By Lawrence J. Christiano
This is a graduate course on the basic tools for the rapidly growing field of Macro/Finance. It is geared to students who will go on to do this type of work in their own research. For this reason, the course will not shy away from the technical details. At the same time there will be a constant focus on getting the intuition right.
Most of the models of finance that we will review in effect represent disturbances to the ‘intertemporal margin’. In models with frictionless labor and goods markets financial frictions on the intertemporal margin tend to drive consumption and investment in opposite directions. But, macro data indicate that consumption and investment move in the same direction. For this and other reasons, we will use the New Keynesian model as our basic macroeconomic platform. For reasons we will see, this model has the advantage of predicting that consumption and labor move in the same direction. In recent years this model has also performed well on several other empirical dimensions: it predicted correctly that fiscal austerity slows down economic activity, rather than speed it up; it predicted correctly that the high money growth in recent years would be associated with low, rather than high inflation.
Next, we turn to models of financial frictions. I will organize the discussion around frictions on the liability and asset sides of financial firm balance sheets. Our analysis will help us in thinking about various problems in monetary policy: how monetary policy should respond to changes in interest rate spreads, what the effect of various types of unconventional monetary policy are, as well as macro prudential policy. We will review Bayesian econometric methods because they are the key tool for the estimation and empirical evaluation of the models we will review. Students will get hands-on practice in the use of Dynare to solve, estimate and analyze dynamic models.
1) The New Keynesian (NK) model (handout, manuscript): basic principles and policy implications (Dynare code for solving and simulating the model in the handout, with some notes on how Dynare does it).
a) The version described is inspired by recent improvements in understanding the network nature of actual production (Acemoglu, et al, 2015; see also). For example, networks can help provide an endogenous theory of price sluggishness through a strategic complementarity mechanism. They also convert the New Keynesian model into a quantitatively serious theory about the costs of inflation.
b) Assignment #9, question 1, accomplishes two things.
i) Gives students experience with Dynare for solving and simulating models.
ii) Gets to the heart of the New Keynesian models by exploring its basic underlying economic principles.
c) Other, related materials.
2) Financial frictions on the asset side of banks’ balance sheets.
i) A microeconomic approach.
Related empirical paper: Levin, Natalucci and Zakrajsek.
ii) Introducing the frictions into a neoclassical growth model.
(2) The ‘financial friction wedge': very useful device for thinking about the dynamic effects of financial frictions.
i) The model.
ii) The importance of risk shocks and news on risk.
iii) The response of monetary policy to an increase in interest rate spreads.
iv) Carefully documented (thanks to Ben Johannsen) Dynare code for replicating the material in this presentation.
3) Financial frictions on the liability side of banks’ balance sheets.
b) Extending the analysis in (a) to multiperiods and to bank runs (‘rollover crises’), using Gertler-Kiyotaki AER2015.
c) Dynamic Model in which financial frictions stem from the fact that to do their job well, bankers must exert costly but unobserved effort. The environment has the implication that imposing leverage restrictions on banks can raise social welfare by addressing an externality. It thus provides a laboratory for thinking about macro prudential policy (background manuscript).
d) The reading also shows (in two-period settings) how financial frictions on the liability side of banks’ balance sheet can arise from adverse selection and costly state verification. We will not discuss these cases in the lectures.
a) State space representation of a model.
b) Elements of Bayesian inference (Bayes’ rule, MCMC algorithm).
c) Assignment #9, questions after 1.
5) A small open economy New Keynesian model.
a) Extending the simple model to the open economy, following the approach of Adolfson-Laséen-Lindé-Villan (RAMSES I).
i) Computer code for exploring the properties of the model.
ii) Further extensions to bring the model to the data.
b) Incorporating financial frictions into the model, following the approach of Christiano-Trabandt-Walentin (RAMSES II).
i) A discussion of the work of Mihai Copaciu addressing the interaction of possible currency mismatch problems in emerging markets and the US Federal Reserve’s eventual ‘exit strategy’.
ii) A slightly simplified version of the CTW model is described here (the relatively complicated labor market part of CTW is replaced by a standard sticky wage setup). You can see how the model is estimated on Swedish data. There are instructions for replacing the Swedish data with another country’s data and using the code to analyze that.
The main reference for New Keynesian models is my chapter with Trabandt and Walentin, in the Handbook of Monetary Economics, edited by Friedman and Woodford.
The primary reference for financial frictions on the liability side of banks’ balance sheets is Christiano and Daisuke, Government Policy, Credit Markets and Economic Activity.
An extensive applications of the methods described in the course, to understand recent events in the US:
Christiano, Eichenbaum and Trabandt (AEJ-M 2015), ‘Understanding the Great Recession’.