Financial markets have been central to academic and policy debates for decades and are crucial to the functioning of economies. However they occasionally lead to financial crises, which have been associated with several and severe downturns in economic activity. Particularly since the 2008 Financial Crisis, a lively literature on appropriate financial regulation emerged. At the forefront of regulatory interventions are macroprudential policies. Macroprudential policies are implemented ex-ante and are supposed to reduce the likelihood and costs of a potential future crisis. Common macroprudential policies resort to countercyclical equity buffers or leverage and liquidity constraints. More recently, a new literature emerged that justifies capital controls from a macroprudential perspective. All of these policies are appealing, because they are incentive compatible and do not require a large fiscal or monetary stimulus.

This dissertation evaluates macroprudential policies in an international context both from a theoretical and applied perspective. The international context is important since financial markets are global, yet little is known about the effects of financial interlinkages on financial regulation. A specific focus of this dissertation is on capital controls, which received renewed interest in the policy debate to limit external overborrowing.

In my first chapter I study the strategic interactions between national regulators in a model of international prudential liquidity regulation. The model justifies coordinated liquidity regulation due to an international fire-sale externality. However, I theoretically and empirically argue that domestically oriented regulators from countries with a smaller banking sector do not internalize the global benefits of regulation and therefore do not adhere to international standards. In terms of policy recommendations, the model justifies capital controls if countries do not cooperate. Though capital controls improve the welfare of regulating economies, they also align the interest of free-riding countries with international regulation.

The second chapter (joint work with Florian Loipersberger) empirically analyzes financial spillovers from advanced economies towards emerging markets. The comovement of financial markets has raised concerns about the ability of emerging market economies to insulate their economy from international financial shocks. We empirically show that capital controls are as potent as floating exchange rates in dampening the response of international financial shocks on domestic financial variables and the real economy. We relate this finding to muted boom-bust cycles in short-term non-resident capital flows. However, the benefits of floats or capital controls are reaped in isolation, i.e. either tool is enough. We argue that these patterns can be explained by nominal frictions in labor markets and provide empirical support for this claim.

In the third chapter, I ask a very simple question: How should countries balance macroprudential capital controls and pure domestic or international prudential policies. I introduce a domestic financial market into an otherwise standard small open economy model with an occasionally binding international borrowing constraint. The key result is that capital controls or international macroprudential policies should be accompanied by purely domestic macroprudential instruments even when domestic markets are frictionless. Intuitively, domestic regulation is welfare enhancing because it shifts resources towards agents who are not able to borrow internationally and as a consequence have a higher propensity to consume. I provide a simple formula that links the degree of domestic regulation to the level of international regulation, the cost of regulation, the investment profitability and the underlying inefficiency in the international financial market.

What determines sovereign risk? We study the London bond market from the 1870s to the 1930s. Our findings support conventional wisdom concerning the low credibility of the interwar gold standard. Before 1914 gold standard adherence effectively signalled credibility and shaved up to 30 basis points from country borrowing spreads. In the 1920s, however, simply resuming prewar gold parities was insufficient to secure benefits. Countries that devalued before resumption were treated more favorably, and markets scrutinized other signals. Public debt and British Empire membership were important determinants of spreads after World War One, but not before.

This dissertation consists of three essays on the monetary policy pass-through to financial markets and bank balance sheets. I use frontier econometric methods combined with rich micro and macro-level datasets to examine the effect of monetary policy on financial markets and banks' balance sheets, focusing on how specific bank and market characteristics amplifies the monetary policy transmission mechanism. Moreover, I show that monetary policy transmits to real economic outcomes through financial markets and banks' balance sheets. Finally, I complement my empirical findings with theoretical models to identify the underlying monetary policy transmission mechanisms.

The first chapter of my dissertation studies the effect of market power on monetary policy transmission to banks' funding dynamics, lending, and profitability by comprehensively studying the interactions among the deposit, wholesale funding, and credit markets, which is missing in the literature. In this chapter, I document the heterogeneous impact of monetary policy on banks' deposit, wholesale funding, and lending spreads depending on the degree of their bank market power. Specifically, I show that after an increase in the policy rate, banks with higher market power increase their deposit and loan rates less and access wholesale funding markets at a relatively lower cost compared to other banks. Hence, banks with higher market power counterbalance the fall in their deposit inflows by increasing their reliance on wholesale funding, and their lending decreases less than other banks following a monetary contraction. This "wholesale funding channel" dampens the adverse effect of contractionary monetary policy on their lending and profitability. I further show that bank market power affects monetary policy transmission to the real economy through its impact on bank-level lending. In particular, aggregate lending and employment decrease less in areas served by banks with higher market power after an increase in the policy rate. Finally, I rationalize my empirical findings by building a theoretical model with monopolistic competition. In the model, banks with higher market power access wholesale funding markets at a lower cost, which generates imperfect pass-through of monetary policy.

