Essays on uncertainty, inflation and monetary policy

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2022-08

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The first paper evaluates the significance of the supply-side effect of monetary policy using cost channel in a New Keynesian business cycle model. I use a standard DSGE framework based on (Smets & Wouters, 2003) to model the effect of a negative monetary shock on inflation. I introduce a cost channel through (Rabanal, 2007) forcing some proportion of firms to borrow to make the wage payments. This setup increases the marginal cost after a contractionary monetary policy and puts upward pressure on inflation. I use two sample periods for estimation- pre-recession (Jan 1980-Dec 2008), and post-recession (Jan 2008- Sep 2020). In doing so, I control for the post-recession interest rates- often argued to be in the zero lower bound (ZLB) regime. The estimation results from pre-and post-recession data suggest that for both time frames, the demand side effect is stronger than the supply side. Hence, the introduction of cost channels is not enough for the supply side to dominate the demand side. Thus, the price must fall in response to a rise in interest rates. It should also be noted that estimates suggested small proportions of the firms are subject to cost channel before and after the great recession. As part of the robustness check, I restrict all firms and no firms to be subject to the cost channel and it can be concluded that even with those restrictions, the supply-side effects are minimal.

In my second paper, I study the effects of monetary policy on the business cycle and specifically the price puzzle (increasing inflation in response to a rising interest rate). I use three different model setups - an SVAR with Cholseky decomposition, a Factor-Augmented VAR model (with three factors), and a Vector Error Correction(VEC) model in my second paper. The SVAR using Cholesky decomposition as suggested in the literature shows that there is a significant price puzzle problem. Hence, we see that both output and inflation rise in response to a contractionary monetary policy. Results from the FAVAR model suggest that it is a significant improvement over the SVAR model as it suppresses the responses of the output and inflation and produces IRFs that are closer to the theoretical models. This result is consistent with the results of (Bernanke, Boivin, & Eliasz, 2005). Finally, I use a Vector Error Correction (VEC) approach to model the effects of a contractionary monetary policy. I use GDP\ GDP growth, trade openness, inflation, exchange rate, and federal funds rate(FFR) in the VEC model. The results demonstrate that imposing restrictions using a long-run cointegrating relationship can resolve the price puzzle problem. The GDP and inflation drop in response to the rising interest rates. This result is similar to (Krusec, 2010). However, the difference is that (Krusec, 2010) uses a three variables in his model while I consider the effects of exchange and trade openness along with other variables. The inclusion of trade openness and exchange is crucial as we are trying to build the response of inflation and output. In doing so, I find two long run-cointegrating relationships among the variable as opposed to (Krusec, 2010)’s one. And the restrictions in the model change. However, we come to a similar conclusion that considering a long run cointegrating VAR model solves the anomaly of the price puzzle.

For my third paper, I use two news-based indicators- News-based policy uncertainty and Equity-Market volatility as a measure for both policy-Specific uncertainty and general economic uncertainty for the period 2000 to 2020. Next, to determine the role of the monetary authority in these cycles, I simulate the response of the interest rates to these shocks. The results, using an SVAR model, indicate that both general and policy-related uncertainty shocks slow down the level of economic activity, with Volatility shocks having a more severe and instantaneous impact on the economy. The robustness tests suggest that the results of the SVAR model are robust.

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Keywords

Monetary Policy, Inflaltion, Uncertainty, Businesse Cycle

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