Analysis of Policy and of Financial Frictions in New Keynesian
Models

By Lawrence J. Christiano

**Overview**

We will
start by developing the New Keynesian model and its policy implications. Here, we
will focus on inflation targeting as well as the dangers posed by the zero
lower bound on the nominal rate of interest. We will then extend the model to
incorporate financial frictions. For the most part, macroeconomic models cannot
be solved analytically and they require numerical simulation to study their
properties. We will use Dynare to gain hands-on
experience analyzing the models discussed in lectures. The
following outline for the course is designed to only provide an indication of
the course material to be covered. We will definitely cover the first three
parts, and will then select topics afterward given the time available and the
interests of students.

**Lectures**

1)
The New Keynesian model.

a)
The basic foundations of the model (handout: this
and this).

b)
Assignment
#9, question 1 (works in Dynare, version 4.3.0).

2)
Introducing financial frictions
into the New Keynesian DSGE Model.

a)
Microfoundations for
the Costly State Verification (CSV) approach ( zip file with code for the computations).

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

i)
The model

ii)
The importance of risk shocks.

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

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

d) An
open economy version
of the model with financial frictions.

3)
Financial frictions in the intermediation
sector, exposited in two-period settings (sections 3, 4, and *maybe* 5 of reading, handout).

a)
Two approaches based on moral hazard.

i)
Two-period version of Gertler-Kiyotaki financial friction model, (section 3) (exercise question).

ii)
Hidden action and implications for
macro-prudential policy (section 4).

b) Adverse selection (section 5).

4) Implications of the zero lower bound on the nominal rate of interest (manuscript).

a)
The deflation spiral, the government spending multiplier.

b)
Quantitative analysis of the role of the zero bound in the
dynamics of US data, 2008 and 2009.

c)
Evidence
on the sensitivity of conclusions to having used linearized equilibrium
conditions (related
material, including exercise).

5)
Estimation
of DSGE models (the handout makes some references to these
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) Assignment #9, not
question 1.

6)
More on the New Keynesian model.

a)
Ramsey-optimal
monetary policy and the timeless perspective (lecture handout,
and longer handout)

b)
Assignment
#8.

c) Consensus,
medium sized New Keynesian (NK) DSGE
model.

7) Monetary policy and asset
prices. (Background
manuscript)

a) News
and inflation targeting.

**b)
**Using Ramsey optimal policy as a benchmark for
evaluating a policy rule. ** **

**Afternoon Sessions**

Apart from giving
students hands-on experience with the quantitative analysis of models, homework
exercises allow us to discuss the following topics:

a)
Bayesian
estimation of DSGE models.

b)
The
HP filter as a way to estimate the output gap.

2)
The
Taylor principle (see section 3.1 of handbook chapter).

a)
The
rationale for the principle in the standard NK model.

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

i)
An
important working capital channel.

ii) News shocks.

Introduction
to model solving with Dynare using the real business
cycle model.

Explores
Ramsey-optimal policy in the Rotemberg model. (For an alternative
software, useful for example when you want to do Ramsey with higher order
approximations, see).

**Assignment #9**** **

This assignment
works heavily with the Clarida-Gali-Gertler
model, which is developed.

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

The
assignment explores the dynamics of the model (question #2) and uses the model
to explore Bayesian estimation and hp-filtering.

**Background readings**

The main reference for New
Keynesian models is my chapter with Trabandt and Walentin, in the just-released
Handbook of Monetary Economics, edited by Friedman and Woodford.

The primary reference for financial frictions is Christiano and Daisuke, Government Policy, Credit
Markets and Economic Activity.

Other references
on financial frictions:

Bernanke, Gertler and Gilchrist’s classic 1999 paper.

Christiano, Motto, Rostagno (2003): Using the BGG model to analyze the cause of the US Great Depression, and the reason it lasted so long.

Christiano, Motto, Rostagno (2009): Using the BGG model to understand the causes of economic fluctuations in the EA and the US.

Christiano, Trabandt and Walentin (2009): Financial and labor market frictions in a small open economy model of Sweden. (Handout)

Government spending and the zero bound:

Christiano, Eichenbaum and Rebelo (JPE, 2011) When is the Government Spending Multiplier Large?