The second chapter of my dissertation provides a new channel of monetary policy-pass-through to bank lending and lending rates, "bank liquidity channel". In particular, I evaluate monetary policy pass-through conditional on bank liquidity using rich bank-level balance sheets and income statement data. I find that after an increase in the policy rate, funding inflows of banks decreases and constrain banks' loan originations. However, banks with less liquid balance sheets reduce their loan supply more due to their liquidity constraints. In particular, these banks start to shrink their balance sheets by reducing their loan originations as they don't have enough buffer stock liquidity to deplete when they face an adverse shock. Second, I document that banks with less liquid balance sheets increase their loan rates more than other banks following a monetary contraction. Lastly, I build a theoretical model with heterogeneous banks that explains the underlying mechanism. In the model, bank liquidity constraints combined with monopolistic competition impose frictions on monetary policy pass-through to bank lending rates, where there is no deposit rate dispersion among banks based on their liquidity position.

Finally, Chapter 3 studies the impact of maturity mismatch between banks' assets and liabilities on monetary policy transmission to bank profitability and asks whether the role of the maturity mismatch channel has changed during the zero lower bound (ZLB) environment. Using high-frequency monetary policy surprises that allow me to separate the effects of conventional and unconventional monetary policy, I first show that bank stock prices decrease significantly after contractionary federal funds rate and forward guidance shocks. That is, the indirect effects of contractionary monetary policy (e.g., the signaling impact of a weaker economy, higher default probabilities, and a weak bank balance sheet performance) outweigh its direct effect (the expected improvement in net interest margins) on banks' stock prices. I then document that banks with larger maturity mismatch are affected less negatively from the contractionary monetary policy surprises as their expected net interest margins rise more after an increase in the level and slope of the yield curve. Turning to the zero lower bound (ZLB) environment, I show that large-scale asset purchases (LSAP) that decrease the long-term yields affect bank stock prices positively during this period. However, the maturity mismatch channel ceased to exist in the ZLB environment. Specifically, the response of bank stock prices stopped varying depending on the maturity structure of their balance sheets, indicating a limitation to unconventional monetary policy.

I explore the dynamic effects of monetary policy on the distribution of household wealthin the United States. I provide new evidence that monetary policy plays a significant role in driving persistent movements in wealth inequality. Using the new Distributional Financial Accounts and high-frequency identification, I find that contractionary monetary policy disproportionately reduces the net worth of the bottom 50% of households by wealth. By decomposing net worth into asset prices and quantities, I find that wealth dynamics for the top 1% of households follow from a reduction in equity prices while the dynamics for the bottom 50% of households are driven by high leverage ratios and a reduction in holdings of and consumer durables, consistent with a consumption smoothing motive. I show that the magnitude of these responses is larger following episodes of monetary tightening than easing for the bottom 50%. Additionally, we study how the level of government debt affects the effectiveness of monetary policy, i.e., the elasticity of economic aggregates to interest rate changes. We build a New Keynesian model where fiscal policy is non-Ricardian and government debt is risk-free. Wealth effects generated by government bonds weaken the transmission of changes in the policy rate to output. Using data on private ownership of public debt for the U.S., we find that when government debt is one standard deviation above its mean, the response of industrial production and unemployment to an expansionary monetary shock is reduced by 0.5pp and 0.075pp, respectively, out to a three-year horizon. Finally, I study the dynamics of the household wealth distribution in response to changes in government spending in the U.S. I find that increases in government spending raise the net worth of all groups except for the top 1%. Decomposing the responses of wealth into broad asset and liability classes, I find that responses are largely driven by an appreciation in the price of real estate. These results are consistent with a mild and temporary compression of the household wealth distribution.

