borrowing is limited by a collateral constraint. When either the loan to value ratio declines or house prices fall, we observe a decrease in the money multiplier. We argue that the central bank should respond to the fall in the money multiplier and therefore to the reduction in house prices or the loan to collateral value ratio. We also nd that optimal monetary policy generates a large and per- sistent fall in the money multiplier in response to the drop in the loan to collateral value ratio. The second chapter is focused on a macroeconomic model with sticky prices, rms borrowing market and the labour market frictions. We study connection be- tween monetary policy and labour market under the negative nancial and the positive productivity shocks. We have found that the interest rate rule with in a- tion and labour market targeting performs better than the rules with the aggregate consumption and debt targeting and is closest to the optimal policy as compared to the other regimes in terms of the welfare measure. We demonstrate too that the sign of the coe¢ cient next to unemployment in the policy rule depends on the value of workers bargaining power. The third chapter co-authored with Tatiana Damjanovic and Keqing Liu uses the classical cobweb model framework to investigate properties of the transition matrix in the bounded memory econometric OLS-type learning. We de ne memory length as the number of past observations used to form a forecast and analytically prove that for any length, the eigenvalues of the transition matrix lie within the unit circle. In addition, we sketch the proof of stationarity of the cobweb model under bounded memory learning. Furthermore, we investigate the relationship between the volatility of forecasts and the length of memory and nd that shorter memory causes higher variance in both forecasts and estimates of the OLS parameters.

Thesis advisor: Fabio Schiantarelli / In the wake of the financial crisis of 2007-2009, academics and policymakers have worked to empirically quantify macro-financial linkages. This dissertation contributes to this debate by covering two broad themes. First, substantial changes in bank regulation and supervision typically follow financial crises. Quantifying the impact of these new policies is of paramount importance to academics and policymakers. To this end, my research in this area sheds light on the ways in which changes in financial stability policy ultimately affect the economy. Bank stress testing has become a major tool of supervisory policy in the past decade. The first chapter, The Real Effects of Stress Testing, uses the introduction of annual stress testing of large U.S. banks in 2009 as a quasi-experiment to examine whether bank supervisory policies affect real economic activity. While stress-tested banks reduced their risk exposure to large corporate loans, foreign banks mostly offset this shock and enabled firms to continue borrowing after the test. However, speculative grade firms that were highly exposed to stress-tested banks borrowed on worse terms after the test, and subsequently reduced fixed investment and employment. In contrast, highly exposed investment grade firms received new loans and expanded intangible investment. This paper provides insights into the effects of stress testing on the reallocation of risks in the financial system and the consequences for real economic activity. The structure of the U.S. mortgage market has experienced dramatic changes in recent years, as Fannie Mae and Freddie Mac (the major government-sponsored enterprises or GSEs) faced substantial reforms to their business practices. An important feature of regulatory reform included changing the pricing of loan guarantees on mortgage-backed securities insured by the GSEs, in particular removing the subsidy paid by small lenders to large lenders in 2012. The second chapter of this dissertation, Lender Cross-Subsidization and Credit Supply in the Fannie Mae MBS Market (co-authored with Igor Karagodsky), shows that the removal of this subsidy resulted in a relative increase in mortgage lending by small lenders. However, states with relatively higher concentrations of large lenders experienced relative reductions in credit following the removal of these subsidies. This research underscores an important link between lender market power and credit supply. Understanding the drivers of the fluctuations in bond returns is a central question in finance. Theoretically, unexpected bond returns should reflect either changes in expectations of future short-term rates or future compensation for risk. The third chapter of this dissertation, Survey Forecasts and Bond Return Decompositions, revisits this question using survey forecasts of professional economists to measure expectations of interest rates and returns, rather than with a statistical model. Two main results emerged from this analysis: (1) News about future short-term interest rates explains relatively more of the variation in unexpected excess bond returns for short-maturity bonds relative to long-maturity bonds. (2) The share of news explained by future short-term interest rates increases with horizon for all maturities. This analysis contributes to the recent academic literature that highlights the importance of subjective expectations in understanding asset-price movements. / Thesis (PhD) — Boston College, 2019. / Submitted to: Boston College. Graduate School of Arts and Sciences. / Discipline: Economics.

Chapter 1.—This chapter addresses model specification uncertainty using the Bayesian Generalized Method of Moments (GMM). Employing Canadian data, I estimate 64 hybrid New Keynesian models which differ in their lag specification, and use a modified GMM quadratic function to produce model posteriors. I compute optimal discretionary policies for each model and then derive a posterior-weighted policy and loss. My results show that i) policy should respond more to the output gap than inflation, ii) a more aggressive policy is prescribed for the period of stagflation in the 1970s and early 1980s and iii) a relatively light-touch policy is recommended during the Great Moderation, and produces better outcomes. This last result supports the hypothesis of ‘good luck’ over ‘good policy’. Chapter 2.—In this chapter I develop an inverse control procedure to recover the under- lying preferences of a monetary authority engaged in discretionary policymaking. I adjoin the first-order condition (FOC) of the optimal interest rate rule-setting derived under discretion to the usual least squares moment conditions during the GMM procedure. Using Monte Carlo simulations, I show that the preferences on output gap stabilization and interest rate smoothing may be recovered. Robustness reveals that recovering the preference on the output gap is dependent upon policy actions having sufficient effect on the macroeconomy. Further testing indicates that the procedure functions for alternative starting values, may be adapted to different lag specifications of the underlying model, and is able to recover different sets of policy preferences. Chapter 3.—This chapter tests the hypothesis that the monetary authorities of Canada, the United States and the United Kingdom have exhibited similar preferences over stabilizing the output gap and smoothing the interest rate, by way of an inverse control algorithm (FOC- based GMM) for a discretionary policymaker. For the sample period covering 1968:1-2006:4, the FOC-based provides comparable structural estimates to a benchmark specification using an instrument-based GMM. The data suggest no role for output stabilization in any country, but a large and significant concern for interest rate smoothing is observed in Canada. Measures of fit reject optimality in the United States for baseline specification sample, but do not preclude it in any country when sample periods are restricted to the current man- dates. Policymakers’ reaction functions are shown to be sensitive to the underlying policy preferences, though decreasingly so at high levels of interest rate smoothing. Robustness is seen with respect to starting values and fixed policy coefficients.

