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)  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 2003AER 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 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 (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’.