Argentina’s money and banking system was hit hard by the Great Depression. The banking sector was awash with bad assets that built up in the 1920s. Gold convertibility was suspended in December 1929, even before the crisis seriously damaged the core economies. Commonly, these events are seen as being driven by external real shocks associated with the World Depression, espite the puzzle of the timing. We argue for an alternative, or complementary, explanation of the crisis that focuses on the inside-outside money relationship in a system of fractional-reserve banking and gold-standard rules. This internal explanation for the crisis involves no timing puzzle. The tension between internal and external convertibility can be felt when banks fall into bad times, and an internal drain can feed an external drain. Such was the case after financial fragility appeared in the 1914–27 suspension. Resumption in 1928 was probably unsustainable due to the problems of the financial system, and a dynamic model illustrates the point well. The resolution of the crisis required lender-of-last-resort actions by the state, discharged at first by the state bank issuing rediscounts to private banks. When the state bank became insolvent, the currency board started bailing out the system using high-powered money. Thus came about the demise of the currency board and the creation of a central bank in 1935, an institution that had no pretense of a nominal-anchor commitment device and no ceiling on lender-of-last-resort actions—innovations with painful long-run consequences for inflation performance and financial-sector health. As one of its first substantive actions, the central bank engineered a bailout of the banking system at a massive social cost. The parallels with recent developing-country crises are remarkable, and the implications for the institutional design of monetary and banking systems are considered.

The exchange-rate regime is often seen as constrained by the monetary policy trilemma, which imposes a stark tradeoff among exchange stability, monetary independence, and capital market openness. Yet the trilemma has not gone without challenge. Some (e.g., Calvo and Reinhart 2001, 2002) argue that under the modern float there could be limited monetary autonomy. Others (e.g., Bordo and Flandreau 2003), that even under the classical gold standard domestic monetary autonomy was considerable. This paper studies the coherence of international interest rates over more than 130 years. The constraints implied by the trilemma are largely borne out by history.

The interwar period was marked by the end of the classical gold standard regime and new levels of macroeconomic disorder in the world economy. The interwar disorder often is linked to policies inconsistent with the constraint of the open-economy trilemma—the inability of policymakers simultaneously to pursue a fixed exchange rate, open capital markets, and autonomous monetary policy. The first two objectives were linchpins of the pre-1914 order. As increasingly democratic polities faced pressures to engage in domestic macroeconomic management, however, either currency pegs or freedom of capital movements had to yield. This historical analytic narrative is compelling—with significant ramifications for today’s world, if true—but empirically controversial. We apply theory and empirics to the interwar data and find strong support for the logic of the trilemma. Thus, an inability to pursue consistent policies in a rapidly changing political and economic environment appears central to an understanding of the interwar crises, and the same constraints still apply today.

In this dissertation, I investigate macroeconomic consequences of monetary policy and trend inflation.

The first chapter studies the role of trend inflation and monetary policy in the determination of bond and stock correlation.I show that Treasuries’ role as hedge assets is determined by the level of trend inflation and the conduct of monetary policy, using a Generalized New Keynesian habit model. A novel prediction from the model is that when trend inflation is high, nominal bonds exhibit a positive correlation with stock returns, making them risky assets. As trend inflation rises, inflation becomes more countercyclical because any transitory inflation generates temporary output loss due to endogenous cost-push effects, which emerge under positive trend inflation. When countercyclical inflation prevails, bond returns drop when stocks underperform, leading to a positive bond-stock correlation. The model explains the shift in US bond-stock correlation from positive to negative in 1997 as a consequence of stabilized trend inflation.

The second chapter explores optimal unconventional monetary policy in a New Keynesian model with trend inflation.A standard New Keynesian model is extended to feature heterogeneous households, financial intermediaries, and unconventional monetary policy. By optimally designing both conventional and unconventional policy, a central bank can completely stabilize both the output gap and inflation, and restore a divine coincidence despite the endogenous cost-push wedges from trend inflation, which is not possible with only one policy tool. Furthermore, optimal unconventional monetary policy at the ZLB highlights the importance of aligning long-run inflation target with policy makers’ objectives between stabilizing output gap and inflation because of the policy trade-offs.

The third chapter examines the impact of bank funding liquidity risk on bank lending in response to monetary policy changes. It finds that the extent of this impact varies depending on banks’ exposure to funding liquidity risk. Banks within an internal banking network, with lower funding liquidity risk, are less affected by monetary policy changes. They experience more stable deposit flows and have easier access to wholesale funding, albeit at higher costs. In contrast, regional banks without such network relationships are more vulnerable to monetary policy shocks and adjust their lending more significantly. These findings highlight the role of funding liquidity risk in shaping the diverse effects of monetary policy across the banking sector.