Three Day Course on the New Keynesian
Model

By Lawrence J. Christiano

I plan to review the basic New Keynesian model and some financial friction extensions that are currently under development. The course is aimed at a broad audience, including people actively doing research with dynamic, stochastic, general equilibrium (DSGE) models, as well as people interested in seeing a review of the structure of these models and what they are used for. There will be afternoon homework sessions. The sessions are designed to acquaint participants with Dynare as a tool for analyzing and estimating DSGE models. The first part of these sessions is integrally related to the lectures (especially (1) below), as they explore the fundamental properties and policy implications of the New Keynesian model. In the second part of the afternoon sessions, we will review the fundamentals of Bayesian inference and then do Bayesian inference using Dynare.

**Three Morning Lectures**

1)
The simple New Keynesian (NK) model without
capital (background: my handbook chapter).

Additional material, not covered in
lectures:

Ramsey-optimal monetary policy and the timeless perspective
(lecture handout,
longer handout, computer
code).

2) Medium Sized NK model (background: handbook chapter).

Additional material, not covered in lectures:

a)
Dynare code a medium-sized New Keynesian model.

b)
Extension of
medium sized NK model to small open economy (manuscript
and code, slides).

3) Introducing financial frictions into the New Keynesian DSGE Model.

a) Microfoundations
for the Costly State Verification (CSV) approach (section 6 of background paper).

b) Integrating CSV
into an NK model and the results of Bayesian estimation of the model using US
and EA data (manuscript).

i) The
model.

ii) The
importance of risk shocks.

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

iv) Background
reading: Bernanke, Gertler and
Gilchrist’s classic 1999
paper and Christiano-Motto-Rostagno.

c)
Very brief discussion of
extending CSV to risky banking (discussion based on papers by Zeng
and by Hirakata, Sudo and
Ueda).

d)
Additional material on financial frictions
specifically in the banking sector (slides, reading).

**Three Afternoon Sessions**

Apart
from giving participants hands-on experience with the quantitative analysis of
models using Dynare, question 1 in assignment 9 allows us to discuss the
following topics using the model developed in the first lecture:

1) The sensitivity of the dynamic response of
inflation and output to the persistence properties of shocks.

a) Making precise the NK concepts of ‘insufficient
aggregate demand’ and ‘excessive aggregate demand’ (see section 3.4 of handbook chapter).

a) The rationale for the principle in the standard
NK model (see section 3.1 of handbook chapter).

b) The Taylor rule moves the interest rate in the
right direction in response to ‘standard’ shocks, but does not move it far
enough (see section 3.4 of handbook chapter).

3) Circumstances when things can go awry with the
Taylor principle:

a) An important working capital channel may
overturn the stabilizing properties of the Taylor principle (section 3.1 of handbook chapter).

b) News shocks may imply that the monetary
authority implementing the Taylor principle moves the interest rate in the
wrong direction (see the following slides; Christiano-Ilut-Motto-Rostagno, Jackson Hole
paper; and section 3.2 of handbook chapter).

Questions 3 and 4 explore some econometric issues
relative to the analysis of dynamic models. Question 3 studies the HP filter
and evaluates its accuracy for estimating the output gap. Question 4 in
assignment 9 explores the tools for Bayesian econometric inference for a DSGE
model (see this handout).

**Assignment
#9**** **

The text for this assignment, as
well as all the necessary software, is included in this zip file.