Electronic Thesis and Dissertation Repository

Thesis Format

Integrated Article

Degree

Doctor of Philosophy

Program

Economics

Supervisor

Williamson, Stephen

Abstract

My dissertation, which consists of three papers, is devoted to studying the implications of conventional and unconventional monetary policies for inflation, asset prices, and welfare.

The first paper examines the sustainability and effectiveness of negative nominal interest rates. I construct a model of multiple means of payment where the cost of holding paper currency—its storage and security costs—determines the effective rate of return on currency, which establishes the effective lower bound on nominal interest rates. I show that central banks can reduce the effective rate of return on currency, and thus the effective lower bound, by altering their policy on bank reserves. However, reducing the lower bound leads to welfare losses associated with individuals holding more currency. Moreover, sustaining a negative rate by reducing the lower bound has no stimulative effects. This occurs because this policy combination reduces both the rate of return on currency and interest rates on financial assets, leaving the relative interest rates between currency and financial assets unchanged.

In the second paper, I develop a two-country model with financial frictions to study how a central bank's unconventional asset purchases affect international asset prices and welfare. In the model, the key financial frictions are limited commitment, differential pledgeability of assets as collateral, and a scarcity of collateralizable assets. Due to the differential pledgeability of assets, financial intermediaries acquire different asset portfolios depending on their home country. I find that quantitative easing can reduce long-term bond yields and term premia internationally and depreciate the creditor country's currency. Foreign exchange intervention always depreciates the local currency, but it can improve welfare globally if implemented by the creditor country.

The third paper studies the implications of heterogeneous payment choices for monetary policy. I construct a model of money and credit where each consumer participates in a small-value or a large-value transaction depending on a preference shock. Financial intermediaries write deposit contracts for consumers to intermediate credit transactions. The preference shock is private information and is costly for intermediaries to observe. I find that, in equilibrium, financial intermediaries create state-contingent deposit contracts for consumers. However, private information and costly monitoring generate an incentive problem, so that the quantity of credit is constrained for consumers in large-value transactions. The effects of monetary policy on the allocation of means of payment vary depending on the size of transaction.

Summary for Lay Audience

Typically, central banks choose a short-term interest rate as a target interest rate and determine the level of the target rate to control inflation. However, they have introduced many other tools to achieve their policy goal. For example, central banks in emerging market economies intervened in foreign exchange markets to stabilize exchange rate fluctuations. Some central banks in advanced economies purchased long-term government bonds (also known as quantitative easing) and promised to keep the short-term rate low for an extended period (forward guidance) to lower long-term interest rates. Some central banks introduced a negative short-term interest rate, the sustainability of which was unknown before. My dissertation is devoted to studying the implications of these non-traditional monetary policies for inflation, asset prices, and welfare.

The first paper examines the sustainability and effectiveness of negative interest rates. Without frictions, negative rates would not have been sustainable due to arbitrage: investors could borrow at the negative rate and hold zero-interest paper currency. However, holding paper currency is costly because of storage and security costs. This makes the effective rate of return on holding paper currency negative, implying that the lower bound on interest rates is also negative. I show that central banks can reduce the effective rate of return on currency, and thus the lower bound, by altering their policy on bank reserves. However, reducing the lower bound leads to welfare losses associated with individuals holding more currency. Moreover, sustaining a negative rate by reducing the lower bound has no stimulative effects. This occurs because this policy combination reduces both the rate of return on currency and interest rates on financial assets, leaving the relative interest rates between currency and financial assets unchanged.

In the second paper, I study how a central bank's unconventional asset purchases affect international asset prices and welfare. I find that a central bank's purchases of long-term government bonds, or quantitative easing, reduce long-term interest rates internationally. Also, quantitative easing relaxes financial constraints in the global economy and improves welfare globally. This occurs because quantitative easing eventually involves the central bank's swaps of short-term bonds for long-term bonds. Short-term bonds are typically more useful as collateral than long-term bonds, so this intervention increases the effective stock of collateral, relaxing financial constraints. The international effects of foreign exchange intervention depend on the implementing country. It can relax financial constraints and improve welfare globally if implemented by the country that supplies more useful bonds in the global economy.

The third paper studies the implications of heterogeneous payment choices for monetary policy. Consumers typically use more cash and less credit in small-value transactions. Based on this observation, I construct a model of money and credit where each consumer participates in a small-value or a large-value transaction depending on a preference shock. Financial intermediaries write deposit contracts for consumers to intermediate credit transactions. A consumer's preference shock is private information and is costly for intermediaries to observe. I find that it is optimal for financial intermediaries to offer state-contingent deposit contracts for consumers. However, private information and costly monitoring generate an incentive problem, so the quantity of credit is constrained for consumers in large-value transactions. The effects of monetary policy on the allocation of means of payment vary depending on the size of the transaction.

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