Transmission Mechanisms of Shocks and Optimal Policy Response

Abstract

This dissertation is the collection of three essays aimed to evaluate the importance of demand and supply side financial frictions for the macroeconomic dynamics and the conduct of stabilization policies in an emerging economy, Pakistan. First essay compares the nature and strength of financial accelerator mechanism arising from price and quantity based financial frictions for macroeconomic fluctuations. For the conduct of stabilization policies, it examines that how switching from exogenous fiscal and macroprudential polices to the rule-based policies affects the strength of financial accelerator mechanism. It is also ascertained that how derived optimal rules of monetary policy alter with different financial frictions intact and with discretionary and rule based fiscal and financial policies. The comparison of the benchmark DSGE model with financial accelerator models highlighted the importance of financial frictions for understanding the drivers of macroeconomic fluctuations and effectiveness of different stabilization policies. The result showed that quantity based financial friction significantly hinders the management through stabilization policies in face of different demand, supply and financial shocks. In the second essay the co-movement of financial and macroeconomic cycles and the effectiveness of the different regimes of monetary policy are examined by estimating DSGE model with demand side financial frictions. The findings of the essay showed that financial and macroeconomic cycles are segregated in face of different shocks. Regarding the efficacy of different monetary policy regimes, the results showed that monetary regime aimed to achieve price stability can also ensure financial stability in Pakistan. In the third essay, role of different components of financial development process like financial depth and access have been examined for macroeconomic fluctuations. By estimating a DSGE model with heterogeneous households and financial intermediary, the findings of study showed that cyclical properties of macroeconomic aggregates depend on the way financial development process takes place. It also revealed that financial development by easing supply side financial constraint better stabilizes the macroeconomic fluctuations.