Fiscal policy, monetary policy and the transmission mechanism of shocks

Abstract

This thesis focuses on the three central themes that have dominated the world economy in recent decades. First, in each of the localized financial crises that have taken place in the world economy, policymakers around the world have reduced policy interest rates to help stimulate the economy. The recent subprime mortgage crisis and the subsequent Great Recession resulted in the reduction of policy interest rates in many advanced economies to historically low levels. Second, governments around the world have implemented huge fiscal stimulus packages. Third, emerging market economies and countries such as Australia, with close trade linkages to China, have remained resilient. The severity of the crisis of 2007-2011 and the resilience displayed by some economies have resulted in renewed interest among policymakers in investigating the transmission mechanism channels of economic shocks, fiscal and monetary policies. There are three main objectives in this thesis. The first objective is to examine the impact of fiscal and monetary policies on the US economy. Chapter 2 uses the Factor Augmented Vector Autoregression (FAVAR) methodology to estimate the impact of fiscal and monetary policy shocks on the US economy. The second objective of the thesis is to investigate the asymmetry in the effects of conventional monetary policy on the economy dependent on financial stress conditions. A Threshold Vector Autoregression (TVAR) model is used to analyze the effects of monetary policy on the US economy during periods of low and high financial stress, specifying a financial stress index as the threshold variable. The third objective of the thesis is to study the transmission of economic shocks from the US and Chinese economies to the Australian economy. Chapter 4 in this thesis uses a FAVAR approach and a large dataset of 414 macroeconomic variables to analyze the international transmission mechanisms between the Australian economy and the US and Chinese economies. Overall, this thesis finds evidence suggesting that fiscal and monetary policies can be effective and potent in helping the US economy recover from a financial crisis. This thesis finds that government spending plays an important role compared to other policy levers. The effects of a government spending shock last for a longer period of time and explain more variability in the macroeconomic variables in the US economy, with some crowding-out effects in the medium term. Analyzing the impact of monetary policy on the US economy in during financial regimes provides further insights. The impact of monetary policy on the US economy is found to be greater during periods of high financial stress when the size of the shock is larger. There is also evidence of a cost channel effect during periods of high financial stress which suggests that there is a short run inflation-output trade off during financial crises. The FAVAR model developed to analyze the international transmission of economic shocks from the US and China to Australia suggests that the US economy continues to play an important role in the Australian economy, despite the increase in trade linkages between Australia and China. Show more