Essays on financial sector and optimal monetary policy

The thesis is composed of three chapters which analyze the monetary and macro-prudential policy using a New Keynesian DSGE model with the banking sector. The first chapter evaluates the effectiveness of time-varying macro-prudential tools and their interaction with monetary policy using the model framework of Gertler and Karadi (2011) which emphasizes the role of bank capital and endogenous leverage constraint due to the moral hazard problem. We consider the following three types of countercyclical macro-prudential tools: (i) capital requirements (CAR), (ii) deposit-based reserve requirements (DBRR), and (iii) asset-based reserve requirements (ABRR). The main findings are as follows. First, all three types of macro-prudential policy tools reacting to the financial condition (credit to output gap) are effective to mitigate the fluctuation of credit and business cycle by weakening the pro-cyclicality of banks' net worth and the counter-cyclicality of the endogenous leverage and external finance premium. Second, the effectiveness of each instrument differs by the source of shocks to the economy. In response to a TFP shock, the counter-cyclical CAR is the most effective to mitigate the fluctuation of credit and output and the ABRR is relatively more effective in response to capital quality shocks (credit supply shock). Third, all types of macro-prudential tools are welfare improving in combination with monetary policy, but the use of macro-prudential policy is relevant in response to the credit supply shock (financial shock). Finally, when the economy is hit by a financial shock, a relatively direct tool like asset-based reserve requirement (ABRR) can be the most welfare-improving and the relationship between monetary and macro-prudential policy can be complementary each other. The second chapter examines the role of banks' endogenous reserves and capital and the usefulness of financial condition (credit aggregates and external finance premium) as an indicator for setting up a relevant monetary policy rule. For the task, I construct an extended version of Goodfriend and McCallum (2007) model which is characterized by banks' loan production function with inputs (collaterals, monitoring works and bank capital buffer) under the households' deposit in advance (DIA) constraint. Main findings are as follows. First, banks' endogenous reserves can mitigate the variation of external finance premium by substituting costly monitoring works for lending. However, the effect of endogenous reserves on output and credits depends on types of shocks (credit-demand vs credit-supply shock), which reflects the role of external finance premium (EFP) as a banking attenuator (pro-cyclical EFP) or financial accelerator (counter-cyclical EFP) respectively. Second, the effect of banks' endogenous reserves can be limited when banks can adjust their capital flexibly compared to when banks' keep their capital to asset ratio (leverage) stable. Third, considering the role of money and the frictions on the credit-supply side, monetary policy reacting actively to the financial condition is welfare improving. These results imply that quantitative easing (QE) policy during the crisis was effective but the effectiveness of QE can be limited when banks can lower their leverage in a pro-cyclical manner. And monetary policy should pay more attention to the financial condition and prevailing interest rates as well as inflation and output gap in the presence of substantive financial frictions on the credit supply side in particular when the banking shocks dominate the economy. In the last chapter (co-authored with Professor Jagjit S. Chadha), we investigate the question facing many emerging economies: the extent to which a workhorse advanced economy model can yield important insights for monetary policy-making. We note that the standard sticky-price, monopolistically competitive model does not allow analysis of money and credit dynamics and led to a concentration of research on simple interest rate reaction functions. However, time-varying financial frictions tend to act as a tax on intermediation activities and so can vary output in a significant manner. In this chapter, we consider the implications of financial frictions for baseline monetary policy using a model calibrated on Indian data and find that a simple interest rate reaction function may not be welfare maximizing when banking shocks are dominant in the economy.

Financial frictions and financial shocks can affect the trade-off between inflation stabilization and output-gap stabilization faced by a central bank.Financial frictions lead to a greater response in output following any deviation of inflation from target and thus lead to an increase in the sacrifice ratio.As a result, optimal monetary policy in the face of credit frictions is to allow greater output gap instability in return for greater inflation stability.Such a shift in optimal monetary policy can be mimicked in a Taylor-type interest rate feedback rule that shifts weight to inflation and the lagged interest rate and away from output.However, the ability of the conventional Taylor rule to mimic optimal policy gets worse as credit market frictions and shocks intensify.By including a financial variable like the lending spread in the monetary policy rule, the central bank can partially reverse this worsening output-inflation trade-off brought about by financial frictions and partially undo the effects of credit market frictions and shocks.Thus the central bank may want to include lending spreads in the policy rule even when financial distortions are not explicitly part of the central bank's objective function.

