Essays on Uncertainty and Stabilization

How should monetary policy deal with endogenous stock and bond market fluctuations? This dissertation focuses on the interaction among uncertainty arising from financial markets, risk- premium (and term-premium), and the business cycle. The main objective is to study various effective monetary policy responses for stabilization purposes.The first chapter offers a non-linear version of the standard New-Keynesian framework, in which I provide an illustration of how the consideration of the first-order effects of endogenous and time-varying aggregate risks changes the business cycle dynamics. With conventional monetary policy rules, my non-linear characterization of the solution features interesting potentials for the sunspot equilibria arising from the aggregate business cycle volatility. I provide a new monetary policy rule that restores model determinacy and achieves the economy’s full stabilization again. The entire results rely on the interaction between aggregate consumption demand and the economy’s aggregate risk through the famous precautionary savings channel. This result is novel.In the second chapter, I develop a more full-fledged New-Keynesian framework with active stock markets that features a potential for self-fulfilling financial uncertainty arising from its interaction with risk-premium, wealth, and aggregate demand. The model remains tractable, providing closed-form expressions for higher-order moments tied to the financial uncertainty and their relations to the rest of the economy. I re-examine the optimality of conventional monetary policy rules and show that the ‘Taylor principle’ no longer guarantees determinacy, with sunspots in aggregate financial volatility not precluded by aggressive targeting of inflation and output gap alone. I then characterize the joint dynamic evolution of financial volatility, risk-premium, asset prices, and the business cycle in a rational expectations equilibrium with sunspots, and uncover that variations in financial uncertainty generate reasonable crises and booms along the business cycle that are consistent with my empirical estimates based on the US data. As this pitfall of the traditional policy rules lies in their inability to target the expected return on aggregate wealth, the relevant rate in stochastic environments, I then propose a ‘generalized’ Taylor rule that targets risk-premium and asset price, and describe the necessary conditions that restore determinacy and achieve the ultra-divine coincidence: the joint stabilization of inflation, output gap, and risk-premium. Finally, I revisit the zero lower bound (ZLB) and show it amplifies the duration, severity, and welfare costs of fluctuations in financial volatility. Alternative policies such as forward guidance reduce these welfare costs on average, but risk worsening economic situations with a non-zero probability, raising interesting trade-offs for policymakers.The failure of conventional monetary policy to stabilize the economy at the zero-lower bound (ZLB) has made unconventional interventions more prevalent in recent times, which calls for a new macroeconomic framework for properly analyzing these policies. In the third chapter, I develop a New-Keynesian framework that incorporates the term-structure of financial markets and an active role for government and central bank’s balance sheet size and composition. I show that financial market segmentation and the household’s endogenous portfolio reallocation are crucial features to properly understand the effects of Large-Scale Asset Purchase (LSAP) programs. I propose a new micro-foundation based on imperfect information about expected future asset returns that easily accommodates distinct degrees of market segmentation across asset classes and maturities, while providing intuitive and tractable expressions for the household’s portfolio shares. My analysis reveals that government’s issuance of risk-less bonds stimulates the economy when conventional monetary policy is constrained at the ZLB, which is consistent with the literature on the so-called “safe-asset shortage problems". I also find that central bank’s bond purchases across different maturities act as a major determinant of the level and slope of the term-structure, and yield-curve- control (YCC) policies that actively manipulate long-term yields are powerful in terms of stabilization both during normal times and at the ZLB. As a drawback, YCC policies increase the likelihood of ZLB episodes and their durations, thereby locking the central bank in a position in which the short-term rate is less useful as a policy tool