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.
b) Log-linearizing the model, quickly.
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.)
2) Econometrics for DSGE models
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.
i) The model.
ii) The importance of risk shocks.
iii) The response of monetary policy to an increase in interest rate spreads.
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’.
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?
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.