UC Berkeley

International economic integration has risen during the last decades and the interdependence between each economy and the rest of the world has become central for policy decisions. My dissertation contributes to the debate about the conduct of monetary policy in a financially integrated world.

In the first chapter of the dissertation I discuss the relationship between domestic policies and the currency denomination of foreign debt. Foreign debt is a double-edged sword. It allows countries to invest more than what would be possible given their own savings, thereby achieving preferable allocations that would not otherwise be feasible. However, it is the root of several crises. Foreign debt is especially hazardous when denominated in foreign currency; in such cases exchange rate depreciations increase the real value of the debt. An important question then is what determines the currency denomination of foreign debt. I use the adoption of Inflation Targeting (IT) in several economies during the last two decades to evaluate the importance of domestic policies in the determination of the currency denomination of debt. In order to control for possible endogeneity in IT adoption, I use matching and instrumental variables estimators; both generate similar estimates. The results show that monetary policy can have substantial effects on the amount of debt in foreign currency and that a more flexible exchange rate regime increases the use of domestic currency in foreign borrowing.

In the second chapter of the dissertation I investigate the relationship between central banks balance sheets and monetary policy. Heavy foreign exchange intervention by central banks of emerging markets have led to sizeable expansions of their balance sheets in recent years - accumulating foreign assets and non-money domestic liabilities (the latter due to sterilization operations). With domestic liabilities being mostly of short-term maturity and denominated in local currency, movements in domestic monetary policy interest rates can have sizable effects on central bank's net worth. In this chapter I examine empirically whether balance sheets considerations influence the conduct of monetary policy. The methodology involves the estimation of interest rate rules for a sample of 41 countries and testing whether deviations from the rule can be explained by a measure of central bank financial strength. My findings, using linear and nonlinear techniques, suggest that central bank financial strength can be a statistically significant factor explaining large negative interest rate deviations from "optimal" levels.

In the third chapter I investigate whether countries that adopted the IT framework for monetary policy have been constrained by exchange rate consideration when taking policy decisions. I present stylized facts which suggest that exchange rates have been allowed to float relatively free in IT countries. I employ Bayesian Analysis techniques to estimate a Dynamic Stochastic General Equilibrium (DSGE) structural model for twenty two IT economies and compute posterior odds tests to check whether the central banks systematically respond to exchange rate movements. The main result is that only five central banks directly respond to exchange rate movements; all the other IT central banks do not respond to the exchange rate. I also confirm that IT central banks have been conducting strictly inflationary policies, raising real interest rates in response to increases in inflation.