Formulation, Estimation and Policy
Analysis in 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 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.

**Lectures**

1) Foundations of the New Keynesian (NK) model (handout,
manuscript).

a) The version if the NK model that is
described is inspired by recent improvements in understanding the network
nature of actual production (Acemoglu, et al, 2015; see
also). For example, networks can help provide an endogenous theory of price
sluggishness through a strategic complementarity mechanism. They also convert
the New Keynesian model into a quantitatively serious theory about the costs of
inflation.

b) Ramsey (‘Natural’) equilibrium.

c) Linearization as a strategy for solving
models.

d) Linearization of NK model: Phillips
curve.

e) Dynare code
for solving and simulating the model in the handout, with some notes
on the linearization strategy used by Dynare. A more
rigorous treatment
of the linearization solution strategy.

f) Assignment #9,
question 1, accomplishes two things.

i) Gives students experience with Dynare for solving and simulating models.

ii) Gets to the heart of the New
Keynesian models by exploring its basic underlying economic principles.

g) For a version of the slides that goes
into a detailed comparison of the New Keynesian and Real Business Cycle models
and other things, see handout.

h) Other,
related materials.

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 data (CMR,
JMCB
2003, AER
2014).

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 reading, handout).

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 (2016 AER P&P, 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**

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

Other
references on financial frictions:

Bernanke, Gertler and
Gilchrist’s classic 1999
paper.

Government spending and the zero bound:

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

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

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

The
labor market in DSGE models:

Christiano, Eichenbaum
and Trabandt (Econometrica, 2016), ‘Unemployment and Business
Cycles’.