Apesar de utilizar amplamente a hipótese de expectativas racionais com informação completa nos modelos macroeconômicos modernos, a literatura sempre enfatizou que os agentes econômicos tipicamente encontram fricções e limitações ao adquirir e processar informação. Os modelos de rigidez de informação surgem como uma alternativa atraente por sua capacidade de explicar atributos dos dados de expectativas, em especial a existência de divergência entre as previsões individuais dos agentes. Nesse trabalho, usamos dados brasileiros de expectativas de inflação, tanto para profissionais de mercado quanto para consumidores, de forma a testar as predições de duas classes de modelos de rigidez informacional: (i) sticky information e (ii) imperfect information. Na primeira categoria, os agentes se atualizam infrequentemente, mas obtêm informação perfeita quando se atualizam; na segunda, os agentes se atualizam continuamente, mas observam apenas um sinal ruidoso sobre o verdadeiro estado das variáveis econômicas. É possível distinguir entre essas duas classes de modelos porque ambas fazem predições conflitantes em termos das respostas dos momentos condicionais das expectativas, isto é, após um choque econômico fundamental. Por isso, uma parte essencial do trabalho consiste na identificação e estimação de choques estruturais. Ao realizar tais experimentos, não encontramos evidências que deem suporte a rigidez de informação, ao menos da forma colocada por esses modelos. Também não encontramos evidências a favor de um modelo no qual os agentes têm informação completa, mas diferentes funções perda em relação a erros de previsão. De forma surpreendente, os mesmos resultados são encontrados para profissionais de mercado e consumidores. No entanto, destacamos as limitações das medidas de expectativa usadas para estes últimos. / Despite assuming full-information rational expectations, part of macroeconomic literature has emphasized that agents typically face frictions and constraints in acquiring and forming expectations. Informational rigidities models stand for an appealing alternative, since they are capable of explaining key features of survey expectations data such as disagreement in forecasts between agents. In this work, we use inflation expectations data for professional forecasters and consumers in order to test the predictions of two classes of informational rigidities models: (i) sticky information and (ii) imperfect information. In the first type of model, agents can update their information sets only infrequently, but when doing so they acquire full information; in the second type, agents can update continuously, but only observe a noisy signal about the state of economic variables. One can distinguish between these two classes because they yield conflicting predictions about the conditional responses of forecast moments to fundamental economic shocks. Therefore, an important part of this work deals with identification and estimation of structural shocks. In performing the tests, we are not able to find evidences that support informational rigidities, at least not in the setting suggested by these models. Likewise, we cannot find support to a model in which agents have full-information, but heterogeneous loss functions about forecast errors. Surprisingly, we find the same results for professional forecasters and consumers. It is worth noting, however, that the consumer expectations measures used have several shortfalls.

A presente dissertação estuda empiricamente a relação entre a inflação e a distribuição de renda, utilizando dados de diversos países. A literatura empírica - baseada principalmente nos trabalhos de Deininger e Squire (1996) e Romer e Romer (1998) - tem se concentrado no estudo dos efeitos que a inflação pode ter sobre a desigualdade, e obteve diferentes conclusões sobre os mecanismos e resultados dessa influência. No entanto, alguns trabalhos teóricos recentes argumentam que há causalidade reversa nessa relação, com a desigualdade causando mudanças na inflação. Dessa forma, nossas contribuições serão: (i) tentaremos isolar os impactos da inflação sobre a distribuição de renda, usando como variáveis de controle: ciclos de crescimento, desenvolvimento econômico, questões regionais e instituições; (ii) procuraremos analisar a causalidade desta relação, utilizando como instrumento da inflação o aumento da quase-moeda. Nossos resultados indicam que há uma forte correlação entre inflação e desigualdade de renda. Porém, essa correlação não é robusta ao controle por variáveis omitidas e problemas de endogeneidade. / This dissertation estimates the relationship between inflation and income distribution, using cross-country data. The empirical literature based mainly on Deininger and Squire (1996) and Romer and Romer (1998) has focused on the impact of inflation on inequality, with mixed results. Nonetheless, recent theoretical work has suggested that causality may actually run in the opposite direction. Our contribution is twofold: (i) we try to estimate more precisely the effect of inflation on inequality by controlling for variables such as growth cycles, economic development, regional effects and institutions; (ii) we address the issue of reverse causality by using the growth rate of quasi-money as an instrument for the inflation rate. Our results indicate that there is a strong positive correlation between inflation and income inequality. Nevertheless, this correlation is not robust to controlling for omitted factors and endogeneity problems.