Analysis of Simple New Keynesian Model and
Extension to Include Financial Frictions
By Lawrence J. Christiano
We will develop
the basic New Keynesian (NK) model from its foundations and discuss its
properties, both analytically and using computer exercises. After that, we will
consider a particular approach to financial frictions and discuss how these
frictions, when introduced into a medium-sized NK model, help to better
understand business cycle fluctuations.
I recommend that
you print out a copy of the lecture notes before lecture, and that you write
notes on them during the lecture. Also, I will be writing by hand and sometimes
adding extra pages as I present the lecture. After each lecture, I will upload
my marked-up lecture notes to this website.
Background readings:
handbook chapter; Journal of Economic Perspectives, JIMF, interview and this.
Lectures and Handouts
1)
Foundations of the New Keynesian
model (handout#1
(day1,
day2,
day3,
day4_before_break,
day4_after_break,
day5,
day6)
and handout#2
(day6)).
Background: handbook chapter.
a) The
linearized Phillips curve (we
probably will not go through this in detail, but it is the most tricky step in
linearizing the NK model and may be useful to review).
b) Solving a model by
linearization (this is a somewhat abstract review of what you have seen in
earlier courses, perhaps from a slightly different perspective and different
notation).
c) We can use the
linearization solution strategy to demonstrate
important properties of the model analytically.
i)
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 (essentially all policymakers in the world adopt the
anti-Fisherian perspective). The New Keynesian model is useful for thinking
about these two extreme scenarios, as well as for thinking about actual
disinflation scenarios (like the US disinflation in the 1980s) which are more
properly thought of as a blend of the two.
ii)
We
derive analytically the so-called forward guidance puzzle associated
with the New Keynesian model.
iii) We can show analytically
that the Taylor principle by itself is not sufficient to fully stabilize
fluctuations about the natural rate (we will probably not cover this explicitly
and will instead do it during assignment #9 below).
d) Assignment #9 (day7),
question 1, accomplishes three things.
i)
Gives students experience with Dynare for solving and simulating models.
ii)
Gets to the heart of the New Keynesian models
by exploring its basic underlying economic principles.
iii) Shows
how ‘news’ shocks might cause an inflation targeter
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.) Also shows how the Taylor
rule can be too weak
in its response to more conventional shocks.
e)
Other,
related materials.
2)
Financial
Frictions in Nonfinancial Firms Useful for Thinking About Business Cycles:
a) Partial
equilibrium model for the Costly State
Verification (CSV) approach (zip file with code for the
computations, and a version of the slides with more
extensive derivations). Related empirical paper: Levin,
Natalucci and Zakrajsek.
b) Integrating CSV
into a New Keynesian model and the results of Bayesian estimation of the model
using US data (CMR,
JMCB
2003, AER
2014).
i)
The model.
ii)
The importance of risk shocks and news on
risk.
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.