**Advanced
Topics in Monetary Economics**

New
Keynesian Model, Bayesian Estimation, Extensions to Open Economy and to Include
Financial Frictions

By Lawrence J. Christiano

**Overview**

We will review
the basic New Keynesian model and its policy implications. We will consider the
pros and cons of inflation targeting, the dangers posed by the zero lower bound
on the nominal rate of interest and rationales for including credit and/or
asset prices in monetary policy interest rate rules. We will discuss how to
compute forecasts conditional on some specified interest rate path (or, the
path of some other variable). We will extend the model to the open economy and
by introducing financial frictions. Finally, we will use Dynare to solve models
and to estimate them using Bayesian methods. No previous experience with Dynare
will be assumed. The course is aimed at a broad audience, including people
actively doing research with dynamic, stochastic, general equilibrium (DSGE)
models, as well as people interested in seeing what these models are about and
what they are used for. A substantial part of the course (including all
analysis with Dynare) will occur in the afternoon sessions, however, these are
not required to follow the morning lectures.

**Lectures**

1) The simple New Keynesian (NK)
model without capital (background: my handbook chapter). We will
stress the key role in short term economic dynamics of aggregate demand, and
the importance of good policy for guiding it. We will evaluate inflation
targeting from this point of view. There is a reference to ‘networks’ in these lecture
notes. See also. For a series of informal videos on DSGE
models, see.

a) The basics:
the model, from the ground up.

b) Log-linearizing the model:

i)
Log-linearizing
the price-setting equilibrium conditions: the NK Phillips
curve.

ii) Log-linearizing the other equations quickly.

iii)
More
general discussion
of log-linearization (a much more general discussion).

c) Assignment #9,
first question in ‘exercises’ section 3, accomplishes three things.

i) Gives students experience with Dynare
for solving and simulating models.

ii) Gets to the heart of the New
Keynesian model by exploring its basic underlying economic principles.

iii)
Shows
how ‘news’ shocks might cause an inflation targeter
to drive the interest rate in the ‘wrong’ direction and inadvertently trigger
an inefficient stock market boom (Slides,
manuscript;
and section 3.2 of handbook
chapter.)

d) Other,
related materials.

2) Estimation of DSGE
models (the handout makes some references to this note on model
solution and here is a note on the
appropriate acceptance rate for the MCMC algorithm).

a) State space representation of a model.

b) Elements of Bayesian inference (Bayes’ rule, MCMC algorithm).

c) A simple example
to illustrate Bayes’ rule.

d) Assignment #9, questions after 1 in ‘exercises’ section 3.

e) As an application for policy analysis, we will
consider two types of conditional forecasts:

i) Forecast conditional on a fixed
value for the policy variable (or, almost any other variable).

ii) Forecast conditional on a sequence of
forecasts of one (or, several) variables of interest.

iii)
Here
is some code for doing
these forecasts in the simple, closed economy New Keynesian model.

3) Extending
the NK model to the open economy. This is a drastically simplified version of
the model in here.
Code
to generate graphs in the lecture notes.

4) Financial
Frictions in Macroeconomics.

a) Micro foundations for the Costly State Verification (CSV) approach (zip file with code for the computations, and a version of the slides with more extensive derivations). The CSV model
is used as a friction on the asset side of a bank’s balance sheet.

b) Integrating CSV into a New Keynesian model and
the results of Bayesian estimation of the model using US data (CMR,
JMCB
2003, AER
2014).

i) The model.

ii) The importance of risk shocks and
news on risk.

iii)
The
response of monetary policy to an increase in interest rate spreads.

iv)
Carefully
documented (thanks to Ben Johannsen) Dynare __code__ for replicating the material in
this presentation.

c) Financial frictions on the liability
side of banks’ balance sheet. Two-period
exposition of Gertler-Karadi/Gertler-Kiyotaki
model in which the financial frictions stem from bankers’ ability to ‘run away’
(section 3 of reading, handout).

d) Informal overview
of financial frictions and their impact on the Great Recession and
macroeconomics (see also).

i) Where the financial crisis fits in,
relative to all the other factors driving the Great Recession. (I will put
emphasis on a rollover crisis in the shadow banking system as described in Gertler-Kiyotaki (AER2015). For detailed lecture notes on
this, as well as code for the simulations, see.)

ii) Why did economists and policymakers not
foresee the Great Recession?

iii)
Why
did the Great Recession last so long?