Formulation, Estimation and Policy Analysis with DSGE Models with Financial Frictions

By Lawrence J. Christiano




The objective is to review the basic New Keynesian model and the financial friction extensions that are currently under development. 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. There will be afternoon homework sessions, which are not required to follow the lectures. The purpose of the homework sessions is to give students hands-on experience solving, estimating and analyzing the models discussed in lectures. We will use the software, Dynare version 4, to do the computations, though no experience with Dynare will be assumed.


1.       Introductory observations.

2.        The consensus, medium sized New Keynesian (NK) DSGE model.

·          Background: Christiano-Trabandt-Walentin, ‘DSGE Models for Monetary Policy’, chapter in Friedman and Woodford’s Handbook of Monetary Economics, 2011 (section 2).

·         Also, handout#1 and handout#2.

3.    Introducing financial frictions into the New Keynesian DSGE Model.

·       Microfoundations for the Costly State Verification (CSV) approach (background: see section 6 in Christiano-Ikeda)

·       Integrating CSV into an NK model and the results of Bayesian estimation of the model using US and EA data.

                                                             i.      The model.

                                                           ii.      The importance of risk shocks.

                                                        iii.      The response of monetary policy to an increase in interest rate spreads.

                                                        iv.      Background reading: Bernanke, Gertler and Gilchrist’s classic 1999 paper and Christiano-Motto-Rostagno paper to be posted in near future.

·       Very brief discussion of extending CSV to risky banking (discussion based on papers by Zeng and by Hirakata, Sudo and Ueda).

4.    Financial frictions in the intermediation sector, exposited in two-period settings (sections 3, 4, and maybe 5 of Christiano-Ikeda, background reading).

·       Two approaches based on moral hazard.

                                                             i.      Two-period version of Gertler-Kiyotaki financial friction model, (section 3)

                                                           ii.      Hidden action (section 4)

·       Adverse selection (section 5).

5.    Implications of the zero lower bound on the nominal rate of interest

·       The deflation spiral, the government spending multiplier, quantitative analysis of the role of the zero bound in US data, 2008 and 2009, and other topics. 

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



Afternoon Sessions

Apart from exploring the use of Dynare for model solution and Bayesian inference, the computer exercises explore the following additional substantive topics:  

1)    The sensitivity of the dynamic response of inflation and output to the persistence properties of shocks.

a)    Making precise the NK concepts of ‘insufficient aggregate demand’ and ‘excessive aggregate demand’ (see section 3.4 of handbook chapter).

2)    The Taylor principle (see section 3.1 of handbook chapter).

a)    The rationale for the principle in the standard NK model.

b)    The Taylor rule moves the interest rate in the right direction in response to ‘standard’ shocks, but does not move it far enough.

c)     Optimal monetary policy and the Taylor principle.

3)    Circumstances when things can go awry with the Taylor principle:

a)    An important working capital channel may overturn the stabilizing properties of the Taylor principle (section 3.1).

b)    News shocks may imply that the monetary authority implementing the Taylor principle moves the interest rate in the wrong direction (section 3.2).

Assignment #7 : Introduction to model solving with Dynare using the real business cycle model.

Relevant background:

Review of log-linearization strategy for solving models (a more detailed discussion: Perturbation and Projection methods).

News about future technology shocks.

Section 3, Handbook chapter (see below)


Assignment #9 

This assignment works heavily with the Clarida-Gali-Gertler model, which is developed here (for a more detailed discussion see this and this).

The text for this assignment, as well as all the necessary software, is included in this zip file.

Review of the relevant time series analysis tools.