Essays on inflation and financial institutions
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This dissertation consists of three essays studying inflation and financial institutions. The first essay develops a neoclassical model to study how a welfare-maximizing government should conduct fiscal and monetary policy to finance exogenous government purchases and transfer payments. The government raises revenue through distortionary taxes, and finances its expenditures by issuing nominal one-period bonds and consols. I study a sequence of example economies to show that under flexible prices the government can support the complete markets allocations of Lucas and Stokey (1983) with moderate inflation volatility and positive bond issuance. Policy that combines state-contingent expected inflation targets with consol issuance is most effective at reducing inflation associated with adverse government purchase shocks and adverse productivity shocks. However, increased consol issuance can increase inflation volatility when the market value of government debt varies little across states. Stylized facts using data from the example economies are comparable to their analogues in post-war U.S. data.
The second essay studies the relationship between shocks to fiscal conditions and inflation. Both unexpected increases to government purchases and unexpected increases to the real discount rate are associated with unexpected increases in inflation. The direction of these effects is consistent with the predictions of the model developed in the first essay.
The third essay models an economy in which commercial banks produce financial instruments to facilitate transactions between households and firms, and in which a central bank conducts monetary policy. All modeled financial instruments would be familiar to a banker: banks create loans that are financed by bonds or deposits, and banks may choose to hold precautionary reserves of base money, or lend these reserves on the Federal Funds market. The single institutional constraint imposed on banks is that they must choose a quantity of reserves to hold before receiving an idiosyncratic deposit withdrawal shock at the end of each period. In equilibrium, monetary and banking policy are described by three interest rates: the Federal Funds rate, the rate on excess reserves, and the overdraft penalty rate. When the rate on excess reserves is below the Federal Funds rate, as was the case before the Global Financial Crisis, banks economize on reserves, holding roughly one to two cents in reserve for every dollar of deposits. When the rate on excess reserves is equal to the Federal Funds rate, the model implies that banks will optimally choose to hold one unit of reserves for every unit of deposits. This change in banks' optimal behavior can rationalize the increase in the size of the Federal Reserve's balance sheet beginning in the Global Financial Crisis.
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