Essays in Monetary Economics

Wumian Zhao, Purdue University

Abstract

In this dissertation I present three chapters all related by their focus on issues of money and finance and the methodological treatment, the New Monetarist methodology, each considering different aspects of the international monetary-financial system. Williamson and Wright (2010) describe the New Monetarist methodology in detail, including enumerating several key principles (Principle 1-3), which put emphasis on microfoundations, especially of the frictions in the exchange process and financial intermediation arising from the environment, which are essential to analyses of macro and monetary economics. All three chapters are related to all three principles in different ways. The first chapter is entitled “Optimal Monetary Policy and the Welfare Cost of Inflation of a Currency Union.” It seeks to answer the question: How do retail trade frictions interact with immigration choices, and how does this interaction affect monetary policy in a currency union? This is especially related to Principle 2 regarding the importance of modeling the exchange process. This chapter studies the welfare cost of inflation and optimal monetary policy of a currency union between two countries using a search-theoretic framework with endogenous composition of buyers and sellers. The model includes three features of a currency union that are key to welfare and policy analysis: heterogeneous market structure (characterized by buyers’ bargaining power), imperfect market integration, and immigration policy. The model yields optimal monetary policy that deviates from the Friedman rule, with the magnitude of inflation rate and welfare cost determined by different policy regimes. The Friedman rule is suboptimal, because a matching congestion externality in the labor market arises from the endogenous composition of buyers and sellers. Higher labor mobility reduces the cost of inflation by alleviating congestion, regardless of buyers’ bargaining power. Market integration may also reduce congestion, lowering the cost of inflation, but only when sellers are relatively scarce. The second chapter is entitled “Liquidity, Collective Moral Hazard, and Government Bailouts”. It tries to answer the question: How does financial intermediaries risk taking respond to monetary/fiscal policy including bailout policy? This is especially related to Principle 3 regarding the importance of having clear microfoundation for financial intermediation. This chapter develops a general equilibrium model of assets market integrating a theory of liquidity risk in a New Monetarist framework. Collective moral hazard arises from the interaction between banks’ maturity transformation and government intervention. With the anticipation and implementation of government bailouts during a crisis, collective moral hazard creates current and deferred social costs. However, under the “correct” monetary policy, the costs are justified by the improvement of liquidity condition as a result of higher provision of public and private liquidity. The third chapter is entitled “On Cross-Border Payments and the Industrial Organization of Correspondent Banking.” It tries to answer the question: How does an understanding of the market structure of international banking affect recent suggestions for the improvement of cross-border payments? This is especially related to Principle 1 on the importance of microeconomic theory for the evaluation of macroeconomic policies. Despite advances in domestic payments arrangements in recent times, cross-border payments remain expensive and slow.

Degree

Ph.D.

Advisors

Zhang, Purdue University.

Subject Area

Banking|Economics|Finance

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