New Challenges for Monetary and Fiscal Policy Posed by Financial Frictions

By Lawrence J. Christiano




This course will address various new challenges for fiscal and monetary policy. Most of these reflect the increased recognition of the economic importance of financial frictions. We first consider financial frictions in the intermediation system and organize the discussion around frictions on the liability and asset sides of financial firm balance sheets. This will allow us to consider various problems in monetary policy: how monetary policy should respond to changes in interest rate spreads, what the effect of various types of unconventional monetary policy are, as well as macro prudential policy. At this point we have a choice of going in two different directions. One possibility (part 3 below) is to dig deeper into models of unconventional monetary policy by introducing a bank run into such a model, as in Gertler-Kiyotaki (AER2015). This model captures the view of many, that a run on the ‘shadow banking system’ that began in July 2007 helped to trigger the Great Recession in the US. Another possibility (part 4 below) is to examine the implications for monetary and fiscal policy of the lower bound on the nominal interest rate. The economic issues that arise here include: the risks for the aggregate economy posed by the lower bound, forward guidance in monetary policy, and the impact of increasing government purchases when the lower bound is and is not binding. Most likely, we will pursue the second possibility.




1.  Financial frictions on the asset side of banks’ balance sheets.

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).

                                   i.     A microeconomic approach.

Related empirical paper: Levin, Natalucci and Zakrajsek.

                                ii.     Introducing the frictions into a neoclassical growth model (BGG, 1999).

1.  Linear aggregation.

2.  The ‘financial friction wedge’.

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

                                   i.     The model.

                                ii.     The importance of risk shocks.

                             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.

2.  Financial frictions on the liability side of banks’ balance sheets (background manuscript).

a.  Two-period exposition of Gertler-Karadi/Gertler-Kiyotaki model in which the financial frictions stem from bankers’ ability to ‘run away’ (handout).

b.  Dynamic Model in which financial frictions stem from the fact that to do their job well, bankers must exert costly but unobserved effort. The environment has the implication that imposing leverage restrictions on banks can raise social welfare and thus represents a laboratory for thinking about macro prudential policy (background manuscript).

3.  Bank runs in a dynamic model (Gertler-Kiyotaki AER2015).

a.  Handout.

b.  Introduces Diamond-Dybvig/Cole-Kehoe style bank runs into infinite horizon models of the type considered in 2 above.


4.  Implications of the zero lower bound on the interest rate.

a.  Implications for fiscal and monetary policy (manuscript). (A quantitative analysis of the role of the zero bound in the dynamics of US data, 2008 and 2009.)

b.  The preceding analysis applies the solution procedure used in the classic Eggertsson and Woodford (2003) paper. That relies on linearization and it was subsequently discovered that linearization ‘hides’ a second equilibrium with very different properties (see, e.g., Mertens and Ravn, RESTUD 2014). These observations are discussed here: lecture notes.


Background readings


Direct references are included in the syllabus. A background reference on New Keynesian models.