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 the intuition.
We describe the basic New Keynesian model. This model serves as a useful starting point for constructing macroeconomic models. After discussing how to solve the model, we discuss its basic properties. We then discuss the econometric tools for estimating dynamic, stochastic, general equilibrium models like the New Keynesian model.
Next, we expand the New Keynesian model to incorporate financial frictions. We will examine in detail the consequences of incorporating financial frictions on the asset side of banks’ balance sheets. We will also discuss, at a more informal level, financial frictions on the liability side of banks’ balance sheets.
Computer exercises will give students hands-on practice in the use of Dynare to solve, estimate and analyze dynamic models.
1) Brief Introductory Remarks.
2) The simple New Keynesian (NK) model without capital (background: my handbook chapter, and this comment on Acemoglu, et al, Macro Annual, 2015). Will stress the impact of networks on the cost of inflation, the slope of the Phillips curve and the value of the Taylor Principle for inflation stabilization. Dynare code for the model is here.
a) The Best (‘Natural’) equilibrium, Ramsey Equilibrium.
b) The linearized Phillips curve and networks.
c) Solving the model by linearization.
d) Assignment #9, question 1, accomplishes three 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.
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.)
e) Other, related materials.
a) State space representation of a model.
b) Elements of Bayesian inference (Bayes’ rule, MCMC algorithm).
c) Assignment #9, questions after 1.
4) 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.
5) Financial frictions on the liability side of banks’ balance sheets (I will only provide a rough sketch of this material).
b) Extending the analysis in (a) to multiperiods and to bank runs (‘rollover crises’), using Gertler-Kiyotaki AER2015 (for an informal discussion of the role of a rollover crisis in the Great Recession, see this and the references therein).
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.
6) Informal Overview of Financial Frictions and US Economy.