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. 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.