The New Keynesian Model: Computational and Econometric Tools, and Financial Market Extensions

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. After a very brief review of the basic New Keynesian model, we discuss extensions of the model to introduce financial market frictions. Finally, we use a model 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.


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.

·       The following exercise explores perturbation in Dynare (the exercise contains an extremely simplified discussion of pruning, something that is discussed in greater detail in this extended version of the class handout). The assignment requires this zip file.

·       For more discussion, see part (1) of this lecture series.

·       Background readings: Christiano-Fisher (JECD, 2000), Ken Judd’s textbook. A detailed review of solving linearized systems.

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).

·       A procedure that lies at the heart of Bayesian methods for econometric inference is the MCMC algorithm. Question 3, part 2, of Assignment #9 explores 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.    Basic New Keynesian model without capital and with flexible labor markets (zip file with Dynare code for computations). (For a more detailed handout, see handout#1 and handout#2 and also my handbook chapter.)

·       The lecture focuses the resource misallocation consequences of price setting frictions and working capital. Some ideas in the growth literature that motivates these slides are you discussed by Chad Jones.

·       We will work on assignment 9, question 1, to explore some economic properties of the NK model. We will then use these properties as we explore questions 3 and later in assignment 9, which review techniques of Bayesian inference.

·       Specifically,  Assignment 9, question 1, explores:

                                                 i.      the rationale for and possible pitfalls of the Taylor principle/inflation targeting. Pitfalls will be shown to be possible if there is a significant working capital channel or if ‘news’ shocks are important (see section 3 of handbook chapter).

                                               ii.      the optimality of using the natural rate of interest (especially if news shocks are important) to guide policy, and identifying measurable proxies for it  (see background manuscript).

                                            iii.      Sensitivity of the dynamic properties of the NK model to the type of persistence in shocks.

·       An alternative approach to solving models is called the extended path method, which – like the perturbation method – has been incorporated into Dynare (lecture notes appear here). A discussion of extended path for doing stochastic simulation appears  here. Two examples, based on the simple NK model without capital, are considered. In each case, the zero lower bound on the interest rate is binding for a while and then not binding (this feature of the example disqualifies the perturbation method as an appropriate model solution method). The first example considers the economic effects of a positive technology shock. The second example considers the welfare and other effects of a government spending shock when it must be financed by distortionary taxes, subject to satisfying the government’s intertemporal budget constraint.

·       Other relevant material:

                                                 i.      Code for exploring different versions of the NK model and investigating, for example, the relative performance of first and second order perturbation methods for model solution. Here is a simple (no capital, closed economy) NK economy with Rotemberg price adjustment costs. Here is a simple NK economy with Calvo price adjustment. Here is code for analyzing a medium-sized NK model.

                                               ii.      To study Ramsey optimal policy in the NK model, see this and for an even more detailed version, see this. Possible time inconsistency of monetary policy and the timeless perspective are discussed. The implications of the working capital channel (briefly discussed in assignment 9) are reviewed.

                                           iii.      Extensions that we will not discuss include:

1.    Using linearized DSGE models to simulate a fixed interest rate path, either because the zero lower bound is binding or as input to a policy briefing (code).

2.    A more extensive discussion of Ramsey optimal policy appears here. Possible time inconsistency of monetary policy and the timeless perspective are discussed. The implications of the working capital channel (briefly discussed in assignment 9) are reviewed.

3.    Exploring the meaning of the fact that money demand and supply are not included standard presentations of the NK model.

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 (AER, 2014). This url has the CMR manuscript, as well as a carefully documented (by Ben Johannsen) set of codes for reproducing the main results in the CMR.

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

·       Open economy version of the model.

6.    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.