Essays on international finance - monetary and exchange rate policy

Abstract

This thesis presents three essays on monetary and exchange rate policies under the broad theme of international finance. The first essay on monetary policy (Chapter 2) considers three key questions on the behavior of the Federal reserve reaction function: (1) did the U.S Federal Reserve actively pursue a loose-fitting monetary policy which contributed to the build-up of the monetary excess prior to the GFC; (2) would an inflation target of 4 percent have provided a higher Federal Fund Rate (FFR) and thus greater room for policy maneuvering during the crisis; and (3) did the Federal Reserve fail to respond to the Black Swan in the financial market during the crisis, that is, counter-party risk and overall market stress? Using monthly data from 1984:M1 to 2010:M9, we find that only the Black Swan hypothesis put forward by Taylor and William (2009) is the most relevant, based on the single equation Generalised Method of Moments (GMM) framework and supported by the Chow test for structural change. This also explains the recent changes in the Federal Reserve monetary policy approach of employing quantitative easing measures, rather than the conventional interest rate based policy. The second essay (Chapter 3) on exchange rate volatility uses the Autoregressive Moving Average [ARMA(1,1)] in a Exponential Generalised Autoregressive Conditional Heteroscedasticity in Mean [EGARCH-M (1,1)] model to study the daily volatility in the Australian Dollar from the 03-Jan-2000 to 28-Sep-2010 based on derivatives carry trade and commodity prices. Overall, results for the mean equation for the volatility in USD/AUD exchange rate highlights: (1) AUD is influenced by the carry trade activities (i.e. currency swap interest rate) and as expected, the significance of carry trade is elevated in periods of rising Australian interest rates; (2) international commodity prices have significant bearing on the USD/AUD exchange rate variability; and (3) Australian stock prices and 3-year bond yields also seems to influence USD/AUD. On the contrary, the conditional variance of the USD/AUD exchange rate illustrates: (1) overwhelming evidence of persistence in shocks; (2) magnitude of the conditional variance is significant; and (3) in large part, absence of any asymmetric behaviour. Finally, the essay (Chapter 4) on exchange rate policy investigates the crucial role of the Australian Dollar as a shock absorber or source of shock relative to its four major trading partners; the U.S., the U.K., Japan and New Zealand. This essay employs a small Keynesian open macroeconomic framework popularised by Clarida & Gali (1994), and utilises a Bayesian Time Varying Parameter Vector Autoregression (TVP-VAR) framework with stochastic volatility to derive time varying impulse response. It demonstrates that the Australian real exchange rate acts as a shock absorber relative to the U.S. and Japanese real exchange rates, while it is the source of shock relative to the U.K. and New Zealand real exchange rates. This study also provides a novel method of investigation and results for the Australian real exchange rate, which outlines the heterogeneity of the Australia real exchange rate across time and relative to its trading partners. Show more