This doctoral dissertation includes three chapters, each with a focus on the interaction of finance and monetary policy in the macroeconomy.
The 2007-2008 Financial Crisis brought about a renewed focus on the role of the financial sector in macroeconomic models. Chapter 1 investigates the role commercial banks play in this relationship by (i) providing business cycle facts for commercial bank balance sheet items (quantities) and balance sheet shares (allocation) along with standard macroeconomic business cycle facts and (ii) characterizing commercial bank responses to monetary policy shocks using local projection methods. A key result is the substitution by commercial banks between liability types in response to monetary policy shocks. This liability substitution limits the effect of monetary policy shocks on the asset side of the balance sheet, thus limiting monetary policy transmission effects on commercial bank balance sheets. This mechanism should be considered in future models of financial intermediation and monetary policy transmission.
Financial shocks have been shown to play a large role in explaining endogenous movements of real variables during the “Great Recession”. Chapter 2 considers a monetary model with an exogenous financial shock. The implications of the presence of financial shocks for optimal monetary policy are explored and the model is estimated via Bayesian techniques. I find inflation targeting accomplishes over 85\% of the potential welfare gains of optimal policy and financial shocks explain over 20\% of the variation in output in United States data from 1984 to 2008.
Chapter 3 is a joint work prepared with Timothy S. Fuerst. The chapter integrates two traditional explanations for the mean and variability of the term premium into a medium-scale DSGE model: (i) time varying risk premia on long bonds, and (ii) segmented markets between short and long bond markets. We consider two sources of business cycle variability, shocks to total factor productivity (TFP) and the marginal efficiency of investment (MEI). We find market segmentation is required to match empirical moments of the term premium in the model. The market segmentation reflects a real distortion, thus smoothing the term premium is typically welfare-improving, although we discuss difficulties with such a policy.