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Essays on Monetary Policy


This dissertation consists of three chapters focusing on the transmission of monetary policy surprises and the challenges faced in modeling unconventional monetary policy. Of that, two chapters analyze the effects of both conventional and unconventional monetary policies on the financial markets and the overall economy. The empirical findings support the argument that the unconventional monetary policies followed by the U.S. Federal Reserve are effective and the Federal Reserve is not very constrained by the lower bound on nominal interest rates. The chapter focusing on modeling of unconventional policy surprises highlights that extensions to standard macroeconomic models are required to realistically reflect the future effects of such policy.

In the first chapter, I estimate the effects of the Federal Reserve's forward guidance and large-scale asset purchase announcements, along with the effects of interest rate changes under conventional policy, on the U.S. stock market, and assess their transmission channels. Although the overall stock market responds meaningfully to a surprise change in the federal funds rate with a high level of statistical significance, a heterogeneity in responses is observed among different sectors in the stock market. In contrast, forward guidance is found to have relatively homogeneous effects on sector-wise stock market performance. Such effects are large in magnitude and highly statistically significant. However, large-scale asset purchases exhibit minimal effects on equity price movements. The present value of future excess returns emerged as the most important channel through which the surprise changes in the federal funds rate as well as forward guidance and large-scale asset purchases affect current equity prices. The present value of future dividends and the real interest rates are found to make smaller contributions to the propagation of policy shocks. However, the relative contribution of future dividends, real interest rates and excess returns vary across different types of policy shocks. The contribution from future dividends is found to be relatively high for a forward guidance shock than a current federal funds rate shock. Large-scale asset purchases shocks are found to have transmission channels making both positive and negative contributions supporting the arguments on information effects associated with such announcements. Meanwhile, the sector-wise analysis highlights that for a federal funds rate shock, the sectors which are more interest rate sensitive tend to report large excess equity return responses. Further, the sectoral equity premium responses derived for a forward guidance shock reaffirmed the relatively homogeneous effects of forward guidance on equity prices.

The second chapter proposes a potential solution to the open economy version of the forward guidance puzzle. Standard models for monetary policy analysis show that far future forward guidance has implausibly large effects on current output and inflation, and these effects grow with the forward guidance horizon, a phenomenon known as the forward guidance puzzle. I attempt to analyze the effectiveness of forward guidance policies in a small open economy model, focusing on an open economy version of the forward guidance puzzle, in order to assess its impact on the exchange rates, in addition to output and inflation. In a standard small open economy model with complete international financial markets, not only the output gap and inflation, but also the exchange rates tend to overreact in a forward guidance experiment. In order to find a possible resolution to this phenomenon, a perpetual youth structure is incorporated into the benchmark small open economy model under consideration. I then show that the presence of agents with finite lives tends to weaken the excessive response of key macroeconomic variables to a forward guidance announcement, including the exchange rate.

In the third chapter, I estimate the high-frequency changes in interest rate expectations and term premia across the yield curve due to monetary policy surprises on the Federal Open Market Committee (FOMC) announcement days, and analyze its effects on the financial markets and the overall economy. Disaggregation of yield curve responses shows that a current federal funds rate shock has a bigger impact on expectations than on term premium for short-term yields. For long-term yields, a forward guidance shock has a bigger impact on expectations than on term premium. A large-scale asset purchase shock is mainly transmitted through expectations supporting the signaling channel of balance sheet policies. It is shown that instruments for the changes in expectations could be identified along the lines of conventional short-term rate shocks as well as forward guidance and asset purchase shocks. In the financial markets, a shock to expectations for the short end of the yield curve is associated with substantial and statistically significant effects on short-term debt instruments, while shocks to expectations about the future interest rate path and asset purchases are associated with substantial and statistically significant effects on long-term debt instruments. Term premium effects, although orthogonalized against expectations, relate to meaningful responses in both short- and long-term instruments. Regarding the macroeconomic impact, a shock to expectations for the short end of the yield curve brings about the usual contractionary effects. A shock to expectations about the future rate path results in an increase in long-term yields and a drop in consumer prices, although with an expansion in economic activity suggesting the presence of either the "Fed response to news'' channel or the "Fed information effect'' channel. A surprise to asset purchase expectations leads to an increase in economic activity and employment, supporting the arguments for the balance sheet policies of the Federal Reserve. Meanwhile, orthogonalized term premium effects on the economy are found to be similar to those of a policy uncertainty shock.

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