| This dissertation focuses on the role of monetary policy in the rapidly changing global environment, characterized in particular by the adoption of the common currency by fifteen European countries and by rapid accumulation of foreign debt (or wealth) by many nations around the world. The first chapter calculates differences in welfare costs of nominal rigidities in the EMU countries. Using a two-country DSGE model with optimizing agents, monopolistic wage and price setting and government debt dynamics, I find that these costs are virtually identical for all members of the EMU, and small countries are not at a disadvantage when it comes to the setting of the common monetary policy. This conclusion is primarily due to highly correlated technological processes in Europe, which cause national and Euro-wide inflations to move together. The second chapter studies the causes of the cyclical behavior of aggregate inflation and regional inflation differentials in the EMU. The answer has strong implications for monetary policy. In the United States, inflation rates move pro-cyclically, and across the Euro Area, inflation differentials are positively correlated with growth differentials. This suggests that demand shocks are the primary determinants of the cyclical behavior of aggregate inflation and regional inflation differentials. The conclusion is that demand shocks are either missing or inadequately modeled in the in typical New Keynesian model. In the last chapter, I study the impact of net foreign wealth on the optimal monetary policy of an open economy in a two-country DSGE model with incomplete markets, sticky prices and deviations from the Law of One Price. I find that by optimally manipulating monetary policy, central banks can affect the timing of interest receipts (or payments) and therefore increase the risk-sharing role of the internationally traded asset. In particular, debtor nations find it optimal to allow their currency to float relatively more freely than do creditor nations. We also find that for most specifications of the model, central banks should target a weighted average of CPI inflation and changes in the nominal exchange rate. |
