Examining the Effectiveness of Monetary Policy

EXAMINING THE EFFECTIVENESS OF MONETARY POLICY by Omid M. Ardakani The University of Wisconsin-Milwaukee, 2015 Under the Supervision of Professor N. Kundan Kishor and Professor Suyong Song The main objective of my dissertation is to examine the causal effect of monetary policy. The first two chapters focus on the effectiveness of inflation targeting considering the role of preconditions such as institutional independence of central banks and a healthy financial system. It also analyzes the time-varying behavior of the inflation gap in all explicit inflation targeting countries and captures the gradual transition of actual inflation to its target over time. The last chapter examines monetary unification impact on bond markets before and after the European crisis. Chapter 2 estimates the treatment effect of inflation targeting for 27 explicit inflation targeting countries. Our approach takes into account the problem of model misspecification and inconsistent estimation of parametric propensity scores by using a nonparametric series estimator and semiparametric single index method. In addition, this chapter also examines the impact of inflation targeting regime on a wider set of macroeconomic outcomes. The findings suggest that the results are sensitive to the choice of propensity score estimates based on different methods, and the semiparametric single-index model of propensity score provides the most economically meaningful results. The findings illustrate that the inflation targeting framework lowers inflation variability and improves ii fiscal discipline. We find that this monetary policy regime reduces the real exchange rate volatility in developing countries but increases it in developed economies. Chapter 3 analyzes the performance of the central banks by examining their success in achieving their explicit inflation targets. For this purpose, we decompose the inflation gap into predictable and unpredictable components. We argue that the central banks are successful if the predictable component in the inflation gap diminishes over time. The predictable component of inflation gap is measured by the conditional mean of a parsimonious time-varying autoregressive model. Our results find considerable heterogeneity in the success of these IT countries in achieving their targets at the start of this policy regime. Our findings also suggest that the central banks of inflation targeting countries started targeting inflation implicitly before becoming an explicit inflation targeter. The panel data analysis suggests that the relative success of these countries in reducing the gap is influenced by their institutional characteristics. Chapter 4 determines the behavior of bond yields in Eurozone by examining the antithetic role of monetary unification before and after the European Debt Crisis. We study the causal effect of monetary unification on the European bond markets. We capture the causal effect by estimating treatment effects of European union. The findings illustrate that the treatment effects on bond yields varies before and after the European crisis. The results indicate that monetary unification reduces the level and volatility of long-term and short-term sovereign bond yields for the period before the crisis, 1993–2008. However, after the banking crisis, we witnessed a rise in yield spreads due to higher degree of debt-GDP ratios and higher risk of default in sovereign bonds. iii