By Lawrence J. Christiano

**Overview**

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.

**Lectures**

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.

3) 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, questions
after 1.

4) Financial
frictions on the asset side of banks’ balance sheets.

a) Micro foundations for the Costly State Verification (CSV) approach (zip file with code for the computations, and a version of the slides with more extensive derivations).

i) A microeconomic approach.

Related empirical paper: Levin,
Natalucci and Zakrajsek.

ii) Introducing the frictions into a
neoclassical growth model.

(1)
Aggregation.

(2)
The
‘financial friction wedge': very useful device for thinking about the dynamic
effects of financial frictions.

b) Integrating CSV into a New Keynesian model and the
results of Bayesian estimation of the model using US data (CMR,
JMCB
2003, AER
2014).

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).

a) Two-period exposition of Gertler-Karadi/Gertler-Kiyotaki model in which the financial frictions
stem from bankers’ ability to ‘run away’ (section 3 of reading, handout).

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.