Essays on Inflation Targeting and Credit Markets

Download or read book Essays on Inflation Targeting and Credit Markets written by Jundong Zhang and published by . This book was released on 2016 with total page 89 pages. Available in PDF, EPUB and Kindle. Book excerpt: The first chapter of the dissertation studies quantitatively and systematically the impacts of a wide range of inflation targets on credit markets, on social welfare and on wealth inequality. To this end, I develop a model featuring market segmentation, market incompleteness and limited commitment to financial contracts. Under incomplete markets, moderate inflation alleviates frictions in credit markets and thus improves social welfare. After calibrating the model to recent U.S. data, I report four major findings. First, as the inflation target increases, endogenous debt limits follow a humped shape with a flat tail. This coincides with the empirical relationship between inflation and credit market activities. Second, social welfare also takes on a humped shape followed by a flat tail, which leads to an optimal inflation rate of 3%. The sizable welfare loss (0.61%) at the Friedman rule inflation and the negligible welfare loss (0.006%) at 2% inflation explain in some sense why central banks in some leading developed countries maintain their inflation targets at 2-3%. Third, the optimal inflation with a complete set of financial assets is lower than that with an incomplete set of financial assets. This result is consistent with the fact that developed countries tend to keep lower inflation targets than developing countries. Fourth, the calibrated model generates a well matched Gini coefficient of wealth at 0.72 and implies that wealth inequality increases slowly with inflation rates. The second chapter of the dissertation studies how inflation targeting affects the U.S. holdings of net foreign assets and explains two facts: the U.S. negative net position in bonds and positive net position in portfolio equity and FDI. I extend the model in the first chapter to a two-country open economy model consisting of the U.S. and emerging markets (EM). Facing idiosyncratic income risks, credit agents in each country hold a portfolio of risk-free bonds and risky productive assets with idiosyncratic investment shocks. Financial integration allows credit agents to trade both kinds of assets globally. The only difference between the two countries is that the U.S. maintains a lower inflation target than EM. Calibrated to recent U.S. data, the model generates a higher debt limit for the U.S., where agents can borrow more than those in EM. With zero net bond supply in the world, the U.S. borrows from EM. This explains the U.S. negative net position of bonds. On the other hand, U.S. credit agents enjoy better risk sharing due to a larger debt limit. Therefore, the U.S. credit agents' consumption is less volatile than that of their foreign counterparts. This leads to a smaller covariance between the return from risky equity and tomorrow's consumption, and thus the U.S. credit agents require a lower risk premium on risky equity. As a result, they value those risky assets more highly and in effect buy them from EM.