Common stochastic trends and policy shocks in the open economy: Empirical essays in international finance and monetary policy

The demise of the Bretton Woods system of pegged exchange rates in the early 1970s gave birth to a number of theoretical and empirical research aimed at explaining the observed volatility of exchange rates and fluctuations in the current accounts of nations. Also, the early 1980s witnessed the world economy plagued by large and uncoordinated innovations in monetary and fiscal variables as well as by high and volatile real interest rates and exchange rate misalignments - i.e. the tendency for the real exchange rate movements to diverge from the long run equilibrium path as measured by relative purchasing power parity. The juxtaposition of these events led to a surge of scientific investigations which up to now, however, have not resolved the existing puzzles in a satisfactory way. This dissertation contributes to this literature on empirical international finance by introducing and using new empirical methods in identifying productivity shocks and monetary policy shocks. The shocks so identified are then used in explaining observed exchange rate and current account fluctuations. The rationale of the studies conducted is to blend international monetary theory with modern time series analysis in an attempt to contribute to our understanding of the current international monetary system. In particular, this dissertation presents empirical analysis on the effects of productivity and policy shocks on capital flows and bilateral exchange rate fluctuations using modern time series methods, and takes a step towards a deeper understanding of the observed phenomena.