Essays in monetary economics

Liu, Ding (2015) Essays in monetary economics. PhD thesis, University of Glasgow.

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This dissertation can be thematically grouped into two categories: monetary theory in the so called New Monetarist search models where money and credit are essential in terms of improving social welfare, and optimal time-consistent monetary and fiscal policy in New Keynesian dynamic stochastic general equilibrium (DSGE) models when the government cannot commit. Arguably, the methodology and conceptual frameworks adopted in these two lines of work are quite different. However, they share a common goal in helping us understand how and why monetary factors can affect the real economy, and how monetary and fiscal policy should respond to developments in the economy to improve social welfare. There are two chapters in each part. In the first chapter, recent advances based on the pre-eminent Lagos-Wright (LW) monetary search model are reviewed. Against this background, chapter two introduces collateralized credit inspired by a communal responsibility system into the creditless LW model, in order to study the role of money and credit as alternative means of payment. In contrast, the third chapter revisits the classic inflation bias problem associated with optimal time-consistent monetary policy in the cashless New Keynesian framework. In this chapter, fiscal policy is trivial, due to the assumption of lump-sum tax. As a follow-up work, chapter four studies optimal time-consistent monetary and fiscal policy mix as well as debt maturity choice in an environment with only distortionary taxes, endogenous government spending and government debt of various maturities.

Chapter 1 introduces the tractable and influential Lagos-Wright (LW) search-theoretic framework and reviews the latest developments in extending it to study issues concerning the role of money, credit, asset pricing, monetary policy and economic growth. In addition, potential research topics are discussed. Our main message from this review is that the LW monetary model is flexible enough to deal with numerous issues where fiat money plays an essential role as a medium of exchange.

Chapter 2, based on the LW framework, develops a search model of money and credit motivated by a historical medieval institution - the community responsibility system. The aim is to examine the role of credit collateralized by the community responsibility system as a supplementary medium of exchange in long-distance trade, assuming that entry cost and the cost of using credit are proportional to distance, due to factors like direct verification and settlement cost and indirect transportation cost. We find that both money and credit are useful in the sense of improving welfare. In addition, the Friedman rule can be sub-optimal in this economy, due to the interaction between the extensive margin (that is, the range of outside villages which the representative household has trade with) and the intensive margin (that is, the scope of villages where credit is used as a supplementary medium of exchange). Finally, higher entry cost narrows down the extensive margin, and similarly, higher cost of using credit, ceteris paribus, reduces the usage of credit and hence lowers social welfare.

Chapter 3 reconsiders the inflation bias problem associated with the renowned rules versus discretion debate in a fully nonlinear version of the benchmark New Keynesian DSGE model. We ask whether the inflation bias problem related to discretionary monetary policy differs quantitatively under two dominant forms of nominal rigidities - Calvo pricing and Rotemberg pricing, if the inherent nonlinearities are taken seriously. We find that the inflation bias problem under Calvo contracts is significantly greater than under Rotemberg pricing, despite the fact that the former typically exhibits far greater welfare costs of inflation. In addition, the rates of inflation observed under the discretionary policy are non-trivial
and suggest that the model can comfortably generate the rates of inflation at which the problematic issues highlighted in the trend inflation literature. Finally, we consider the response to cost push shocks across both models and find these can also be significantly different. Thus, we conclude that the nonlinearities inherent in the New Keynesian DSGE model are empirically relevant and the form of nominal inertia adopted is not innocuous.

Chapter 4 studies the optimal time-consistent monetary and fiscal policy when surprise inflation (or deflation) is costly, taxation is distortionary, and non-state-contingent nominal debt of various maturities exists. In particular, we study whether and how the change in nominal government debt maturity affects optimal policy mix and equilibrium outcomes, in the presence of distortionary taxes and sticky prices. We solve the fully nonlinear model using global solution techniques, and find that debt maturity has drastic effects on optimal time-consistent policies in New Keynesian models. In particular, some interesting nonlinear effects are uncovered. Firstly, the equilibrium value for debt is negative and close to zero, which implies a slight undershooting of the inflation target in steady state. Secondly, starting from high level of debt-GDP ratio, the optimal policy will gradually reduce the level of debt, but with radical changes in the policy mix along the transition path. At high debt levels, there is a reliance on a relaxation of monetary policy to reduce debt through an expansion in the tax base and reduced debt service costs, while tax rates are used to moderate the increases in inflation. However, as debt levels fall, the use of monetary policy in this way is diminished and the policy maker turns to fiscal policy to continue the reduction in debt. This is akin to a switch from an active to passive fiscal policy in rule based descriptions of policy, which occurs endogenously under the optimal policy as debt levels fall. It can also be accompanied by a switch from passive to active monetary policy. This switch in the policy mix occurs at higher debt levels, the longer the average maturity of government debt. This is largely because high debt levels induce an inflationary bias problem, as policy makers face the temptation to use surprise inflation to erode the real value of that debt. This temptation is then more acute when debt is of shorter maturity, since the inflationary effects of raising taxes to reduce debt become increasingly costly as debt levels rise. Finally, in contrast to the Ramsey literature with real bonds, in the current setting we find no extreme portfolios of short and long-term debt. In addition, optimal debt maturity, implicitly, lengthens with the level of debt.

Item Type: Thesis (PhD)
Qualification Level: Doctoral
Keywords: Search models of money, credit, New Monetarists Economics, New Keynesian models, Time consistency, Optimal monetary policy, Fiscal policy, Inflation Bias, Debt maturity, Credibility
Subjects: H Social Sciences > HB Economic Theory
Colleges/Schools: College of Social Sciences > Adam Smith Business School > Economics
Supervisor's Name: Leith, Prof. Campbell and Nolan, Prof. Charles
Date of Award: 2015
Depositing User: Dr. Ding Liu
Unique ID: glathesis:2015-6692
Copyright: Copyright of this thesis is held by the author.
Date Deposited: 06 Oct 2015 11:25
Last Modified: 09 Oct 2015 14:11

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