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Introducing Financial Frictions and Unemployment into a Small Open Economy Model

83 Pages Posted: 20 Dec 2007 Last revised: 18 Oct 2011

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)

Mathias Trabandt

Board of Governors of the Federal Reserve System; Sveriges Riksbank

Karl Walentin

Sveriges Riksbank

Multiple version iconThere are 2 versions of this paper

Date Written: June 1, 2011

Abstract

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.

Keywords: DSGE model, financial frictions, labor market frictions, unemployment, small open economy, Bayesian estimation

JEL Classification: E0, E3, F0, F4, G0, G1, J6

Suggested Citation

Christiano, Lawrence J. and Trabandt, Mathias and Walentin, Karl, Introducing Financial Frictions and Unemployment into a Small Open Economy Model (June 1, 2011). Riksbank Research Paper No. 214. Available at SSRN: https://ssrn.com/abstract=1077535 or http://dx.doi.org/10.2139/ssrn.1077535

Lawrence J. Christiano

Northwestern University ( email )

2003 Sheridan Road
Evanston, IL 60208
United States
847-491-8231 (Phone)
847-491-7001 (Fax)

Federal Reserve Bank of Cleveland

East 6th & Superior
Cleveland, OH 44101-1387
United States

Federal Reserve Bank of Chicago

230 South LaSalle Street
Chicago, IL 60604
United States

Federal Reserve Bank of Minneapolis

90 Hennepin Avenue
Minneapolis, MN 55480
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Mathias Trabandt (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sveriges Riksbank ( email )

Brunkebergstorg 11
SE-103 37 Stockholm
Sweden

Karl Walentin

Sveriges Riksbank ( email )

Brunkebergstorg 11
SE-103 37 Stockholm
Sweden

HOME PAGE: http://www.riksbank.com/research/walentin

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