INTERRELATIONSHIP OF INFLATION, EXCHANGE RATE AND INTEREST RATES IN THE CONTEXT OF HUNGARY'S STRATEGIC POLICY

Understanding the monetary policy transmission mechanism is pivotal for the design of an effective monetary policy. In this regard, the coexistence of interest rate and cost channel of monetary policy has raised important implications for the conduct of monetary policy. This article estimates a New Keynesian model to quantify the strength of interest rate and cost channel by estimating retail rate stickiness and share of firms considering interest rate in their marginal cost function. It examines the extent of interest rate pass-through and cost channel for exogenous monetary policy shock and endogenous movement in official rate arising due to other financial, nominal, and real shocks in the economy. The trade-off between the degree of pass-through and cost channel of monetary policy has also been examined. The minimum distance estimation of the Dynamic Stochastic General Equilibrium (DSGE) model has confirmed that the degree and nature of interest rate pass-through depend on the nature of shock hitting the economy and the cost channel exists only for monetary and financial shocks. A weak trade-off also exists between the degree of pass-through and cost channel of monetary policy. The study recommends that coordination between central banks and financial and non-financial firms is essential for effective stabilization through monetary policy.

This dissertation consists of four essays, focusing on the relationship between financial risks, financial market uncertainty and macroeconomic conditions. The first essay estimates the effects of anticipated and unanticipated monetary policy changes on jump variation by employing high frequency non-parametric jump detection methods. We use an event study approach and a structural VAR framework in examining stock price jump variation for the aggregate economy, the financial, health, energy and telecommunication-information technology sectors (Tel-Info). We find that anticipated changes in the Fed funds have no significant effect on jumps. In contrast, jump variation in the price of financial market data increases with monetary policy surprises. We document evidence of asymmetries in the response of jumps to monetary policy changes. Monetary policy surprises and positive changes in the Fed target rate induce increment in jumps. Similar results exist in the sector analysis. In addition, this study uncovers no evidence of endogenous response between jumps and monetary policy surprises. The second essay estimates the response of uncertainty/risk aversion to monetary policy actions in both the financial sector and the aggregate economy using a Structural Vector Autoregressive (SVAR) model. When compared with other sectors, our constructs reveal that financial risk aversion/uncertainty has greater correlation with the aggregate risk aversion and uncertainty. Our analysis reveals that financial risk aversion and uncertainty exhibit stronger interdependence with monetary policy actions than aggregate uncertainty and risk aversion. The third essay provides the dynamic characterization of the link between ex-ante financial distress risk and the real economy. Using 219, 990 firm-year observations, an ex-ante measure of financial distress is generated at sector level. By employing simultaneous equation model, we provide a comprehensive set-up for predicting ex-ante financial distress risk and examining its effect on GDP growth. Over the period of 1970-2012, the results from the US firms reveal that ex-ante financial distress strongly relate to GDP growth. Ex-ante distress risk contracts GDP growth by up to 10%. Similar contractions in the growth of GDP are uncovered when a single equation approach is used in establishing the relationship between financial distress and growth in GDP. In addition, the results remain consistent when a confirmatory analysis is generated by using a weighted sector index of financial distress. The fourth essay examines liquidity risk and financial integration using bank level flows for 95 countries. The results suggest that global banking network influences liquidity risk. The more the banks are connected to each other the more they are prone to liquidity risk and the result is the same for intermediaries in the network formation. Borrowers that connect to important lenders are not at an advantage, but banks that have independent access to finance in the financial network are at an advantage. On a regional basis, banks in Europe, Africa and Asia and Pacific that have strong connections are prone to liquidity risk. American banks that function as intermediary in the network are prone to liquidity risk. Banks in the American region that have independent access to financing in the financial network are able to reduce liquidity creation, but their degree of connectivity worsens net stable funding.

