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

By Lawrence J. Christiano

**Overview**

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.

**Lectures**

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).

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.