Optimal Policy Before, During and After the Crisis

This thesis contributes to the debate on optimal policy, using New Keynesian dynamic stochastic general equilibrium (DSGE) models that contain a variety of monetary,fiscal and credit policy tools. First, we examine optimal monetary policy in an open economy, utilizing Gali and Monacelli's (2005) DSGE model. We find that the utility based loss function in the open economy depends on the variance of the terms of trade, in addition to the variance of consumption and inflation. As a result, optimal policy in the open economy is not isomorphic to the one in the closed economy and does not require strict domestic inflation targeting. In the open economy, interest rate rules which react to the movements in inflation and the terms of trade are preferred to the domestic inflation based Taylor rule. Second, we examine the effectiveness of macroprudential tools and their interaction with monetary policy. Using a Gertler and Karadi (2011) type DSGE model with financial frictions, we present a formal comparative analysis of three macroprudential instruments: (i) reserve requirements, (ii) capital requirements and (iii) a regulation premium. We find that capital requirements are the most effective macroprudential tool in mitigating the negative effects of the financial accelerator mechanism built in banks' borrowing constraints. Irrespective of the type of shock affecting the economy, use of capital requirements generates the highest welfare gains. Finally, we analyze unconventional monetary and fiscal policy measures that can be used to counteract the unfavorable consequences of a financial crisis. Adding distortionary taxation to Gertler and Karadi's (2011) framework, we provide a comprehensive assessment of credit easing and bank capital injections. We find that the use of both policies mitigates the negative effects of financial shocks to the economy. Credit easing results in a lower stabilizing effect on aggregate output and a decrease in tax rates. Bank capital injections, on the other hand, lead to a rise in government expenditures and hence, taxes. As the relative importance of distortions in financial markets is higher than the distortions caused by variable tax rates, use of bank capital injections generates the highest welfare gains, under both distortionary and lump-sum taxation.