Structural changes and financial frictions in the monetary transmission mechanism : GMM, VAR and Bayesian DSGE approaches

Mulat-Weldemeskel, Eyob (2016) Structural changes and financial frictions in the monetary transmission mechanism : GMM, VAR and Bayesian DSGE approaches. Doctoral thesis, London Metropolitan University.


This thesis focuses on five independent but integrated current topics in macroeconomics and finance. It aims to achieve six objectives: first, it evaluates the UK monetary policy rules and determines if monetary policy rule should be different in a financial crisis and recession regimes. Second, it investigates the MTM and the dynamics of the channels before and after the GFC. Third, it explores the role of credit supply shocks and addresses if the issue of credit supply shocks has a plausible macroeconomic effects in the UK economy. Fourth, it addresses the issue of structural changes and determines the degree of significant changes assuming that MSBs exist. Specifically, the study examines the robustness of the Augmented Dickey-Fuller (ADF) and the ZA one break unit root tests to the presence of endogenously determined multiple structural breaks. Fifth, it studies credit supply shocks to determine how monetary policy and credit shocks differ during the pre and post-IT regimes. Sixth, it explores the role of MP and determines whether financial frictions that accounts for price and financial stability will have more plausible control of the economy than being limited to price stability. The empirical investigation employs a GMM, VAR and estimates Bayesian DSGE models for the UK data from 1955 to 2014.

The GMM simulation analysis confirmed that the UK monetary policy is more of a forward-looking Taylor type and a hybrid Taylor-McCallum MP rules RFs with a mixture of conventional and unconventional policy frameworks in the post-Global Financial Crisis (GFC). The structural break analysis showed that the financial and monetary sectors have more persistent shocks than the macroeconomic sector. Using the MSB approach, the study identified four major structural breaks in the UK economic structure from 1960 to 2014 and showed that the ZA method does not improve the traditional ADF method. The VAR and Bayesian DSGE analyses revealed that the UK MTM has changed in the post-GFC. The empirical analysis, based on the Bayesian likelihood DSGE model, revealed that the traditional view of the interest rate channel has now been replaced by the credit channel. The specified VAR and VEC models identified the bank-lending channel as a major credit channel than the balance sheet channel. The overidentified Augmented SVAR (A-SVAR) model characterised credit supply volatilities as aggregate supply shocks that moves price and output in opposite direction. The study also investigated the prudence of monetary policy alone and monetary policy with a financial component. The DSGE model with financial frictions represented the data well and showed that the role of investment has reduced significantly in the run up to the GFC and gradually replaced by the Spread shock. Spread shocks constituted about 14% of output decline as compared with 3.5% decline due to investment shocks. Although economic theory strongly advocates the self-balancing mechanism of the financial sector, the evidence found in this study proved otherwise. The financial and monetary systems are two integral sides of the same coin.

MULAT-WELDEMESKEL, Eyob - THESIS 2016.pdf - Published Version

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