Modelling the sources of Business Cycle Fluctuations (BCF)1 in an open economy Dynamic Stochastic General Equilibrium (DSGE) framework is a fascinating area of research. The main advantage of this framework over traditional modelling approach is due to an additional feature of micro-foundations in terms of welfare optimisation. This feature allows structural interpretation of deep parameters in a way that is less skeptical to Lucas critique [Lucas (1976)]. In DSGE modelling context, the sources of BCF are normally viewed as exogenous shocks, which have potential power to propagate the key endogenous variables within the system. This requires a careful identification, as the transmission of these shocks may emanate from internal side, such as, political instability; weak institutional quality in terms of low governance, or from external side, such as, natural disaster (like, earth quacks and floods); international oil and commodity prices; sudden stops in foreign capital inflows; changes in term of trade and exchange rate, or any combination of shocks from both sides. Also, the nature and magnitude of these shocks may vary, depending upon their variances and persistence levels.

In recent years, the importance of international capital flows has been increasing, which has significantly accelerated the integration process of the international financial system. After 2008, the central banks of major western developed economies implemented loose monetary policy, which led to a large amount of capital flowing into new market countries. However, international capital flowed out of new market countries after Federal Reserve Chairman Ben Bernanke said in 2013 that the Federal Reserve would gradually withdraw from quantitative easing.The great fluctuation of international capital has aroused the debate about monetary policy and macro-prudential policy. Rey (2015) believes that under any exchange rate system, only the control of international capital flows can maintain the independence of monetary policy. In view of the above findings, since 2016, the People’s Bank of China has established a macro-prudential regulatory mechanism for international capital flows to resist external financial shocks.By introducing domestic and international financial institutions, this paper brings the macro-prudential policy of foreign financial shocks and capital flows into the DSGE framework of small countries’ open economy. Domestic financial institutions can raise funds by absorbing the deposits of their own residents and foreign residents; international financial institutions buy and sell the creditor’s rights issued by various countries, so as to implement capital flows.It is found that under the impact of foreign interest rate increase, on the one hand, it will tighten the balance sheet of domestic financial institutions, and reduce the scale of corporate credit through bank incentives and constraints; on the other hand, it will cause the devaluation of domestic currency and international capital outflows, and affect the stability of the financial system. The macro-prudential management mechanism of capital flows can enhance the ability to resist external financial shocks. For China, the proportion of foreign debt is relatively low, and the policy effect is relatively mediocre for the counter cyclical tax adjustment mechanism of external borrowing of domestic financial structure; however, the counter cyclical adjustment mechanism for the capital flow of international financial institutions can significantly improve social welfare.This paper gives the following policy recommendations: Firstly, we should increase the significance of external financial risk prevention. In recent years, the rapid growth of international capital flows has brought new challenges to new economies. Secondly, we should strengthen the supervision of cross-border capital flows to resist external financial risks. In the process of further opening up of China’s financial market, the People’s Bank of China should improve the macro-prudential supervision of foreign exchange market, real estate market and credit market to prevent systemic financial risks. Finally, we should properly solve the financing problems of enterprises. For China, capital outflows will aggravate the already severe credit market pressure. Therefore, on the one hand, resist the external financial risk contagion through the macro-prudential supervision mechanism of capital flows; on the other hand, maintain the liquidity at a reasonable level through the flexible operation of monetary policy, in order to support economic growth.

