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.    Introductory remarks.

2.    Overview of tools for solving DSGE models: Perturbation and Projection methods with a Dynare file to do the computations reported in the handout.

·       a much more detailed version of this handout, with software used to generate the graphs in the more detailed handout, and a zip file that uses Dynare to do some of the computations.

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

3.     Estimation of DSGE models (the handout makes some references to these notes on model solution and here is 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).

4.    Features of New Keynesian model needed for assignment #9. (For a more detailed handout, see handout#1 and handout#2 and also my handbook  chapter).

5.    Introducing financial frictions into the New Keynesian DSGE Model.

·       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).

6.    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).

                                            iii.      Adverse selection (section 5).

7.    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 (the exercise makes some references to these notes)

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 and also in the text of assignment #9.

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