UC Davis

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.