New Keynesian DSGE Models, Financial Frictions and Bayesian Estimation

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 discuss how to compute forecasts conditional on some specified interest rate path (or, the path of some other variable). We will extend the model to the open economy and by introducing financial frictions. 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) The simple New Keynesian (NK) lecture 1 and lecture 2 on model without capital (background: my handbook chapter). We will stress the key role in short term economic dynamics of aggregate demand, and the importance of good policy for guiding it. We will evaluate inflation targeting from this point of view

a) Handout on linearization as a tool for solving models (a more in depth discussion appears here).

b) Derivation of linearized NK Phillips curve.

c) Assignment #9, question 1, accomplishes three 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.

iii) Shows how ‘news’ shocks might cause an inflation targeter to drive the interest rate in the ‘wrong’ direction and inadvertently trigger an inefficient stock market boom (Slides, manuscript; and section 3.2 of handbook chapter.)

d) As an application for policy analysis, we will discuss how to explore the implications of different fixed interest rate paths (code).

e) Other, related materials.

2) Estimation of DSGE models (the handout makes some references to this 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) A simple example to illustrate Bayes’ rule.

d) Assignment #9, questions after 1.

3) Extending the NK model to the open economy. This is a drastically simplified version of the model in here. Code to generate graphs in the lecture notes.

4) Financial.

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). The CSV model is used as a friction on the asset side of a bank’s balance sheet.

b) Integrating CSV into a New Keynesian model and the results of Bayesian estimation of the model using US data (CMR, JMCB 2003, AER 2014).

i) The model.

ii) The importance of risk shocks and news on risk.

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.

c) Financial frictions on the liability side of banks’ balance sheet. 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).