Analysis of Policy and of Financial Frictions in New Keynesian Models
By Lawrence J. Christiano
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.
1) The New Keynesian model.
b) Assignment #9, question 1 (works in Dynare, version 4.3.0).
2) 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) An open economy version of the model with financial frictions.
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).
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.
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.
b) Assignment #8.
c) Consensus, medium sized New Keynesian (NK) DSGE model.
a) News and inflation targeting.
b) Using Ramsey optimal policy as a benchmark for evaluating a policy rule.
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).
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.
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.
Government spending and the zero bound:
Christiano, Eichenbaum and Rebelo (JPE, 2011) When is the Government Spending Multiplier Large?