Essays on Interest Rates, Exchange Rates and Flight to Safety

Abstract

This dissertation consists of three independent chapters on interest rate dynamics and international macroeconomic policies. The first chapter presents new empirical evidence connecting the banking sector and the dynamics of the federal funds rate, and the rest two chapters study topics in international macroeconomic policies. In the first chapter, I document that the income gap, a measure of banks’ interest-rate risk exposure, strongly forecasts future changes in the federal funds rate at the one-year horizon before the 2008 financial crisis. The forecasting power comes from predicting the unexpected component of the federal funds rate relative to market expectations. I show that the income gap’s predictability of the unexpected component in the short rate leads to bond excess return predictability. I present additional evidence to support the view that the bond excess return predictability of the income gap does not result from a risk-premium-based explanation. The second chapter presents a model to study a signaling channel of policies aiming to stabilize the nominal exchange rate. For small open economics, nominal exchange rate devaluation is an important tool for aggregate demand management. Ex-ante commitment to stabilize exchange rate reduces ex-post flexibility of deploying exchange rate devaluation in the face of shortfall of aggregate demand. As a result, such commitment can serve as a costly signal for informing foreign investors about the country’s fundamentals. The model presents a new rationale for stabilizing exchange rates absent concerns for financial stability. The third chapter, co-authored with Markus Brunnermeier, studies fickle international capital flows induced by flight-to-safety. We provide a model of the flight-to-safety crisis. Domestic investors have to co-invest in a safe asset and physical capital. In times of crisis, investors replace the initially safe domestic government bonds with safe US Treasuries and fire-sell part of their capital. The reduction in physical capital lowers GDP and tax revenue, leading to increased default risk justifying the loss of the government bond’s safe-asset status. We compare different ways to mitigate this self-fulfilling scenario.