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This thesis addresses interactions between monetary and fiscal policies in a theoretical dynamic stochastic general equilibrium (DSGE) model of a small open economy and in an empirical model under a structural vector error correction model (SVECM). The thesis consists of three essays. The contribution is both theoretical and empirical that enables a better understanding of the complexity of interactions between monetary and fiscal policies in small open economies. The first essay examines the equilibrium determinacy under monetary and fiscal rules. The goal is to investigate how monetary and fiscal policy interactions ensure a unique and non-explosive (determinate) equilibrium for a small open economy. The study focuses when policy makers implement a set of policy mixes to address domestic output price inflation control for monetary policy, debt stabilization for fiscal policy, and joint output stabilization tasks. The result indicates that two policy schemes facilitate a determinate equilibrium. First, monetary policy actively controls inflation when fiscal policy sets a sufficient feedback on debt. Second, monetary policy becomes passive against inflation when fiscal policy is insolvent. Adding output stabilization to each rule simply causes variants of this fundamental. An interest rate rule with output stabilization can be more passive against inflation while providing a stronger response to the output gap. Fiscal policy is required to set higher feedback on debt along with its stronger counter-cyclical policy. The second essay links between the equilibrium determinacy and policy optimization. This essay provides insights into the design of policy mixes and compares determinacy outcomes between two theoretical models of a small open economy: with and without an explicit exchange rate role. This study shows that policy interactions in a small open economy with an endogenous exchange rate is quite sophisticated, especially when a monetary rule is added with an output stabilization task and/or targeted to Consumer Price Index (CPI) inflation. Additional concern for monetary policy in an open economy causes a partial offset to its reaction on domestic output price inflation that weakens its effect on the real debt burden. To minimize economic fluctuations, policy makers should mute the role of output stabilization for monetary policy, and set minimum feedback on debt that is compatible with the degree of counter-cyclical fiscal policy. Substantially active response to inflation is satisfactory for monetary policy with CPI inflation targeting. The third essay empirically presents monetary and fiscal policy interactions in Thailand's SVECM suggested by a theoretical DSGE model developed from the previous essays. This essay shows that the DSGE-SVECM model can be supported by Thai data. A shock to monetary policy is effective with a lag. Government spending policy is also effective with a lag and some crowding-out effects on output. An adverse shock in tax policy unexpectedly stimulates the economy, indicating room for enhancing economic growth by relaxing revenue constraint. Monetary policy is mainly implemented to correct a consequence of a fiscal shock on inflation (and also the domestic and foreign shocks), while fiscal policy appears to counter a consequence of the monetary policy shock on output.
This dissertation studies the dynamic effects of various economic shocks in a two-sector small open economy. It is divided into three essays. Essays 1 and 2 have a theoretical focus; they involve the developing of intertemporal optimizing models of a small open economy. In these essays, we use the representative-agent framework to derive dynamic macroeconomic effects. Specifically, in the first essay we examine the effects of monetary policy targeted at an inflation rate in a small open economy. We adopt a two-sector dependent economy where money is introduced through various cash-in-advance (CIA) constraints. Results are very significant and sensitive to various CIA constraints as well as relative capital intensities. Higher inflation will generate more investment in the economy leading to a higher level of capital stock and a lower level of net foreign assets in the long-run when the nontraded sector is more capital intensive and households need cash for purchasing tradable goods. However, the long-run effects are completely opposite if households need real balances for purchasing nontradable goods instead. In the second essay we examine the effects and the associated dynamics of an increase in international oil prices and domestic inflation. We show that an increase in oil prices or higher domestic inflation lowers the level of investment, production, and consumption in the long-run. The economy experiences a current account surplus along with a fall in capital stock by holding more foreign traded bonds. Transitional dynamics significantly depend on sectoral capital intensity as well. In essay 3 we investigate the explanatory power of yield spread in predicting economic activities in developing economies. We employ both the Markov regime switching model (MS) and the probit model to estimate the probability of recessions during the Asian financial crisis. We find that three-regime MS model is better predictor of recessions than tworegime MS model. The MS results are also compared with that of the standard probit model for comparison. The MS model does not significantly improve the forecasting ability of the yield spread in forecasting business cycles.
In this dissertation we use Dynamic Stochastic General Equilibrium (DSGE) models to explain empirical regularities and policy implications related to (1) durable goods, interest rates and small open economy business cycles, (2) Terms-of-Trade (ToT) and economic fluctuations in small open economies and (3) Budget Stabilization Funds (BSFs) and States' business cycles. In the first essay, we document that durable spending in developed small open economies constitutes a large share of their total income. Their spending is highly procyclical, sensitive to interest rates, and leads the business cycle. We address these regularities with a RBC model with durable goods. The model successfully replicates the observed business cycle regularities and explains many anomalies not explained in the existing literature. It also emphasizes the role of interest rates uncertainty in explaining the dynamics of the small open economies. The second essay addresses the impacts of the ToT fluctuation on the business cycles of various small open economies. We argue that differences in the degree of durability in domestic production and imports may make these economies more or less sensitive to an identical ToT shock. We found that economies with higher durability usually enjoy more stable business cycle comparing with economies with lower degree of durability. Differences in the persistence of the ToT do affect the dynamic of the external accounts but it cannot explain the observed differences business cycles across small open economies. In the last essay, we evaluate the economic impacts of the Budget Stabilization Funds (BSF) on State-level business cycles. We lay out a State economy RBC model in which a State's government applies a designated saving rule consistent with households' optimization. Given the suggested rule we find that the BDFs become a significant automatic stabilizer. It is not only mitigates the procyclicality of the government spending but it also smooth the State's business cycle.
