UC Irvine

The three chapters in this dissertation analyze the unconventional monetary policy tools that were utilized in response to the global financial crisis of 2007-2009. Chapter 1 examines the degree of misspecification in a mainstream DSGE model with unconventional monetary policy using the DSGE-VAR approach. The findings indicate that this type of model exhibits a high level of misspecification. For instance, estimation results point to the data favoring an unrestricted vector autoregression model over a DSGE model with unconventional monetary policy. Thus, policymakers should exercise caution when using new macroeconomic models that incorporate unconventional monetary policy.

Chapter 2 examines the link between expectations formation and the effectiveness of central bank forward guidance. In a standard New Keynesian model, agents form expectations about future macroeconomic variables via either the standard rational expectations hypothesis or a more plausible theory of expectations formation called adaptive learning. The results show that the efficacy of forward guidance depends on the manner in which agents form their expectations. During an economic crisis (e.g. a recession), for example, the assumption of rational expectations overstates the effects of forward guidance relative to adaptive learning. Specifically, the output gap is higher under rational expectations than adaptive learning. Thus, if monetary policy is based on a model with rational expectations, which is the standard assumption in the macroeconomic literature, the results of forward guidance could be potentially misleading.

Chapter 3 investigates the effectiveness of forward guidance while relaxing two standard macroeconomic assumptions: rational expectations and frictionless financial markets. A standard DSGE model is extended to include the financial accelerator mechanism. The results show that the addition of financial frictions amplifies the differences between rational expectations and adaptive learning to forward guidance. During a period of economic crisis (e.g. a recession), output under rational expectations displays more favorable responses to forward guidance than under adaptive learning. These differences are exacerbated when compared to a similar analysis without financial frictions. Thus, monetary policymakers should consider the way in which expectations and credit market frictions are modeled when examining the effects of forward guidance.