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).