Modern Challenges to Monetary Policy

The decade following the Financial Crisis of 2008-09 has illustrated that monetary policy faces several challenges. This thesis aims to make a step in the direction of identifying and better understanding four such modern challenges to monetary policy.

The first challenge, identified in Chapter 1, is particular to monetary unions and arises if economic agents largely base their expectations on domestic variables, and less so on foreign variables. We show that such a home bias creates cross-country heterogeneity in expectations and may cause country-specific disturbances to generate larger and more prolonged macroeconomic imbalances.

The second challenge, which is central to Chapter 2, concerns the effect of central bank communication of expected future monetary policy, so-called forward guidance, once nominal interest rates are constrained by their effective lower bound. Different from the common literature, this chapter explicitly allows for imperfect and endogenous central bank credibility when studying the effects of forward guidance by assuming that private agents are boundedly rational.

The third challenge lies in the vulnerability of open economies to sudden shifts in cross-border capital flows as highlighted by the recent experience of the euro area sovereign debt crisis. In Chapter 3, we show novel empirical evidence of the transmission of such country-risk premium shocks and then turn to a structural model in order to find a normative answer to the question of whether capital controls can help to mitigate the negative effects of these shocks.

The fourth challenge to monetary policy discussed in this thesis arises from the protracted decline in interest rates across developed economies since the 1980s.In Chapter 4, we show that the observed decline in yields appears more due to a fall in equilibrium interest rates and less to a decline in term premia than typically reported.