Essays on Monetary Policy Rules and Exchange Rate Volatility

My thesis consists of three essays. Essay one presents a theoretical framework to analyze the optimal choice of exchange rate regimes based on the welfare e ect, and to identify the relationships between trading taxes and exchange rate volatilities. Essay two integrates both the new open economy macroeconomic model and the international real business cycles approach to investigate monetary policy e ects. Essay three explores the real e ects of nominal shocks in a world economy with traded and non-traded goods. The first study develops a simple dynamic general equilibrium framework for assessing the welfare properties of both floating and fixed exchange rate regimes in a two-country, sticky price, and tax distortion model. An important feature of the model is the deviation from the assumption of complete markets, caused by taxes and price stickiness. This study thus provides a positive and normative analysis of alternative exchange rate systems in a model with di erent external shocks. The main findings are as follows. First, a fixed exchange rate regime produces no less welfare than a floating exchange rate regime. Second, taxes on foreign exchange transactions discourage speculation by increasing currency trading costs, and thus increasing exchange rate stability. Finally, a tax distortion does not influence the choice of optimal exchange rate system. The second work explores implications of monetary policy rules in a general equilibrium two-country framework with sticky prices, and monopolistic competition. We assume the monetary authorities adopt an ad hoc monetary policy rule as the reaction function, which concern the money growth and velocity. We derive a solution for the nonlinear model, used by calibrating standard international real business cycle techniques. There are two uncertainties in the economy: 1) money growth rate shock, and 2) interest rate shock. Specifically, the model using the monetary rules fits the real economies well. The investigation also implies that the ‘expenditure switching effect’is not significant. Additionally, we find that the exogenous shocks impact on the real macroeconomic aggregates dramatically, when the aggregate price is staggered. The last paper develops a theoretical framework for analyzing the dynamics of real exchange rates in responses to nominal innovations. The model develops a twosector, traded and non-traded products’framework with a monopolistic supply in the labour market and in which nominal wage rates are set one period in advance. We thereby empirically investigate the role of monetary shocks in driving real exchange rate fluctuations in a set of VAR models, using an alternative identification scheme. The results would suggest that, in the post-Bretton Woods era, monetary shocks have played a significant role in driving the real exchange rates of Group of Seven Countries.Table of Contents v Abstract vii Acknowledgements ix Introduction 1 1 Exchange Rate Regimes and Taxes in an Open Economy 3 1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 1.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 1.2.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 1.2.2 Consumption and Price Indices . . . . . . . . . . . . . . . . . 7 1.2.3 Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 1.2.4 Producers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 1.2.5 Market Equilibrium . . . . . . . . . . . . . . . . . . . . . . . . 12 1.2.6 Stochastic Processes and Tax on Capital Flows . . . . . . . . 12 1.3 Solving the Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 1.4 Comparison of Exchange Rate Regimes . . . . . . . . . . . . . . . . . 16 1.4.1 Floating Exchange Rates . . . . . . . . . . . . . . . . . . . . . 16 1.4.2 Fixed Exchange Rates . . . . . . . . . . . . . . . . . . . . . . 23 1.5 Welfare Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 1.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27 2 Monetary Policy Rules and Business Cycles in a Two-CountryModel 29 2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 2.2 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 2.2.1 Households . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 2.2.2 Consumption Allocation . . . . . . . . . . . . . . . . . . . . . 33 2.2.3 Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 2.2.4 Prices and Optimal Conditions . . . . . . . . . . . . . . . . . 34 2.2.5 The Equilibrium Conditions . . . . . . . . . . . . . . . . . . . 36 2.2.6 Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 2.3 Sticky Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 2.4 Monetary Policy Rules . . . . . . . . . . . . . . . . . . . . . . . . . . 39 2.5 Calibrations and Solutions . . . . . . . . . . . . . . . . . . . . . . . . 40 2.5.1 Calibrations . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 2.5.2 Quantitative Evaluations of the Model . . . . . . . . . . . . . 42 2.6 Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 3 The E ect of Monetary Shocks on Real Exchange Rates in G-7 Countries 54 3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 3.2 The Model . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 3.2.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 3.2.2 Consumption and Price Indices . . . . . . . . . . . . . . . . . 58 3.2.3 The Firm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 3.2.4 Government . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60 3.2.5 The Optimal Conditions . . . . . . . . . . . . . . . . . . . . . 60 3.2.6 Steady-State Equilibrium . . . . . . . . . . . . . . . . . . . . . 61 3.3 The Empirical Methods . . . . . . . . . . . . . . . . . . . . . . . . . 62 3.3.1 Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62 3.3.2 Econometric Methods . . . . . . . . . . . . . . . . . . . . . . 63 3.4 Results . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 3.4.1 Variance Decompositions . . . . . . . . . . . . . . . . . . . . . 65 3.4.2 Impulse Responses . . . . . . . . . . . . . . . . . . . . . . . . 68 3.5 Concluding Remarks . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 4 Conclusions 75 Bibliography 7