Essays on expectations and monetary policy

Gerko, Elena (2018) Essays on expectations and monetary policy. Doctoral thesis, University of London: London Business School.

Abstract

This thesis contains three essays on expectations and monetary policy. The first chapter uncovers a new channel of monetary policy transmission in a New-Keynesian model under Internal Rationality, which assumes that agents are rational but cannot forecast inflation and output perfectly. The departure from rational expectations is small; yet, empirical and policy implications differ significantly as the inflation-output trade-off responds to the evolution of agents' expectations. In particular, high inflation expectations lead to a persistent combination of low output and high inflation, which closely resemble the missing disinflation and the slow recovery associated with the Great Recession. The model matches several stylized facts on inflation, output and their expectations found both in the survey and aggregate data. On the methodological side, the chapter provides a micro-foundation for the optimality of adaptive learning in a monetary economics model. The second chapter (a paper joint with Helene Rey) examines the transmission of monetary policy in two important financial centres, the United States and the United Kingdom. It documents the importance of financial channel of monetary policy in both countries by studying the responses of mortgage and corporate spreads to monetary policy innovations. The identification strategy makes it possible to study movements in the policy rates and the effect of forward guidance, broadly defined. The chapter also analyses international financial spillovers between the United States and the United Kingdom. The spillovers are found to be asymmetric. The third chapter focuses on a common tool for studying expectations about macroeconomic variables in general, and inflation process in particular - constant gain learning. This chapter proposes an exponentially weighted smooth transition (EWST) filter, which allows for time variability in the gain parameter and performs quite well in forecasting inflation, given the historical inflation series for both countries with stable inflation and countries that have experienced hyperinflation. This approach allows for endogenous, fully rational shifts in the expectation formation mechanism, which also has behavioural explanations. This helps to explain the formation and persistence of both deflationary and hyperinflationary expectations.