Formulation, Estimation and Policy Analysis with DSGE Models with 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 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.

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: 

1)    Empirical methods

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?