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Essays on the Open Economy Trilemma: New Empirical Methods Open Access

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This dissertation develops new methods to solve problems related to the open economy trilemma. It consists of three chapters:Chapter 1 revisits the definition of monetary policy autonomy and develops a new method to identify autonomy regimes for a set of countries. Compared to the traditional identification approach, which only focuses on correlations with the base country interest rate, monetary policy autonomy discussed in this paper is jointly determined by how the domestic interest rate responds to the foreign monetary policy as well as its domestic inflation and real GDP. Using a Bayesian Markov Switching model for the monetary policy function, I estimate policy responses in two regimes, and obtain measures of monetary policy autonomy in the estimation process. Testing the method with case studies and simulated data demonstrates the robustness of the approach under different scenarios. Applying the method to the data of a set of advanced countries, I find monetary policy autonomy decreases when the exchange rate is fixed or capital controls are loosened, which is consistent with the open economy trilemma.Chapter 2 extends the discussion in chapter 1. When using a Markov switching model to identify monetary policy autonomy, one question that needs to be addressed is: Given the limited number of observations, how well does the method actually work? By changing parameters in the data generating processes, this paper conducts simulation exercises under different scenarios. Results indicate that, in order to properly identify high and low autonomy, a larger variance in the error term requires greater differences between switching parameters in the two states. In practice, regime classification therefore can be polluted by large variances. To better identify the monetary policy autonomy regime, I adopt the regime switching model introduced by Kaufmann (2015) and show that incorporating endogenous switching could help to improve estimations.Chapter 3 studies monetary policy with a fixed exchange rate regime. Based on the study of Posch (2007), strong evidence of Jumps has been found in industrial production series. Instead of focusing on structural general equilibrium models, this paper incorporates jump process into a Vector Autoregression model and applies it to evaluate monetary policy effects in a fixed exchange rate regime. As with outliers in industrial production data, financial variables in a country with a fixed exchange rate regime also presents non-normality. One of the reasons is that pegs with no capital controls are fragile to speculative attacks. An attack can result in an abrupt increase in either the interest rate or the exchange rate. Given that the outliers in the data may bias the estimation, we use the jump component to model and separate outliers from the underlying dynamic system. Based on the case study of Denmark, the traditional VAR model indicates that impacts of a monetary policy shock on domestic variables are weak. After controlling for outliers, it indicates that a contractionary monetary policy shock has significant negative impacts on both industrial production and CPI. Meanwhile, its impacts on the exchange rate are also discussed in the paper.

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