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Introducing Financial Frictions and Unemployment into a Small Open Economy Model

Federal Reserve Bank of Atlanta CQER Working Paper No. 10-04

73 Pages Posted: 23 Sep 2010  

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: August 2010

Abstract

The current financial crisis has made it abundantly clear that business cycle modeling can no longer abstract from financial factors. It is also clear that the current standard approach of modeling labor markets without explicit unemployment has its limitations. We extend what is becoming the standard new Keynesian model in three dimensions. First, we incorporate financial frictions in the accumulation and management of capital. Second, we model the labor market using a search and matching framework. Third, we extend the model into a small open economy setting. Finally, we estimate the model using Bayesian techniques with Swedish data. Our main results are as follows: (1) The financial shock to entrepreneurial wealth is pivotal for explaining business cycle fluctuations. It accounts for two-thirds of the variance in investment and a quarter of the variance in GDP. (2) The marginal efficiency of investment shock has very limited importance. The reason for this is that we match financial market data. (3) In contrast to the existing literature on estimated DSGE models, our model does not need any wage markup shocks or similar shocks with low autocorrelation to match the data. Furthermore, the low-frequency labor preference shock that we do allow is not important in explaining GDP. (4) The tightness of the labor market is unimportant for the cost of adjusting the workforce. In other words, there are costs of hiring but no significant 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 (August 2010). Federal Reserve Bank of Atlanta CQER Working Paper No. 10-04. Available at SSRN: https://ssrn.com/abstract=1680651 or http://dx.doi.org/10.2139/ssrn.1680651

Lawrence J. Christiano (Contact Author)

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
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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

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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