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 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.
1) The New Keynesian model.
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).
i) The model
ii) The importance of risk shocks.
iii) The response of monetary policy to an increase in interest rate spreads.
d) An open economy version of the model with financial frictions.
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).
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.
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).
b) Assignment #8.
c) Consensus, medium sized New Keynesian (NK) DSGE model.
a) News and inflation targeting.
b) Using Ramsey optimal policy as a benchmark for evaluating a policy rule.
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.
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.
Government spending and the zero bound:
Christiano, Eichenbaum and Rebelo (JPE, 2011) When is the Government Spending Multiplier Large?