Recent economic events pose challenging questions for macroeconomists. The rising global imbalances raise the issue whether existing international macroeconomic models can explain the patterns observed in the data on real exchange rates and current accounts. The first chapter of this dissertation addresses the question whether a standard portfolio balance model can account for the long-run dynamic behavior of the real exchange rate and net foreign debt in the United States (US). The rest of the dissertation does not test how well theoretical models fit reality but uses models in order to understand reality better. The second and third chapters are motivated by the most significant economic event in the last decade-the US 2008 financial crisis. It triggered a major collapse in US real activity, called the Great Recession, and disrupted the job matching process in the labor market. The second chapter of this dissertation addresses the challenges faced by monetary policymakers in response to an increase in labor market frictions. Two striking features of the Great Recession are the speed and synchronicity with which real activity collapsed across the world. The third chapter analyzes how shocks such as the 2008 crisis are transmitted across countries. The findings of each chapter are briefly summarized in the following paragraphs.

A strand of models of the joint behavior of the current account, net foreign debt stock and the real exchange rate postulate that this behavior is driven by saddle-path dynamics and the related portfolio balance effect. This saddle-path dynamics is based on the assumption that domestic and foreign assets are imperfect substitutes and that the financial markets clear before the goods markets. Chapter 1 uses the Johansen test for cointegration to check the prediction of a portfolio balance model that the net foreign debt stock and real exchange rate display saddle path dynamics. Newly constructed quarterly series on the face value of the United States net foreign debt as a percentage of nominal GDP, together with data on the broad real effective exchange rate index of the United States Dollar, are analyzed. The results indicate that the US net foreign debt and real exchange rate are cointegrated and do not display saddle path dynamics. The cointegrating relationship is found to be negative and trend-stationary. These empirical results suggest that a richer framework that incorporates the dynamic behavior of relative asset supplies is more appropriate for interpretation of the joint dynamics of the US net foreign debt and real exchange rate.

In chapter 2 I build a dynamic stochastic general equilibrium model with search and matching frictions in the labor market and analyze the optimal monetary policy response to an outward shift in the Beveridge curve. The main finding is that the optimal monetary policy depends on the shock that causes the shift. A fall in the efficiency of matching does not cause an increase in the unemployment gap; the optimal response of the central bank is to stabilize inflation. An increase in the elasticity of employment matches with respect to vacancies presents the policy maker with a trade off between stabilizing inflation and unemployment. The optimal policy response to the efficient labor market shock changes when real wages are sticky but remains unchanged when home and market goods are imperfect substitutes, compared to the case when they are not. When contrasted to a Taylor rule that targets inflation and output growth, the optimal monetary policy is more aggressive in pursuit of its objectives.

Chapter 3 is a joint effort with Abigail Hughes from the Bank of England and explores how financial factors affect the international transmission mechanism. We look at how financial frictions affect the international transmission of country specific productivity shocks. We then explore how two types of shocks that affect the external finance premium are propagated across countries. We build a two country DSGE model with financial frictions to explore the size and nature of international spillovers. Our main findings are that financial frictions magnify movements in international relative prices. In addition, external finance premium shocks can generate significant and persistent international spillovers but they depend on the type of shock. A shock to the dispersion of the productivity of entrepreneurs results in a shift in the foreign aggregate supply curve. A shock to the survival probability of entrepreneurs generates a shift in the foreign aggregate demand curve.