The New Keynesian Model: Computational and Econometric Tools, and Extensions to Introduce Financial Frictions

By Lawrence J. Christiano




The course begins with a review of computational and econometric tools useful in the analysis of dynamic, stochastic general equilibrium (DSGE) models. We then review several ways to build financial frictions into the otherwise-standard New Keynesian DSGE model. Finally, we use one of the models of financial frictions to discuss the interaction between monetary policy and stock market volatility. Afternoon sessions will be devoted to computer exercises using Dynare that illustrate the points discussed in the lectures. The afternoon sessions will assume no previous exposure to Dynare.


1.    Overview of tools for solving DSGE models: Perturbation and Projection methods.

·       Background readings: Christiano-Fisher (JECD, 2000), Ken Judd’s textbook.

2.    Some time series analysis tools for estimation and analysis of DSGE models (a note on the appropriate acceptance rate for the MCMC algorithm).

·       James Hamilton, Time Series Analysis.

·       Christiano-Trabandt-Walentin, ‘DSGE Models for Monetary Policy’, chapter in Friedman and Woodford’s Handbook of Monetary Economics, 2011 (sections 3.3.3 and 5).

·       Using Vector Autoregressions to estimate a medium-sized New Keynesian model (an example of ‘long-run identification’).

3.    Introducing financial frictions into the New Keynesian DSGE Model (for background material on the basic NK model, see my handbook chapter and also handout#1 and handout#2).

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

·       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.

                                                        iv.      Background reading: Bernanke, Gertler and Gilchrist’s classic 1999 paper and Christiano-Motto-Rostagno paper to be posted in near future.

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

4.    Financial frictions in the intermediation sector, exposited in two-period settings (sections 3, 4, and maybe 5 of Christiano-Ikeda, background reading).

·       Two approaches based on moral hazard.

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

                                                           ii.      Hidden action (section 4)

·         Adverse selection (section 5).

5.    Monetary policy and asset prices. (Christiano-Ilut-Motto-Rostagno, background manuscript; and section 3.2 of handbook chapter).

·       News and inflation targeting.

·       Using Ramsey optimal policy as a benchmark for evaluating a policy rule. 



Afternoon Sessions

Apart from illustrating various points and concepts from the lectures, the computer exercises explore the following additional substantive topics:  

1)    The sensitivity of the dynamic response of inflation and output to the persistence properties of shocks.

a)    Making precise the NK concepts of ‘insufficient aggregate demand’ and ‘excessive aggregate demand’ (see section 3.4 of handbook chapter).

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

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

b)    The Taylor rule moves the interest rate in the right direction in response to ‘standard’ shocks, but does not move it far enough.

c)     Optimal monetary policy and the Taylor principle.

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

a)    An important working capital channel may overturn the stabilizing properties of the Taylor principle (section 3.1).

b)    News shocks may imply that the monetary authority implementing the Taylor principle moves the interest rate in the wrong direction (section 3.2).

Assignment #7

Introduction to model solving with Dynare using the real business cycle model.


Assignment #9 

This assignment works heavily with the Clarida-Gali-Gertler model, which is developed here (for a more detailed discussion see this and this).

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