Essays on Monetary Policy and Financial Markets

Abstract

My dissertation utilizes the valuable information present in forward looking financial securities to understand important aspects of monetary policy analysis. In the first chapter, I attempt to address the long standing empirical challenge of estimating the forward-looking component of the New Keynesian Phillips Curve (NKPC). Since future inflation expectations are unobservable, I use the information in the inflation-indexed bond market to estimate the NKPC for the U.K. In order to account for any possible measurement error present in the inflation-indexed bond market proxy, the unobserved component model is used. This approach has the advantage of being able to extract the unobserved inflation expectations using the Kalman filter and to jointly estimate the parameters of the NKPC. Results show that the estimated inflation expectations from the model play a significant role in explaining the inflation dynamics in the U.K. Evidence also suggests in favor of the Phillips curve trade-off between inflation and output. The second chapter of my dissertation uses the information in the federal funds futures market and conduct an event study to evaluate the impact of Fed's policy actions on 35 leading stock price indices across the world. Using a time-varying parameter model, the study finds significant time-variation in the response of global equity markets to U.S. monetary policy surprises with a greater response during the crisis periods. Interestingly, in the recent financial crisis stock markets in Europe and the U.S. responded negatively to unanticipated interest rate cuts by the Fed. Further, the response of the Asia-pacific region and Latin American stock markets is at least as strong as the response of the U.S. and the European equity markets. The final chapter of my dissertation asks the question whether the federal funds futures rate contains information about the Treasury bill rate. Using high frequency daily data, I examine the dynamic relationship between these two interest rates. The results show that the one month federal funds futures rate move together with the 3-month T-bill rate in the long-run. More importantly, in contrast to the existing literature, any deviation from this long-term equilibrium is corrected by subsequent movements in both the T-bill rate and the federal funds futures rate.