Tools for Macro/Finance

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 start with a phenomenon that lies at the heart of an emerging consensus about an important factor which amplified the Great Recession in the US: a rollover crisis in the shadow banking system. We do this by reviewing papers by Gertler and Karadi and Gertler and Kiyotaki. We then turn to a model of financial frictions in nonfinancial firms, the model of costly state verification (CSV) and asymmetric information.

After that, 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 introduce CSV financial frictions and argue that the resulting model matches US time series well.

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 (background: forthcoming Journal of Economic Perspectives, interview).

2) Financial Frictions in Financial Firms

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).

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).

3) Financial Frictions in Nonfinancial Firms

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). Related empirical paper: Levin, Natalucci and Zakrajsek.

b) Introducing the frictions into the neoclassical growth model.

(1)                     Aggregation.

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

4) The simple New Keynesian (NK) model without capital (background: my handbook chapter). The foundations are here and a quick and dirty linearization is here. Dynare code for the model is here.

a)  The linearized Phillips curve.

b) Solving the model by linearization.

c)   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.)       Also shows how the Taylor rule can be too weak in its response to more conventional shocks.

d) Other, related materials.

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

6) Overview of financial frictions: Recent Economic Events in the US (see).

7) A model of financial frictions in banking, in which the agency problem reflects ‘hidden’ effort inside the banks (lecture notes, manuscript).

a)  In a two-period version of the model, Ramsey methods show that a leverage restriction on banks raises welfare because it forces them to internalize a particular negative externality associated with issuing deposits.

b) An infinite-horizon version of the model is used to display the implication of the model for dynamics.

8) 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.