| Summary: | This thesis consists of three self-contained essays on monetary policy, financial stability, and default risk, which are applied in the context of Advanced Economies (AEs) and Emerging Market Economies (EMEs). Chapter 1 explores whether concerns for financial stability are a justification for Euro Area monetary policy to lift off the zero lower bound (ZLB) on nominal interest rates. Through the lens of an optimizing central bank, I study the consequences of a departure from the ZLB in a general equilibrium model with banks, collateral constraints, and default. Debt-deflationary forces of default sharpen the policy trade-off to central banks as they erode bank profitability and depress aggregate demand. My results thus support the argument that central banks ought to internalize the externality of their monetary policy decision on financial stability. Chapter 2 investigates the role of financial stability for monetary policy in EMEs, which are notoriously vulnerable to external shocks. Using the Mexican economy as a laboratory, I build a small open economy DSGE model with banks and firm default. I study whether a “leaning against the wind” policy can mitigate the effects of an external funding shock to the banking sector. I find that an interest rate rule augmented by a measure of expected default risk and the regulatory cost of bank capital outperforms conventional interest rate rules. This is because monetary policy takes into account financial amplification of firm default via banks’ balance sheets, which firms do not internalize. Chapter 3 uncovers whether credit risks that emanate from the corporate sector in EMEs can causally explain international capital flows. Using granular data on the universe of corporate bonds issued by non-financial firms in a large set of EMEs, I extract idiosyncratic shocks to large corporate borrowers. These shocks allow me to construct “Granular Instrumental Variables” (GIV) to identify this causal relationship. I show that corporate credit risk acts as a powerful amplifier of business cycle fluctuations in EMEs above and beyond global and sovereign risk. This thesis thus provides a novel policy implication: the interaction of private default and liquidity frictions can create important pecuniary externalities that, beyond the use of prudential regulatory measures, ought to be taken into account by monetary policy makers.
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