Essays on Macro-Financial Linkages and Monetary Policy

The financial crisis of 2007-2009 triggered a major recession in the U.S., the fallout of which spilled over to many advanced economies. My dissertation examines three topical questions that emerge from this episode.

In the first chapter, "Do Credit Shocks Matter? A Global Perspective", we examine the importance of credit market shocks in driving global business cycles over the period 1988:1-2009:4. We first estimate common components in various macroeconomic and financial variables of the G-7 countries. We then evaluate the role played by credit market shocks using a series of vector autoregressive (VAR) models. Our findings suggest that these shocks have been influential in driving global activity during the latest global recession. Credit shocks originating in the U.S. also have a significant impact on the evolution of world growth during global recessions.

In the second chapter, "Credit Shocks and the U.S. Business Cycle: Is This Time Different?", I examine whether the effects of credit shocks on the U.S. economy show time variation during the Great Moderation period. By estimating a time-varying VAR model with stochastic volatility, I discriminate between two possible sources of time variation: stochastic volatility of shocks and changes in their transmission mechanism. This chapter finds that credit shocks exhibit stochastic volatility: the conditional volatility of these shocks systematically rises during periods of stress to the U.S. financial sector like the 2001 dot-com bust and the 2007 subprime crisis. Adjusted for shock size, I do not find any evidence that the transmission mechanism of credit shocks is time varying. In the specific context of the Great Recession of 2007-2009, I find that credit shocks have a non-trivial role. But, they do not entirely explain the magnitude of this recession.

In the third chapter, "Raising the Inflation Target to Manoeuvre the Zero Lower Bound: The Role of Fiscal Policy", I examine the recent monetary policy proposal that central banks should pursue a higher inflation target in view of the recession-induced zero lower bound. Because countercyclical fiscal policy is an alternative macroeconomic stabilization tool at the zero lower bound, this chapter explores how fiscal policy matters when deciding whether or not policy makers should raise the inflation target. I find that the scope for a countercyclical fiscal policy weakens the case for raising the inflation target as a means to mitigate the effects of the zero lower bound. The efficacy of countercyclical fiscal policy during zero lower bound episodes, however, depends on the initial level of government debt - a high initial level of government debt limits that efficacy.