PurposeThe purpose of this paper is to compare business cycle fluctuations in Ethiopia under interest rate and money growth rules.Design/methodology/approachIn order to achieve this objective, the author constructs a medium-scale open economy dynamic stochastic general equilibrium (DSGE) model. The model features several nominal and real distortions including habit formation in consumption, price rigidity, deviation from purchasing power parity and imperfect capital mobility. The paper also distinguishes between liquidity-constrained and Ricardian households. The model parameters are calibrated for the Ethiopian economy based on data covering the period January 2000–April 2015.FindingsThe main result suggests that: the model economy with money growth rule is substantially less powerful or more muted for the amplification and transmission of exogenous shocks originating from government spending programs, monetary policy, technological progress and exchange rate movements. The responses of output to fiscal policy shocks are relatively stronger under autarky which appears to confirm the findings of Ilzetzki et al. (2013) who suggest bigger multipliers in self-sufficient, closed economies. With regard to positive productivity shock, however, the model with interest rate feedback rule generates a decline in output and an increase in inflation, which are at odds with conventional empirical regularities.Research limitations/implicationsThe major implication is that a central bank regulating some measure of monetary stocks should not expect (fear) as much expansion (contraction) in output following currency devaluation (liquidity withdrawal) as a sister central bank that relies on an interest rate feedback rule. As emphasized by Mishra et al. (2010) the necessary conditions for stronger transmission of interest-rule-based monetary policy shocks are hardly existent in emerging and developing economies targeting monetary aggregates; hence the relatively weaker responses of output and inflation in the model economy with money growth rule. Monetary policy authorities need to be cautious when using DSGE models to analyze business cycle dynamics. Quite often, DSGE models tend to mimic the proverbial “crooked house” built to every man’s advise. Whenever additional modification is made to an existing baseline model, previously established regularities break down. For instance, this paper documented negative response of output to technology shock. Such contradictions are not uncommon. For example, Furlanetto (2006) and Ramayandi (2008) have also found similarly inconsistent responses to fiscal and productivity shocks, respectively.Originality/valueUsing DSGE models for research and teaching purposes is not common in developing economies. To the best of the author’s knowledge, only one other Ethiopian author did apply DSGE model to study business cycle fluctuation in Ethiopia albeit under the implausible assumption of perfect capital mobility and a central bank following interest rate rule. The contribution of this paper is that it departs from these two unrealistic assumptions by allowing international risk premium as a function of the net foreign asset position of the country and by applying money growth rule which closely mimics the behavior of central banks in low-income economies such as Ethiopia.

An Assessment of the Impacts of Banking Sector Reforms in Nigeria

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Financial shocks and the US business cycle

The notion of an ‘independent’ central bank has dominated monetary policy debates for the past three decades. The arguments for the political independence of central banks are closely related to the adoption of ‘inflation targeting’. The arguments for an independent central bank are based on the ‘credibility’ of the ‘conservative’ central bank in comparison to government decision making. The independence of a central bank has been a matter of independence from government but not independence from the grip of the ‘new consensus in macroeconomics’ nor from the interests of the banking and financial sector. That independence has also supported a lack of co-ordination between monetary and fiscal policies, diminishing the effectiveness of macroeconomic policies. In addition, there remain doubts about the effectiveness of ‘inflation targeting’ on the achievement of low inflation. The policy mandates of central banks have begun to shift towards financial stability and paying attention to issues of inequality and the climate emergency.

This paper challenges monetary policy after the financial crisis. The discussion shows that forward guidance of theinterest rate and Quantitative Easing (QE) may give monetary policy more power when the short term nominalinterest rate is close to zero lower bound. The current recession is a consequence of excessive debt in private andpublic sector, and since both public and household sector need time to pay down debts and rebuild savings, standardmonetary policy as well as non-standard monetary policy (QE) will have limited effects on the present recession. Animportant lesson from financial crisis is that imbalances in the financial sector and high debt in private and publicsector may fly under the inflation radar screen in conventional monetary policy and undermine the economy.Monetary policy in future should therefore target also financial stability. Taylor’s rule affords a monetary policy withmaximum of transparency, but it is unlikely to perform better than a central bank’s carefully judgment of inflation,production gap, other possible targets, and the means that the bank has available (the interest rate). The Tinbergenrule tells us that we need one instrument for every independent target, and monetary policy therefore needs help fromother economic policy areas. Even if we need an independent central bank, the central bank must also communicateand cooperate with government. Finely, the paper suggests that one should use market mechanisms to a higherdegree in the bank market to make clear to lending institutions that they are responsible and must consider the risk inrelation to their investments.

Financial Shocks and Optimal Policy

This paper proposes a fully micro-founded framework that incorporates optimizing banks, into a DSGE model, and evaluates the role of banks and financial shocks in the Iranian business cycles. We assume banks that offer different banking services and interact in an interbank market. Loans are produced using interbank borrowing and drposit. Banks have monopoly power, but cannot set nominal deposit and prime lending rates. The model also includes financial and unconventional monetary policy shocks. The main findings are that: (1) The model captures the key features of the Iranian economy; (2) bank behavior substantially affects credit supply conditions and the transmission of different shocks; (3) financial shocks have significant effects on the Iranian business cycle fluctuations.