Financial Frictions and the Macroeconomy

By Lawrence J. Christiano

The course will take the form of
lectures in each of five mornings. These will concentrate on financial
frictions in DSGE models. There will be three and one-half afternoon sessions.
These sessions will stress computer exercises involving the solving, simulation
and estimation of models.

**Lectures and
Handouts**

1)
Introducing financial frictions
into the New Keynesian DSGE Model.

a)
Microfoundations for
the Costly State Verification (CSV) approach.

b)
Integrating CSV
into an NK model and the results of Bayesian estimation of the model using US
and EA data.

i)
The model

ii)
The importance of risk shocks.

iii) The
response of monetary policy to an increase in interest rate spreads.

c) Very
brief discussion of extending CSV to risky banking (discussion based on papers
by Zeng and
by Hirakata, Sudo and
Ueda.)

2)
Financial frictions in the intermediation
sector, exposited in two-period settings (sections 3, 4, 5 of reading, handout).

a)
Two approaches based on moral hazard.

i)
Two-period
financial friction model of Gertler-Kiyotaki, (section
3)

ii)
Hidden action (section 4)

b) Adverse selection (section 5).

3) Implications of the zero lower bound on the nominal rate of interest (manuscript).

a) The deflation spiral, the government spending multiplier.

b) Quantitative
analysis of the role of the zero bound in the dynamics of US data, 2008 and
2009.

4) Monetary
policy and asset prices. (Background
manuscript)

a) News
and inflation targeting.

b) Using Ramsey optimal policy as a benchmark for evaluating a policy rule.

5)
Introducing unemployment with imperfect
labor market insurance into the NK Model (we will most likely not get to this section).

a)
Revisiting Lucas’ cost of business cycles.

**b)
**Using unemployment data to estimate the output
gap (see section 3.3,
3.4 of handbook chapter).** **

**Afternoon Sessions**

Apart from
giving students hands-on experience with the quantitative analysis of models,
the two homework exercises allow us to discuss the following topics:

a)
Bayesian
estimation of DSGE models.

b)
The
HP filter as a way to estimate the output gap.

2)
The
Taylor principle (see section 3.1 of handbook chapter).

a)
The
rationale for the principle in the standard NK model.

b)
Circumstances
when things can go awry with the Taylor principle:

i)
An
important working capital channel.

ii) News shocks.

**3)
**The timeless perspective in Ramsey-optimal monetary policy (handout).

**Assignment #9**** **

This assignment
works heavily with the Clarida-Gali-Gertler model,
which is developed here.

The
text for this assignment, as well as all the necessary software, is included in
this zip file.

**Background readings**

The main reference for New Keynesian
models is my chapter with Trabandt and Walentin, in the forthcoming Handbook of
Monetary Economics, edited by Friedman and Woodford.

The primary reference for financial frictions is Christiano and Daisuke, Government Policy, Credit
Markets and Economic Activity.

Other
references on financial frictions:

Bernanke, Gertler and Gilchrist’s classic 1999 paper.

Christiano, Motto, Rostagno (2003): Using the BGG model to analyze the cause of the US Great Depression, and the reason it lasted so long.

Christiano, Motto, Rostagno (2009): Using the BGG model to understand the causes of economic fluctuations in the EA and the US.

Christiano, Trabandt and Walentin (2009): Financial and labor market frictions in a small open economy model of Sweden. (Handout)

Government spending and the zero bound:

Christiano, Eichenbaum and Rebelo (2009) When is the Government Spending Multiplier Large?