Formulation, Estimation and Policy Analysis in 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 frictions and to the open economy. 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 (NK) model.

a)   The basic foundations of the model (handout #1, handout #2).

b)  Assignment #9, question 1, explores:

i)    the rationale for and possible pitfalls of the Taylor principle/inflation targeting. Pitfalls will be shown to be possible if there is a significant working capital channel or if ‘news’ shocks are important.

ii)            the optimality of using the natural rate of interest (especially if news shocks are important) to guide policy, and identifying measurable proxies for it  (see background manuscript).

c)   Extensions not discussed formally in class:

i)    Code for exploring different versions of the NK model and investigating, for example, the relative performance of first and second order perturbation methods for model solution. Here is a simple (no capital, closed economy) NK economy with Rotemberg price adjustment costs. Here is a simple NK economy with Calvo price adjustment. Here is code for analyzing a medium-sized NK model.

ii)            An alternative to perturbation for solving models is called the extended path method, which – like the perturbation method – has been incorporated into Dynare. A discussion of that method for doing stochastic simulation appears  here. Two examples, based on the simple NK model without capital, are considered. In each case, the zero lower bound on the interest rate is binding. One case considers the economic effects of a positive technology shock. The other case considers the welfare and other effects of a government spending shock when it must be financed by distortionary taxes and the government’s intertemporal budget constraint must be satisfied.

iii)        Using linearized DSGE models to simulate a fixed interest rate path, either because the zero lower bound is binding or as input to a policy briefing (code).

iv)         A more extensive discussion of Ramsey optimal policy appears here. Possible time inconsistency of monetary policy and the timeless perspective are discussed. The implications of the working capital channel (briefly discussed in assignment 9) are reviewed.

v)  Exploring the meaning of the fact that money demand and supply are not included standard presentations of the NK model.

2)  Financial frictions on the asset side of banks’ balance sheets.

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).

b)  Integrating CSV into a New Keynesian model and the results of Bayesian estimation of the model using US data (CMR, JMCB 2003, AER2014).

i)    The model.

ii)            The importance of risk shocks.

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.

3)  Financial frictions on the liability side of banks’ balance sheets (not covered in class).

a)  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).

b)  Dynamic Model in which financial frictions stem from the fact that to do their job well, bankers must exert costly but unobserved effort. The environment has the implication that imposing leverage restrictions on banks can raise social welfare and thus represents a laboratory for thinking about macro prudential policy (background manuscript).

c)   This reading also shows (in two-period settings) how financial frictions on the liability side of banks’ balance sheet can arise from adverse selection and costly state verification. We will not discuss these cases in the lectures.

4)  A small open economy New Keynesian model.

a)   Computer code for exploring the properties of the model.

b)  Addressing uncovered interest rate parity in the small open economy model.

c)   Extensions to include financial frictions and possible currency mismatch problems.

d)  Version of the model described here, designed to be estimated on actual data.

e)       Discussion of the work of Mihai Copaciu, addressing the interaction of possible currency mismatch problems in emerging markets that are anticipated as the US Federal Reserve implements ‘lift off’.

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  (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)  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 (background manuscript).


Background readings

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

The primary reference for financial frictions on the liability side of banks’ balance sheets 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?

Thinking about the Great Recessions through the lens of a New Keynesian model:

Christiano, Eichenbaum and Trabandt (AEJ-Macro, 2015), ‘Understanding the Great Recession’.