New Keynesian DSGE Models

By Lawrence J. Christiano

  

 

Overview

This is a graduate-level course on tools for macroeconomics. It is geared to people interested in applying the tools in situations not necessarily considered previously in the literature. For this reason, the course will not shy away from the technical details. At the same time, there will be a constant focus on the intuition.

We begin by describing the basic New Keynesian closed economy model with no capital. The simplicity of this model will allow us to highlight core principles that apply more generally across models with price-setting frictions. It will also allow us to focus on a core technical problem in the New Keynesian model, how to aggregate across heterogeneous firms.

Next we extend the NK model into an open economy setting. We discuss properties of the model, its limitations, as well as problems (e.g., the UIP puzzle) which have been the focus of open economy macro for a long time and which still resist a satisfactory solution.

Finally, we consider financial frictions. We will consider financial frictions on the asset side of banks’ balance sheets and also financial frictions on the liability side of banks’ balance sheets.

Computer exercises will give students hands-on practice in the use of Dynare to solve, estimate and analyze dynamic models.

Background readings: my handbook chapter; Journal of Economic Perspectives paper, interview and this.

 

Lectures

1) The basic closed economy New Keynesian (NK) model without capital. We will build the model from the ground up, stressing its most basic properties and policy implications.

a) First, we (i) talk about the classical dichotomy and how it does not occur when there are sticky prices; (ii) discuss some implications of the model for the velocity of money; (iii) derive carefully the model’s equilibrium conditions.

b) Second, anticipating that we want to evaluate the operating characteristics of inflation targeting, we discuss two benchmark equilibria: the Natural Equilibrium and the Ramsey equilibrium. We’ll argue that the ideal benchmark for evaluating policy is the Ramsey equilibrium, but often the Natural equilibrium is a workable substitute. We’ll see that the two concepts are identical in the simple model. Our discussion will inevitably have to confront the fact that the demand and supply of money are typically ignored in the New Keynesian literature. Papers that do this are said to adopt the ‘cashless limit’, a concept that will be discussed.

c)  Third, we will move to linearize the model and solve the resulting sytem: (i) we derive the Phillips curve, with particular emphasis on the special assumptions required to obtain the classic Phillips curve familiar to all; (ii) we linearize the whole model and proceed to solve it;

d) Fourth, we can use the linearization solution strategy to demonstrate analytically two important properties of the model: (a) in the case of ‘standard’ specifications of shocks, the Taylor rule with a big coefficient on inflation is too weak, by comparison with the Ramsey or Natural equilibrium benchmarks; (b) we use the New Keynesian model to discuss a scenario in which the response of the economy to an inflation target shock is ‘Fisherian’ in nature and a scenario in which it is ‘anti-Fisherian’ in nature. In the Fisherian scenario, the way to reduce inflation is to cut the interest rate and the anti-Fisherian scenario has the opposite property.  The New Keynesian model is useful for thinking about these two extreme scenarios, as well as for thinking about actual disinflation scenarios (like the Volcker disinflation) which are more properly thought of as a blend of the two. (See also these notes.)

e) Next, we turn to running the New Keynesian model on the laptop to learn about more of its properties. Assignment #9, question 1, accomplishes three things.

i)    Gives students experience with Dynare for solving and simulating models.

ii)  Shows how ‘news’ shocks might cause the Taylor principle to drive the interest rate in the ‘wrong’ direction and inadvertently trigger an inefficient stock market boom (Slides, manuscript; and section 3.2 of handbook chapter.)

f)   Other, related materials that will not be covered.

2) Extending the NK model to the open economy. This is a drastically simplified version of the model built for policy analysis at the Riksbank (Ramses II) and described here (for a more extended version of the slides, see this). Code to generate graphs in the lecture notes.

3) Informal Overview of Financial Frictions.

a) Financial frictions originating with the people that borrow from banks: integrating CSV into a New Keynesian model and the results of Bayesian estimation of the model using US data (CMR, JMCB 2003, AER 2014).

(1)                The model.

(2)                The importance of risk shocks and news on risk.

(3)                The response of monetary policy to an increase in interest rate spreads.

(4)                Carefully documented (thanks to Ben Johannsen) Dynare code for replicating the material in this presentation.

b)     Financial frictions originating inside the banking sector: an informal review. Summary of Gertler-Kiyotaki AER2015 (here is a more extended set of lecture notes). The focus here will be on shadow banking, which grew very large in the US in the 2000s.