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 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.

**Lectures**

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
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.

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.