Introducing Financial Frictions and Unemployment into a Small Open Economy Model
Lawrence J. Christiano
Northwestern University; Federal Reserve Bank of Cleveland; Federal Reserve Bank of Chicago; Federal Reserve Bank of Minneapolis; National Bureau of Economic Research (NBER)
Board of Governors of the Federal Reserve System; Sveriges Riksbank
June 1, 2011
Riksbank Research Paper No. 214
Which are the main frictions and driving forces of business cycle dynamics in a small open economy? To answer this question we extend what is becoming the standard new Keynesian model in three dimensions. First, we incorporate frictions in the financing of the capital stock. Second, we model employment frictions in the labor market using a search and matching framework, allowing for endogenous job separations. Third, we extend the model into a small open economy setting. We estimate the model using Bayesian techniques on Swedish data. Our main results are: i) A financial shock to entrepreneurial wealth is pivotal for explaining business cycle fluctuations accounting for substantial amounts of the variance in investment and GDP. ii) The marginal efficiency of investment shock has very limited importance when we match financial market data. iii) Our model does not need any high frequency wage markup shocks to match the data. Furthermore, the labor supply shock is unimportant in explaining GDP. iv) The data indicates that there are costs of hiring, but no costs of vacancy postings per se.
Number of Pages in PDF File: 83
Keywords: DSGE model, financial frictions, labor market frictions, unemployment, small open economy, Bayesian estimation
JEL Classification: E0, E3, F0, F4, G0, G1, J6
Date posted: December 20, 2007 ; Last revised: October 18, 2011
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