This thesis is composed of three independent chapters, but all centered around the broader topic of how macroeconomic policies interact with various aspects of household heterogeneity. Monetary Policy and Inequality under Labor Market Frictions and Capital-Skill Complementarity We provide a new channel through which monetary policy has distributional consequences at business cycle frequencies. We show that an unexpected monetary easing increases labor income inequality between high and less-skilled workers. In particular, this effect is prominent in sectors intensive in less-skilled labor, that exhibit high degree of capital-skill complementarity (CSC) and are subject to matching inefficiencies. To rationalize these findings we build a New Keynesian DSGE model with asymmetric search and matching (SAM) frictions across the two types of workers and CSC in the production function. We show that CSC on its own introduces a dynamic demand amplification mechanism: the increase in high-skilled employment after a monetary expansion makes complementary capital more productive, encouraging a further rise in investment demand and creating a multiplier effect. SAM asymmetries magnify this channel. Monetary-Fiscal Interactions and Redistribution in Small Open Economies Ballooning public debts in the wake of the covid-19 pandemic can present monetary-fiscal policies with a dilemma if and when neutral real interest rates rise, which might arrive sooner in emerging markets: policymakers can stabilize debts either by relying on fiscal adjustments (AM-PF) or by tolerating higher inflation (PM-AF). The choice between these policy mixes affects the efficacy of the fiscal expansion already today and can interact with the distributive properties of the stimulus across heterogeneous households. To study this, I build a two agent New Keynesian (TANK) small open economy model with monetary-fiscal interactions. Targeting fiscal transfers more towards high-MPC agents increases the output multiplier of a fiscal stimulus, while raising the degree of deficitfinancing for these transfers also helps. However, precise targeting is much more important under the AM-PF regime than the question of financing, while the opposite is the case with a PM-AF policy mix: then deficit-spending is crucial for the size of the multiplier, and targeting matters less. Under the PM-AF regime fiscal stimulus entails a real exchange rate depreciation which might offset "import leakage" by stimulating net exports, if the share of hand-to-mouth households is low and trade is price elastic enough. Therefore, a PM-AF policy mix might break the Mundell-Fleming prediction that open economies have smaller fiscal multipliers relative to closed economies. Weak Wage Recovery and Precautionary Motives after a Credit Crunch During the economic recovery following the financial crisis many advanced economies saw subdued wage dynamics, in spite of falling unemployment and an increasingly tight labour market. We propose a mechanism which can account for this puzzle and work against usual aggregate demand channels. In a heterogeneous agent model with incomplete markets we endogenize uninsurable idiosyncratic risk through search-and-matching (SAM) frictions in the labour market. In this setting, apart from the usual precautionary saving behaviour, households can self-insure also by settling for lower wages in order to secure a job and thereby avoid becoming borrowing constrained. This channel is especially pronounced for asset-poor agents, already close to the constraint. We introduce a credit crunch into this framework modelled as a gradual tightening of the borrowing constraint (and utilizing a continuous time approach, known as HACT). The perfect foresight transition dynamics feature falling wages despite a tightening labour market and expanding employment. As households suddenly find themselves closer to the borrowing constraint, the increased precautionary motive drives them to accept lower wages in the bargaining process, while firms respond to this by posting more vacancies, leading to a tighter labour market and falling unemployment. If the household deleveraging pressure is persistent enough after the credit crunch, it can explain the weak wage recovery in spite of already stronger aggregate demand.
Investigating various fiscal policy issues in the context of an open economy, this dissertation consists of three essays. The first essay addresses the question of the volatility of foreign aid and its impact on resource-constrained developing economies. A small open-economy business cycle model is developed that accounts for the effect of external shocks specific to developing economies. The model produces business cycle patterns consistent with the data and key stylized facts. The model is calibrated to reflect the structural empirical regularities of an aid-dependent developing country. The parameters of the exogenous stochastic shocks are estimated using Bayesian methods and 50 years of data for Cote d'Ivoire. The results suggest that foreign aid's unpredictability helps explain business cycles' volatility in developing countries. In the second essay, a dynamic stochastic general equilibrium model (DSGE) is used to analyze the effects of fiscal stimuli, such as investment tax credits (ITC) and wage subsidies, in a small open economy. Various cost-equivalent fiscal schemes are considered in response to an economic downturn. The baseline open-economy model's results are also contrasted with a closed economy case to highlight the role the current account plays during recession and recovery episodes. The results suggest that wage subsidies have faster but shorter effects on production and employment while ITCs have slower but longer lasting impacts. The persistence of fiscal shocks appears to play a significant role in the initial response of investment. The third essay provides empirical evidence to address a question heavily debated among lawmakers yet hardly ever investigated in the empirical literature: Does increasing taxes on the rich hurt or help employment growth? Proponents of tax hikes on the rich reject the idea that such taxes, which some refer to as "millionaire" taxes, have any negative impact on jobs. Critics, on the other hand, believe taxing the rich, whom they consider "job creators," hurts the economy by hampering job creation. Using newly constructed time series based on the IRS Statistics of Income, this study finds strong and statistically significant positive effects in the short run and some evidence of negative effects in the long run.
