Emerging market financial crises, investors and monetary policy

This dissertation consists of two essays. The first essay brings a competing explanation for the channel of contagious emerging market crises of the 1990s. It develops a three-country GEIM model to show a debt crisis in one emerging market country transmits to others via common investors through the world interest rate. This constitutes an alternative explanation to the literature suggesting that contagion is due to liquidity, incentives problems or imperfect information or flight to quality. Quantitative analysis of the equilibrium show that the model can explain 60% of the correlation across the emerging market bond spreads since the 1990s. The high correlation across the spreads has often been documented by papers as an important indicator of financial contagion even at times of no-crisis. Additionally, the model can explain 50% of the average debt-to-GDP ratio observed across emerging market economies during the 1990s. One of the goals of any model in sovereign default literature is to generate an equilibrium that sustains a large debt-to-income ratio. The second essay contributes to the literature in proposing alternative interest rate rules for inflation targeting. It introduces a SOE model built on the financial accelerator framework. The model is solved quantitatively and simulated. First set of results suggest that in targeting inflation the dynamics of consumer rather than domestic price index should be the focus. This is mainly because when consumer price index is the target the exchange rate becomes a determinant in policy response and enables the authority to reduce the distortion on the return to capital that may arise due to liability dollarization. Second set of results suggest that forward-looking smoothing interest rate as a policy rule achieves the least volatility in the economy. Final set of results suggest that the monetary authority should adopt a regime switching policy during financial distress, where at the start of the distress the domestic interest rate should be adjusted according to the forward-looking smoothing rule and, once the economy returns to its pre-shock output level, the authority should switch to a simple rule.