Formulation,
Estimation and Policy Analysis with DSGE Models with 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 also explore extensions to incorporate financial and labor
market frictions. The discussion of financial frictions will allow us to
consider aspects of ‘unconventional monetary policy’, such as when and why
government purchases of privately issued assets may help repair a dysfunctional
financial system. 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 New Keynesian model.

a)
The basic foundations of the model (handout: this
and this).

b)
Assignment
#9, question 1 (works in Dynare, version 4.3.0).
The discussion of labor market frictions will be handled as an extension of
question 1, assignment #9.

2)
Introducing financial frictions
into the New Keynesian DSGE Model.

a)
Microfoundations for
the Costly State Verification (CSV) approach (much more
detailed presentation that introduces CSV
into an rbc model and this zip file has the code for the computations).

b)
Integrating CSV
into an NK model and the results of Bayesian estimation of the model using US
and EA data (code).

i)
The model

ii)
The importance of risk shocks.

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

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

d) An
open economy version
of the model with financial frictions.

3)
Financial frictions in the intermediation
sector, exposited in two-period settings (sections 3, 4, and *maybe* 5 of reading, handout).

a)
Two approaches based on moral hazard.

i)
Two-period version of Gertler-Kiyotaki financial friction model, (section 3) (exercise question).

ii)
Hidden action and implications for
macro-prudential policy (section 4).

b) Adverse selection (section 5).

4) Implications of the zero lower bound on the nominal rate of interest (manuscript).

a)
The deflation spiral, the government spending multiplier.

b)
Quantitative analysis of the role of the zero bound in the
dynamics of US data, 2008 and 2009.

c)
Evidence
on the sensitivity of conclusions to having used linearized equilibrium
conditions (related
material, including exercise).

5)
Estimation
of DSGE models (the handout makes some references to these
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) Assignment #9, not
question 1.

6)
More on the New Keynesian model (we are very unlikely to get to
this).

a)
Ramsey-optimal
monetary policy and the timeless perspective (lecture handout,
and longer handout)

b)
Assignment
#8.

c) Consensus,
medium sized New Keynesian (NK) DSGE
model.

7) Monetary policy and asset
prices (background
manuscript). We will do the essence of this in our work on assignment #9.

a) News
and inflation targeting.

**b)
**Using Ramsey optimal policy as a benchmark for
evaluating a policy rule. ** **

**Afternoon Sessions**

Some
lectures will be presented in afternoon sessions and all computations will be
based on assignment #9. Apart from giving students hands-on experience with the
quantitative analysis of models, assignment #9 exercises allow us to discuss
the following topics:

a)
Bayesian
estimation of DSGE models.

b)
The
HP filter as a way to estimate the output gap.

2)
The
Taylor principle (see section 3.1 of handbook chapter).

a)
The
rationale for the principle in the standard NK model.

b)
Circumstances
when things can go awry with the Taylor principle:

i)
An
important working capital channel.

ii) News shocks.

3) Labor market frictions: Nash
bargaining and alternating offer bargaining.

**Background readings**

The main reference for New
Keynesian models is my chapter with Trabandt and Walentin, in the just-released
Handbook of Monetary Economics, edited by Friedman and Woodford.

The primary reference for financial frictions is Christiano and Daisuke, Government Policy, Credit
Markets and Economic Activity.

Other
references on financial frictions:

Bernanke, Gertler and Gilchrist’s classic 1999 paper.

Christiano, Motto, Rostagno (2003): Using the BGG model to analyze the cause of the US Great Depression, and the reason it lasted so long.

Christiano, Motto, Rostagno (2009): Using the BGG model to understand the causes of economic fluctuations in the EA and the US.

Christiano, Trabandt and Walentin (2009): Financial and labor market frictions in a small open economy model of Sweden. (Handout)

Government spending and the zero bound:

Christiano, Eichenbaum and Rebelo (JPE, 2011) When is the Government Spending Multiplier Large?