This dissertation consists of two essays in international macroeconomics. The first essay shows that optimal fiscal and monetary policy is time consistent in a standard small open economy. Further, there exist many maturity structures of public debt capable of rendering the optimal policy time consistent. This result is in sharp contrast with that obtained in the context of closed-economy models. In the closed economy, the time consistency of optimal monetary and fiscal policy imposes severe restrictions on public debt in the form of a unique term structure of public debt that governments can leave to their successors at each point in time. The time consistent result is robust: optimal policy is time consistent when both real and nominal bonds have finite horizons. While in a closed economy, governments must have both nominal and real bonds, and have at least real bonds over an infinite horizon to render optimal policy time consistent.
This dissertation consists of two independent essays on open economy macroeconomics. The first chapter of the dissertation is motivated by the question: "What rationalizes the stylized facts of emerging market business and credit cycles?" Business and credit cycles in emerging countries display very volatile consumption, highly volatile and countercyclical net exports, strongly countercyclical real interest rates, and procyclical flows of credit to the household sector and to the business sector. The standard small-open-economy (SOE) model cannot generate this cyclical pattern of the interest rate and the change in credit market liabilities of households. In order to correct this irregularity and account for the data pattern, this paper augments the SOE model to include collateral constraints for the household sector and limited enforcement constraints for the banking sector. The model generates business and credit cycles consistent with Korean data and gives a rationale for highly volatile consumption, countercyclical country interest rates, and procyclical credit flows. In the counterfactual experiments, we find that the output volatility in Korea is reduced by 11% and welfare gains amount to 0.17% increase in one quarter's steady-state consumption when the default risk in the financial sector is completely eliminated. The second chapter investigates how the presence of pricing-to-market and the degree of imperfect financial market integration affects the effectiveness of optimal monetary policy. Global resource allocation can be inefficient because exporting firms may set different prices among markets and households in different countries may pay different prices for identical goods. On the other hand, political, technological, or informational barriers may hinder capital flows across countries, leading to deviations from perfect cross-country risk sharing. Considering this stylized setting, we augment a standard monetary open economy model to include the failure of the law of one price and imperfect financial market integration. We characterize the optimal monetary policy and assess its effectiveness in compared to inward-looking policies
This dissertation research puts a focus on small open economies, whose policies do not affect world prices and interest rates. In the first chapter, it is shown that recent Canadian data from 2001 to 2013 feature a notable procyclical trade balance, which contrasts with the countercyclical trade balance in 1981-2000. By using a dynamic small open economy model built based upon Mendoza's (1991) framework, driven by correlated domestic productivity shocks and world credit spread shocks, I can generate the observed trade balance pattern in the pre-2000 and post-2000 periods. In addition, my analysis shows that the world credit spread shocks explain a large portion of the considerable change in the cyclicality of trade balance, and that the low world real risk-free interest rate after 2000 partially accounts for the procyclical trade balance in the same time period. Applications of the model to other developed small open economies, such as Australia and New Zealand, yield similar results, suggesting that the world credit spread shocks have an impact on macroeconomic dynamics and help improve model performance. The second chapter concerns an innovative exchange rate policy implemented by the Reserve Bank of Australia (RBA). From 2013 to mid-2015, in order to achieve balanced economic growth, the RBA tried to bring down the Australian dollar by presenting public speeches and monetary policy statements that expressed a strong preference for a lower exchange rate, which is known as jawboning down the currency. To investigate the effectiveness of the central bank's jawboning strategy, I analyze the Australian economy with a structural vector autoregressive (SVAR) model, in which the Exchange Rate Stance Index (ERSI) is constructed to measure the magnitude of jawboning. The empirical results show that an unanticipated increase in the ERSI, which is equivalent to strengthened jawboning by the RBA, will lead to a significant and lasting fall in the real exchange rate. However, the ERSI shock fails to improve GDP over the medium term, suggesting that the jawboning strategy is not an effective exchange rate policy tool to boost GDP growth. The third chapter investigates how the global and local financial shocks would contribute to the large fluctuations of the unemployment rates in the emerging markets. We use a panel structural vector autoregressive (VAR) model to analyze monthly data from six emerging countries between 1999 and 2015. The results show that the local financial risk factors, including the country spread and the dividend yield, account for a larger portion of unemployment movements than the global financial risks, including the U.S. risk-free real interest rate and the global financial risk proxied by the U.S. Baa corporate spread.