Essays in Open Macroeconomic Dynamics

Abstract

Will capital controls enhance macro economy stability? How will the results be influenced by the exchange rate regime and monetary policy reaction? Are the consequences of policy decisions involving capital controls easily predictable, or more complicated than may have been anticipated? The first chapter of this dissertation will answer the above questions by investigating the macroeconomic dynamics of a small open economy. In recent years, these matters have become particularly important to emerging market economies, which have often adopted capital controls. We especially investigate two dynamical characteristics: indeterminacy and bifurcation. Four cases are explored, based on different exchange rate regimes and monetary policy rules.

Compared with flexible exchange rates, the fixed exchange rate regime should be a more careful policy choice due to the economic complexities. Firstly, more factors need to be considered for economic stability, such as the stickiness of prices and the elasticity of substitution between labor and consumption. Secondly, fixed exchange rate regimes with capital controls produce larger posterior probability of the indeterminate region than a flexible exchange rate regime. Thirdly, we prove the existence of Hopf bifurcation under capital controls with fixed exchange rates and current-looking monetary policy. Numerically, more types of bifurcation are detected under this policy combination.

With capital controls in place, we find that indeterminacy depends upon how the interest rate feedback to inflation and to output gap coordinate with each other in the Taylor rule. When forward-looking, both passive and positive monetary policy feedback can lead to indeterminacy. We provide monetary policy suggestions on achieving macroeconomic stability through financial regulation and references for countries facing different choices on exchange rate regimes.

As a complement for the first chapter, the second chapter of this dissertation examines the dynamics of exchange rate as a diffusion process under flexible exchange rate regimes. When exchange rates are free floating, they are known as highly volatile, nonstationary. They are also hard to be explained and predicted by fundamentals, such as output, price level and monetary supply. This chapter uses both nonparametric method and parametric method (MLE) to estimate exchange rate as a diffusion process. In line with previous literature’s finding, the nonparametric drift estimators show some nonlinearity. The result of parametric estimation shows that Geometric Brownian Motion process could be a quite good capture of the exchange rate dynamics.