Formulation, Estimation and Policy Analysis with DSGE Models
By Lawrence J. Christiano
The objective is to review the basic tools of modern macroeconomic analysis. This includes model solution and simulation methods, as well as methods for estimating and testing models using aggregate data. We will develop in detail the basic New Keynesian model and review its key policy implications. For example, we will use of the model to analyze the risks posed by the zero lower bound on the interest rate and what to do when the zero lower bound binds. We will also explore extensions of the model that integrate financial frictions. 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. In addition, the homework sessions will be used to review several important policy-relevant properties of the NK model (e.g., Ramsey-optimal policy, the Taylor principle, the timeless perspective). We will use the software, Dynare version 4, to do the computations, though no experience with Dynare will be assumed. The following outline for the course is designed to only provide an indication of the course material to be covered. The outline and lecture notes will be refined in the weeks before the course.
1) Solving and simulating DSGE models.
a) Review of perturbation and projection methods for solving, simulating and computing impulse response functions for models (software used to generate the graphs in the handout, a zip file that uses Dynare to do some of the computations).
i) Do assignment #7, questions 1-3.
b) The application emphasized in (a) is the neoclassical model. Following is an analysis of first and second order perturbations in the simple New Keynesian model without capital.
i) A simple New Keynesian economy with Rotemberg price adjustment costs. In this model there is no endogenous state variable, and pruning has only a very small effect (see Rotemberg.mod, and the writeup at the beginning of that mod file).
ii) A simple New Keynesian economy with Calvo price adjustment. In this model there is an endogenous state variable (lagged price dispersion) and pruning has a very substantial effect. Moreover, a second order approximation seems to make a difference over the first order approximation. In particular, the price distortion term, ignored in first order approximations, appears to matter in the second order approximation (see Calvo.mod and the writeup at the beginning of that mod file).
2) The New Keynesian model.
b) Assignment #9, question 1.
3) Introducing financial frictions into the New Keynesian DSGE Model.
i) The model
ii) The importance of risk shocks.
iii) The response of monetary policy to an increase in interest rate spreads.
d) An open economy version of the model with financial frictions.
a) Two approaches based on moral hazard.
i) Two-period version of Gertler-Kiyotaki financial friction model, (section 3) .
ii) Hidden action and implications for macro-prudential policy (section 4).
b) Adverse selection (section 5).
a) The deflation spiral, the government spending multiplier.
b) Quantitative analysis of the role of the zero bound in the dynamics of US data, 2008 and 2009.
a) State space representation of a model.
b) Elements of Bayesian inference (Bayes’ rule, MCMC algorithm).
c) Assignment #9, not question 1.
7) More on the New Keynesian model.
b) Assignment #8.
c) Consensus, medium sized New Keynesian (NK) DSGE model.
d) Dynare code, for computing impulse responses in a medium-sized New Keynesian model with the option of doing first or second order perturbations, pruning, or not, etc.
a) News and inflation targeting.
b) Using Ramsey optimal policy as a benchmark for evaluating a policy rule.
Apart from giving students hands-on experience with the quantitative analysis of models, homework exercises allow us to discuss the following topics:
a) Bayesian estimation of DSGE models.
b) The HP filter as a way to estimate the output gap.
2) The Taylor principle (see section 3.1 of handbook chapter).
a) The rationale for the principle in the standard NK model.
b) Circumstances when things can go awry with the Taylor principle:
i) An important working capital channel.
ii) News shocks.
Introduction to model solving with Dynare using the real business cycle model.
Explores Ramsey-optimal policy in the Rotemberg model. (For an alternative software, useful for example when you want to do Ramsey with higher order approximations, see).
This assignment works heavily with the Clarida-Gali-Gertler model, which is developed.
The text for this assignment, as well as all the necessary software, is included in this zip file.
The assignment explores the dynamics of the model (question #2) and uses the model to explore Bayesian estimation and hp-filtering.
The readings for the computational material include: Judd’s textbook (perturbation and projection), Christiano-Fisher (JEDC,2000) (projection), Kim-Kim-Schaumburg-Sims (JEDC, 2008) (pruning), den Haan-de Wind (2009) (perturbation and projection), Lombardo (2011) (perturbation).
The main reference for New Keynesian models is my chapter with Trabandt and Walentin, in the just-released Handbook of Monetary Economics, edited by Friedman and Woodford.
The primary reference for financial frictions is Christiano and Daisuke, Government Policy, Credit Markets and Economic Activity.
Other references on financial frictions:
Bernanke, Gertler and Gilchrist’s classic 1999 paper.
Christiano, Motto, Rostagno (2003): Using the BGG model to analyze the cause of the US Great Depression, and the reason it lasted so long.
Christiano, Motto, Rostagno (2009): Using the BGG model to understand the causes of economic fluctuations in the EA and the US.
Government spending and the zero bound:
Christiano, Eichenbaum and Rebelo (JPE, 2011) When is the Government Spending Multiplier Large?