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

By Lawrence J. Christiano

**Overview**

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.

**Lectures**

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.