New Keynesian DSGE Models, Financial Frictions and
Bayesian Estimation

Lawrence J. Christiano

I
plan to review the basic New Keynesian model and an extension that takes into
account financial frictions. 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 practicum sessions. The sessions are
designed to acquaint participants with Dynare as a tool for analyzing, solving
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). 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. There is a reference to ‘networks’ in the
lecture notes, and for more on this see the handbook chapter, lecture
and also. For a series of informal videos on DSGE
models, see.

a)
The
basics:
the model, from the ground up (long version of handout).

b) Log-linearizing the model, quickly.

i) More general discussion
of log-linearization (a *much* more
general discussion).

ii) Careful derivation of Phillips
curve and significance of linearizing around zero price distortion steady
state.

c) Assignment #9,
first question in ‘exercises’ section 3, accomplishes three things.

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

ii) Gets to the heart of the New
Keynesian model 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.)

d)
Other,
related materials. The simple New Keynesian (NK) model without
capital (longer
version of slides; background: my handbook chapter).

2) Econometrics
for DSGE models

a) Lecture on Bayesian inference (example to illustrate Bayes’
rule).

i) Assignment
9, question 5 in section 3 (‘Exercises’).

b) Conditional
forecasting (code
for (i) and (ii)):

i) How to
predict what will happen if the central bank deviates from ‘business as usual’
by simply holding the interest rate fixed
for one or two years.

ii) Forecasting,
conditional on some future random variables taking on particular values.

(1)
What happens if the central bank holds the
interest rate fixed, but agents interpret the fixed interest rate policy in
real time as ‘business as usual’ with an unusual sequence of shocks to the
policy rule.

(2)
What will happen if another department’s
forecast of the foreign economy actually occurs?

(3)
What will happen if there is a rise in oil
prices?

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

a)
Microfoundations
for the Costly State Verification (CSV) approach (longer handout; 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)
Extension to
small open economy (manuscript and code,
slides).

d)
Extension
by Copaciu-Nalban-Bulete,
addressing the interaction of possible currency mismatch problems in emerging
markets that are anticipated as the US Federal Reserve implements ‘lift off’.

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

f) Informal overview of financial frictions and their impact on the Great Recession and macroeconomics (see also).

i) Where the financial crisis fits in,
relative to all the other factors driving the Great Recession. (I will put
emphasis on a rollover crisis in the shadow banking system as described in Gertler-Kiyotaki (AER2015). For detailed lecture notes on
this, as well as code for the simulations, see.)

ii) Why did economists and policymakers not
foresee the Great Recession?

iii) Why did the Great Recession last so
long?

**Computer Sessions**

We will work with Dynare programs to
explore: (i) basic economic principles implied by the
New Keynesian model and (ii) methods for the empirical analysis of DSGE models,
including Bayesian inference and conditional forecasting.