Information in Corporate Bond Yield for Optimal Policy Rules

This thesis examines the information in corporate bond yields relevant to conducting simple optimal policies. It is a compendium of three self-contained essays, each addressing emerging questions that pertain to the impact of financial outcomes on the macroeconomy. The 2007-2009 financial crisis demonstrated the importance for policy authorities of considering developments in the financial sector in devising their techniques for managing business cycle fluctuations.

The first essay entitled "Corporate Bond Spreads in a DSGE Model" presents a medium-scale dynamic stochastic general equilibrium (DSGE) model as in Smets and Wouters (2007), with endogenously determined government and corporate bond yields. This approach is taken to assess the effect of financial conditions on macroeconomic outcomes. In particular, it explores the information that corporate bond yields convey in relation to the macroeconomy. The model incorporates an Epstein-Zin preference, as in Epstein and Zin (1989), and financial friction in the form of a costly verification problem (Bernanke et al., 1999). The corporate bond spread is investigated as a proxy for the external finance premium in DeGraeve (2008) and Gilchrist et al. (2009). Based on the contribution of these studies, the model in this essay is embedded with bond pricing equations and a stochastic discount factor, which are consistent with a recursive Epstein-Zin preference and financial friction, as in Bernanke et al., 1999 and following the formulation in Christensen and Dib (2008). The standard Bayesian technique is employed to estimate model parameters, using macroeconomic and bond yield data as observables. The 10-year BAA grade corporate bond yield is preferred because it explains the business cycle fluctuation better than other bond yields. In addition, it clearly contains information that is not included in the 10-year government bond yield. Furthermore, the implied corporate bond spread is sizeable, and the magnitude of its volatility aligns with the data. Unsurprisingly, investment is most sharply affected by an external financial premium shock. The fluctuation in investment is well captured in the estimated model, and the estimated investment adjustment parameter is thus not excessively large. Also evident from the analysis is the structural break in the corporate bond spread before and after Paul Volcker's term as chair of the Federal Reserve Board of Governors.

The second essay entitled "Optimal Policy Rules and Corporate Bond Premium" extends the model developed in the first essay with interest in a macroprudential-like monetary policy. In the model, policy makers take into account financial conditions implied by corporate bond yields, in addition to the traditional macro-economic indicators such as inflation and the output gap. More specifically, the essay investigates the information contained in financial indicators for optimal monetary policy. The essay extends the standard Taylor rule to allow the central bank to respond to the corporate bond premium and other related financial indicators, such as net worth and the asset ratio. The optimal rule-based policy that maximises households' conditional welfare is computed. Adding this information improves welfare and also reduces the volatility of inflation by almost half.

Lastly, the third essay entitled "Government Investment and External Finance Premium" examines how monetary and fiscal policies are affected by the financial friction within one model. It assesses how the interventions of the government and the central bank jointly affect entrepreneurs' balance sheets, particularly focusing on the impact that government spending has on the cost of sourcing external finance. Furthermore, it offers an understanding of the multiplier effects of fiscal instruments over a short and long horizon by evaluating its present value multiplier (as in Mountford and Uhlig (2009)) on output, consumption, and investment. The results show the advantage of government investment over other fiscal instruments; it reduces the cost of external finance while also generating the highest short-run and long-run output and investment multipliers.