New Keynesian DSGE Models, Financial Frictions and Bayesian Estimation
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 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.
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
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.)
e) Other, related materials.
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.
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.
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).