Essays in Monetary Economics

This dissertation studies topics of monetary policy and macro-finance, such as the use of monetary policy for financial stability, the impacts of financial friction and investment dynamics on lost recovery, and the new observed financial heterogeneity in the currency union area and its implications for monetary policy.The first chapter studies banks' risk-taking behavior and the impact of macroprudential monetary policy. Should a central bank address buildups of bank risk taking and associated increased probability of financial crises? Banks tend to accumulate risks on their asset portfolio when risk premium shrinks due to low interest rates and resulting in “search for yield”. I address this question by evaluating the macroprudential role of monetary policy in a model in which banks' portfolio risk taking and bank runs are endogenous, in an otherwise standard New Keynesian model. Consistent with my empirical findings from bank-level balance sheet data, my model predicts that holding riskier assets generate self-fulfilling vulnerability to a financial panic. A higher interest rate during a financial boom can reduce vulnerabilities to a bank run by unwinding the compression of the risk premium and, hence, excessive risk taking by banks. I analyze an augmented Taylor rule that responds to bank risk taking. The optimal augmented Taylor rule trades off the loss from a curtailed credit supply during booms and the gain from the lowered probability of financial panic amid recessions. Under reasonable parameterizations, the net welfare gain from implementing the augmented Taylor rule is larger than the net gain from having a standard Taylor rule policy.The second chapter investigates the effects of financial friction on investment dynamics and its impacts on explaining the lost recovery. One of the most puzzling facts in the wake of the Global Financial Crisis (GFC) is that output across advanced and emerging economies recovered at a much slower rate than anticipated by most forecasting agencies. This paper delves into the mechanics behind the observed slow recovery and the associated permanent output losses in the aftermath of the crisis, with a particular focus on the role played by financial frictions and investment dynamics. The paper provides two main contributions. First, we empirically document that lower investment during financial crises is the key factor leading to permanent losses of output and total factor productivity (TFP) in the wake of a crisis. Second, we develop a DSGE model with financial frictions and capital-embodied technological change capable of reproducing the empirical facts. We also evaluate the role of financial policies in stabilizing output and TFP in response to a financial crisis.The third chapter studies the impact of heterogeneity in financial frictions across the Eurozone on bank balance sheet dynamics and the bank-lending channel of monetary policy. The bank-lending channel of monetary policy means the transmission channel of monetary policy through the banks' balance sheet. In particular, when banks' net worth is high due to easing monetary policy, banks supply more credit into the loan market. Using country-level bank balance sheet data, I estimate financial frictions in a two-country monetary union New Keynesian model with banks. The results indicate that financial frictions in core countries are significantly smaller than in peripheral countries in the Eurozone. Given this financial heterogeneity, my model predicts the following two observations consistent with stylized facts. First, financial shocks cause more severe recessions in peripheral countries than in core countries. Second, the bank-lending channel has a weaker stimulus effect in peripheral countries. In light of financial heterogeneities, simulation results show that asset purchase policies, particularly region-specific asset purchases, can complement the bank-lending channel's unequal outcomes inside a region