Essays in Macroeconomics

Abstract

This dissertation consists of three essays that investigate the effects and transmission mechanisms of monetary policy to the macroeconomy, and the role of financial frictions in modeling the business cycle. The first essay focuses on the question of how to include financial sector dynamics into macroeconomic models in order to improve their efficacy for macroeconomic policy analysis. We augment a standard New Keynesian model with a financial accelerator mechanism and show that financial frictions generate large state-dependent amplification effects. We fit the model to US data and show that the nonlinear model produces much stronger propagation of shocks than the linear model, particularly when shocks drive the model far away from the steady state. We document that these amplification effects are due to endogenous variation in financial conditions and not due to other nonlinearities in the model. Motivated by these findings, we propose a regime-switching DSGE framework where financial frictions endogenously fluctuate between moderate (low risk) and severe (high risk) depending on the state of the economy. This framework allows for efficient estimation with many state variables and improves fit with respect to the linear model. The second essay focuses on the following question: does monetary policy effectiveness in influencing the economy depend on households' balance sheets in the US economy? We investigate the interrelation between household balance sheets, collateral constraints, and monetary policy. We estimate a monetary DSGE model with financial frictions and occasionally binding borrowing constraints. The model implies stronger effects of monetary policy interventions when the borrowing constraint is binding compared to situations when it turns slack. In a prediction analysis we find that, out of a set of alternative plausible endogenous model variables, the level of household net worth is the single best predictor of the tightness of the borrowing constraint, which implies that monetary policy is more effective when household net worth is low. We test this model prediction in the data and provide robust empirical evidence on asymmetric effects of monetary policy across the household net worth cycle that validates the model predictions. A contractionary monetary policy shock leads to a large and significant fall in economic activity during periods of low household net worth. By contrast, monetary policy shocks have only small and mostly insignificant effects when net worth is high. The third essay focuses on the following question: how do credit constraints affect households' consumption response to monetary policy in the US economy? Combining detailed survey data on household portfolios, loan rejections, and consumption, I estimate the consumption response to exogenous changes in interest rates at the household level. I find large and statistically significant heterogeneity in the consumption responses across households, with constrained households being significantly less responsive. Specifically, the consumption response of unconstrained households to a monetary policy shock is between two to three times larger than the average response across all households. Using a New Keynesian model with heterogeneous households, I argue that this empirical finding is consistent with a model where financially constrained households have a low direct sensitivity to interest rates and indirect effects of monetary policy take time to materialize.