New Keynesian DSGE Models, Financial Frictions and Bayesian Estimation

By Lawrence J. Christiano

  

 

Overview

This is a graduate-level course on tools for macroeconomics. It is geared to people interested in applying the tools in situations not necessarily considered previously in the literature. For this reason, the course will not shy away from the technical details. At the same time, there will be a constant focus on the intuition.

We begin by describing the basic New Keynesian closed economy model with no capital. The simplicity of this model will allow us to highlight core principles that apply more generally across models with price-setting frictions. It will also allow us to focus on a core technical problem in the New Keynesian model, how to aggregate across heterogeneous firms.

We then turn to a discussion of the econometric tools for estimating dynamic, stochastic, general equilibrium models like the New Keynesian model.

Next we extend the NK model into an open economy setting. We discuss properties of the model, its limitations, as well as problems (e.g., the UIP puzzle) which have been the focus of open economy macro for a long time and which still resist a satisfactory solution.

Finally, we consider financial frictions. We will examine in detail the consequences of incorporating financial frictions on the asset side of banks’ balance sheets. We will also discuss, at a more informal level, financial frictions on the liability side of banks’ balance sheets.

Computer exercises will give students hands-on practice in the use of Dynare to solve, estimate and analyze dynamic models.

 

Lectures

1) The simple New Keynesian (NK) lecture 1 and lecture 2 on model without capital (background: my handbook chapter; Journal of Economic Perspectives paper, interview and this). We will stress the key role in short term economic dynamics of aggregate demand, and the importance of good policy for guiding it. We will evaluate inflation targeting from this point of view.

a) This is a follow up on lecture 2. It: (i) illustrates the undetermined coefficients solution method described in lecture 2, (ii) discusses the relationship between the nominal rate of interest and inflation (Fisherian versus anti-Fisherian relationship). Another follow-up shows how the computational findings at the end of lecture 2 can be demonstrated analytically.

b) Handout on linearization as a tool for solving models (a more in depth discussion appears here).

c)  Derivation of linearized NK Phillips curve.

d) Assignment #9, question 1, accomplishes three things.

i)    Gives students experience with Dynare for solving and simulating models.

ii)  Gets to the heart of the New Keynesian models by exploring its basic underlying economic principles.

iii)        Shows how ‘news’ shocks might cause an inflation targeter to drive the interest rate in the ‘wrong’ direction and inadvertently trigger an inefficient stock market boom (Slides, manuscript; and section 3.2 of handbook chapter.)

e) Other, related materials.

2) Estimation of DSGE models (the handout makes some references to this note on model solution and here is a note on the appropriate acceptance rate for the MCMC algorithm).

a) State space representation of a model.

b) Elements of Bayesian inference (Bayes’ rule, MCMC algorithm).

c)  A simple example to illustrate Bayes’ rule.

d) Assignment #9, questions after 1.

3) Extending the NK model to the open economy. This is a drastically simplified version of the model in here. Code to generate graphs in the lecture notes.

4) Financial.

a) Micro foundations for the Costly State Verification (CSV) approach (zip file with code for the computations, and a version of the  slides with more extensive derivations). The CSV model is used as a friction on the asset side of a bank’s balance sheet.

b) Integrating CSV into a New Keynesian model and the results of Bayesian estimation of the model using US data (CMR, JMCB 2003, AER 2014).

i)    The model.

ii)  The importance of risk shocks and news on risk.

iii)        The response of monetary policy to an increase in interest rate spreads.

iv)        Carefully documented (thanks to Ben Johannsen) Dynare code for replicating the material in this presentation.

c)  Financial frictions on the liability side of banks’ balance sheet. Two-period exposition of Gertler-Karadi/Gertler-Kiyotaki model in which the financial frictions stem from bankers’ ability to ‘run away’ (section 3 of reading, handout).

5) Financial frictions inside the banking sector: an informal review. Summary of Gertler-Kiyotaki AER2015 (here is a more extended set of lecture notes). The focus here will be on shadow banking, which grew very large in the US in the 2000s.

6) Multiplicity of equilibria in New Keynesian models. We have discussed the ‘local uniqueness’ of equilibrium when the coefficient on inflation in the Taylor rule is large. However, that is not sufficient to satisfy global uniqueness of equilibria. Here, I discuss a modification of the Taylor rule, which includes an escape clause: ‘if an undesired equilibrium appears to be forming, then switch to another policy that brings inflation back towards target’. I’ll describe an example in which the policy that works for this is a constant money growth policy. In the example, the escape clause renders the locally unique equilibrium globally unique. Here is a very preliminary manuscript.