Financial Markets and the Macroeconomy: Theory, Evidence and Policy Prescriptions

This dissertation investigates the role of financial markets as a driving force behind business cycle fluctuations and studies effective monetary policy responses that mitigate the negative economic impact of such fluctuations. The first chapter empirically investigates the consequences of the 2007 interbank market freeze and provides a new theoretical framework to study the economic benefits and risks arising from complex financial networks. I use highly detailed proprietary microdata from the German Bundesbank to provide evidence that exposure to the US financial market had a negative impact across several measures on domestic German monetary financial institutions (MFIs) and their clients. I develop a dynamic stochastic general equilibrium model of the macroeconomy with a banking sector that intermediates funds between depositors and firms. I show that interbank fund transactions improve the allocation of household savings across the economy, but also affect its volatility by determining how sensitive the aggregate supply of credit becomes to individual-bank shocks. I use the model to provide estimates of the welfare contribution of the interbank market to the German economy and the costs of bank disintermediation that followed the 2007 financial crisis. I study the welfare benefits of standard monetary policy and central bank lender-of-last-resort interventions, and I find that policies that actively target the credit spread arising from the banking sector are more effective.The second chapter studies the historical (1868-1930 period) propagation of banking panics across the United States. I develop a partial equilibrium model of the interbank market consistent with the historical pyramidal reserve structure of deposits that was in place throughout the period. The model presents a simple tradeoff between an efficient allocation of bank funds and exposure to cross-border deposit fluctuations. I empirically estimate the dynamic spatial propagation of panics and I find that panics are accompanied by moderate but temporary drops in variables capturing banking sector activity, together with a robust spatial propagation consistent with the model. The third chapter investigates the welfare costs of the zero-lower bound (ZLB) on nominal interest rates and presents a theoretical New-Keynesian framework that incorporates the main empirical properties of ZLB spells. Employing a regime-switching (RS) risk-premium process to bring rates to the ZLB, I demonstrate how both frequency and duration of ZLB episodes can be jointly matched to realistic values. I find that duration exerts a strongly non-linear negative effect on welfare, which leads traditional models of the ZLB to seriously underestimate the costs of ZLB episodes. I conclude the chapter by discussing the optimal monetary policy inflation target and its relationship to the prevalence of ZLB episodes. I show that the optimum target lies at the point in which the marginal costs and benefits of trend inflation are equalized, and a calibration of the model to the U.S. economy generates optimal inflation mandates consistent with the 2% target commonly followed in most advanced economies