Book Description

The thesis consists of three chapters of self-contained empirical and theoretical studies. In Chapter 1, I examine whether the Balassa-Samuelson effect is indeed the reason behind the behaviour of the currencies of transition economies. So far, in the literature, transition Economies appear to be subject to the Balassa-Samuelson effect. This implies that their currencies experience a prolonged appreciation in real terms as their convergence goes on. However, in the current literature, the effects of the capital account have not been analyzed extensively. In this paper I show that the capital account, rather than productivity, is a key determinant of the appreciation of the currencies of transition economies. I find that a long-run relationship exists between the real exchange rate, productivity, the real interest rate differential and the capital account. Moreover, those variables are found to cointegrate in a nonlinear fashion according to a smooth transition autoregressive model. This implies that a multivariate smooth transition error correction model is the appropriate model to describe their short-run and long-run dynamics. In Chapter 2, I examine the importance of a real exchange rate target in the monetary policy of a central bank. I address that question both empirically and theoretically. Using monthly data I estimate of a structural VAR model for the Eurozone providing evidence in favour of real exchange rate targeting. I examine this case theoretically using a twocountry DSGE model; I find that when the home central bank includes a real exchange rate target in its interest rate rule, it achieves lower welfare losses compared to the Taylor rule. Contrary to similar papers, I compute the optimized coefficients in the interest rate rules considered. I show that the benefits from real exchange rate targeting at home rise as persistence in inflation and output increases. In the robustness analysis I show that a rise in the fraction of backward looking consumers affects negatively the performance of the real exchange rate targeting rule and positively that of the Taylor rule. Asymmetries in the degree of rule-of-thumb behavior in consumption have important effects, as regards the performance of a real exchange rate targeting rule. The performance of both rules is not sensitive to variations in the degree of backward looking price setting behavior . In Chapter 3, I show, using both empirical and theoretical analysis, that changes in monetary policy in one country can have important effects on other economies. My new empirical evidence shows that changes in the monetary policy behaviour of the Fed since the start of the Euro, well captured by a Markov-switching Taylor rule, have had significant effects on the behaviour of inflation and output in the Eurozone even though ECB's monetary policy is found to be fairly stable. Using a two-country DSGE model, I examine this case theoretically; monetary policy in one of the countries (labelled foreign) switches regimes according to a Markov-switching process and this has nonnegligible effects in the other (home) country. Switching by the foreign central bank renders commitment to a time invariant interest rate rule suboptimal for the home central bank. This is because home agents expectations change as foreign monetary policy changes which affects the dynamics of home inflation and output. Optimal policy in the home country instead reacts to the regime of the foreign monetary policy and so implies a time-varying reaction of the home Central Bank. Following this time-varying optimal policy at home eliminates the effects in the home country of foreign regime shifts, and also reduces dramatically the effects in the foreign country. Therefore, changes in foreign monetary regimes should not be neglected in considering monetary policy at home.