Macroeconomic Models with Financial Frictions
By Lawrence J. Christiano
The course will explore the implications of several models of financial frictions – costly state verification, hidden effort and ‘running away’ – for the open economy, for business cycles and also for unconventional monetary policy and leverage restrictions on banks. The emphasis will be on models that are sufficiently flexible that their implications can meaningfully be compared with quarterly time series data.
1) Financial frictions on the asset side of banks’ balance sheets.
i) A microeconomic approach.
ii) Introducing the frictions into a neoclassical growth model (BGG, 1999).
(1) Linear aggregation.
(2) The ‘financial friction wedge'.
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.
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).
c) The reading also shows (in two-period settings) how financial frictions on the liability side of banks’ balance sheet can arise from adverse selection and costly state verification. I don’t anticipate there will be enough time to go over these two models.
3) A small open economy New Keynesian model.
a) The simple closed economy New Keynesian model (see).
b) Extending the simple model to the open economy, following the approach of Adolfson-Laséen-Lindé-Villan (RAMSES I).
i) Computer code for exploring the properties of the model.
ii) Further extensions to bring the model to the data.
c) Incorporating financial frictions into the model, following the approach of Christiano-Trabandt-Walentin (RAMSES II).
i) A discussion of the work of Mihai Copaciu addressing the interaction of possible currency mismatch problems in emerging markets and the US Federal Reserve’s eventual ‘exit strategy’.
d) A slightly simplified version of the CTW model is described here (the relatively complicated labor market part of CTW is replaced by a standard sticky wage setup). You can see how the model is estimated on Swedish data. There are instructions for replacing the Swedish data with another country’s data and using the code to analyze that.