Monetary Policy Transmission Mechanism, Financial Frictions in closed and open economy DSGE models

Abstract

The broad objective of the thesis is to analyze the monetary policy transmission and relative importance of various shocks in business cycles after considering the financial sector structure for both developing and developed countries in three self-contained chapters (Chapter 2-4). The thesis contributes both theoretically and empirically to the literature relating to monetary policy, financial frictions and competition structure, exchange rate pass through and open economy in general, using Structural Vector Auto-Regression (SVAR) and Dynamic Stochastic General Equilibrium (DSGE) models. Since the global financial crisis, a growing awareness of the roles of financial frictions has led to renewed interests in transmission mechanisms of monetary policy and other shocks. Two different financial frictions are incorporated in the DSGE models of Chapter 3-4 while Chapter 2 does not explicitly model financial friction and uses SVAR model to analyze the research questions.

The effectiveness of monetary policy and its economy wide transmission mechanism are relatively unexplored in Bangladesh where financial sector is still developing. Hence, in Chapter 2, I investigate the effectiveness of monetary policy and its transmission mechanism with special emphasis on the lending channel. A SVAR model for Bangladesh is constructed, taking into account the exchange rate and monetary policy regimes in the identification scheme. The estimated model finds support for empirical regularities and existence of the bank lending channel. However, exchange rate channel appears less effective, reflecting a high degree of market intervention by the Bangladesh Bank.

Frictions complicate the role of the financial sector particularly in the advanced financial markets. Therefore, in Chapter 3, I analyze the transmission mechanism of investment specific technology (IST) shock in presence of frictions between depositors and bankers (a la Gertler and Karadi, 2009) and implications of considering the capital quality and the net worth shocks as financial shocks. I use a DSGE framework in Chapter 3 as it allows to design and experiment shocks and frictions explicitly. The estimated model with a closed economy representation for the US shows that, financial friction weakens the impacts of IST shocks in business cycles. Also, the financial sector is important not only as amplifier of shocks originating in the real sector, but also as an independent source of shocks affecting the real economy substantially.

Financial sector in many countries are not as competitive as in the US. Therefore, the financial friction discussed in Chapter 3 may not be relevant in those countries. Highly concentrated structure of the financial sector itself creates frictions affecting bank credits in important ways. Thus, in Chapter 4, I construct an open economy DSGE model with an oligopolistically competitive banking sector, considering Australia as an example. Oligopolistic competition is measured through interest markup which depends on the number of competing banks. The number of competitors is determined endogenously. The estimated model for Australia finds a strong stock market effect in presence of oligopolistic banks after a monetary policy shock making the shock less effective and such banks may amplify external shocks. Also, these banks appear to be more resilient to financial shocks indicating healthy bank balance sheet positions.

The big picture projected by the dissertation is, the depth and complexity of the financial sector affect the way intermediaries contribute to cyclical fluctuations when shocks including monetary policy hit the economy. For example, IST shock's impacts on output are weakened by the financial frictions through a bank balance sheet effect when intermediaries are highly competitive. However, under oligopolistic bank competition, the IST shock may not trigger effective enough balance sheet effects due to strategic behavior among the banks, leaving a large role for the shock to play. Policy implications of the thesis along with a discussion on future research directions are summarized in Chapter 5.