Advanced Topics in Monetary Economics

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

By Lawrence J. Christiano




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.



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 2003AER 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 readinghandout).

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?