Essays on macroeconomics

Abstract

This dissertation consists of four essays on macroeconomics with a special focus on monetary economics, and shows the rationale behind non-optimality of expectation formation both empirically and theoretically. The first essay is empirical, and studies the role of inflation experience in the formation of inflation expectations in the euro area by investigating whether and to what extent inflation expectations of different forecasters are affected by the inflation they observe in the area they are residing in. We exploit the fact that many forecasters provide forecasts of the euro area inflation and these forecasters are in different firms, located in different countries. Hence there is a spatial dimension in the inflation experience of the forecasters. In particular, we first focus on the expectations of professional forecasters from different countries and ask whether their forecast errors are correlated with the observed inflation in the forecaster’s country at the time the expectation was formed. We find that current home inflation unduly affects expectations of next year’s euro area inflation, which may be because forecasters think euro area is more like their own country than it actually is (spatial) and/or think inflation is more strongly auto correlated everywhere than it actually is (temporal). We devise tests to decompose this effect into i) spatial error and ii) temporal error. We provide evidence showing that the source of this error is exclusively the temporal dimension. Forecasters perceive the world to be more serially correlated than it actually is for their home country, and for other countries as well which results in more pronounced and forecastable forecast errors. They understand the spatial dimension of inflation correctly. The second essay analyzes whether and how model uncertainty affects the amplification mechanism of the New Keynesian models. A first finding on a benchmark New Keynesian model with staggered price setting is that a robust optimal commitment policy necessitates more aggressive policy under a demand shock. Further, bringing additional persistence into the model deteriorates the effectiveness of monetary policy. Hence, allowing for either habit formation or partial indexation of prices to lagged inflation rate requires a stronger response for the policy to a demand shock. Together with the specification doubts, in order to reassure the private sector and signal that it will stabilize the fluctuations in the output gap, the policymaker reacts more aggressively as persistence rises. Although inflation persistence does not change the impact of model uncertainty, habit formation in consumption eliminates -even reverses- the impact of uncertainty on the policy reaction to a supply shock. The policymaker always attributes less importance to nominal interest rate inertia when there are concerns about model uncertainty. The third essay analyzes how the optimal behavior of a central bank changes if the central bank has a concern for robustness regarding model uncertainty when there is a possibility of a regime switch in the economy in which the transmission mechanism of monetary policy weakens. The aim is to stress the expectational effects arising from the regime-switching structure. The framework allows identifying the contribution of time-varying doubts about model misspesification on top of the risk of a future weakening of the policy transmission. The result implies a more active policy stance to reduce the possibility to experience a deterioration of monetary transmission mechanism even in normal times. The fourth essay takes a different turn and measures the monetary policy transmission mechanism in Turkey. Quantifying the impact of policy decisions on financial markets is complicated because of the simultaneous response of policy actions to the asset prices, and possible omitted variables that both variables respond to. This chapter applies a heteroscedasticity-based generalized method of moments (GMM) technique for financial markets in Turkey to overcome these problems. This approach is based on the heteroscedasticity of the policy surprises on monetary policy committee meeting dates to identify the financial market reaction to monetary policy. The findings are used as a cross-check for the widely-used identification technique, namely the OLSbased event study. The results suggest that event study estimates are biased for some asset returns.