New Keynesian Models and Financial Frictions

By Lawrence J. Christiano




We will develop the basic New Keynesian model in detail and review its key policy implications. The policy implications focus on getting aggregate demand to do the ‘right thing’, something that is not guaranteed, according to the New Keynesian model. We will then integrate the particular set of financial frictions proposed by Bernanke-Gertler-Gilchrist into the model. We will discuss how the introduction of these financial frictions alters conclusions about the sources of business cycle fluctuations and expands the set of policy questions that can be studied. We will then discuss other models of financial frictions, which are designed for thinking about the channels by which ‘unconventional monetary policy’ might improve economic outcomes.





1)    Introductory remarks.

2)    The New Keynesian model.

a)    The basic foundations of the model (handout: this and this).

b)    Assignment #9, question 1.

c)     For a discussion of this material, see the handbook chapter referenced below. In addition the material on ‘news’ shocks is taken from my August 2010 Jackson Hole paper.

3)    Introducing financial frictions into the New Keynesian DSGE Model.

a)    Microfoundations for the Costly State Verification (CSV).

b)    Integrating CSV into an NK model and the results of Bayesian estimation of the model using US and EA data (code).

i)       The model

ii)    The importance of risk shocks.

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

c)     Very brief discussion of extending CSV to risky banking (discussion based on papers by Zeng and by Hirakata, Sudo and Ueda.)

d)    An open economy version of the model with financial frictions.

4)       Financial frictions in the intermediation sector, exposited in two-period settings (sections 3 and maybe 4 of Christiano-Ikeda, background reading).

a)    Two-period version of Gertler-Kiyotaki financial friction model, (section 3).

b)    Hidden action (section 4). (For a dynamic version, and its implications for leverage restrictions, of this model, see.)



Background readings

The main reference for New Keynesian models is my chapter with Trabandt and Walentin, in the 2011 Handbook of Monetary Economics, edited by Friedman and Woodford.


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 why it lasted so long.

Christiano, Motto, Rostagno (2012): Using the BGG model to understand the causes of economic fluctuations in the US in the past few decades.

Christiano, Trabandt and Walentin (2009): Financial and labor market frictions in a small open economy model of Sweden. (Handout)