Introducing financial frictions and unemployment into a small open economy model

Abstract

The current …nancial crisis has made it abundantly clear that business cycle modeling no longer can abstract from …nancial factors. It is also becoming increasingly clear that the stylized modeling of labor markets without explicit unemployment that is the current standard approach has its limitations. Some questions which the dominating extant business cycle models are mute on, but that we would like to answer are: How important are …nancial and labor market frictions for the business cycle dynamics of a small open economy? In particular, what are the quantitative e¤ects of …nancial factors on output and in ‡ation, and how do they interact with monetary policy? What drives the variation in the intensive and extensive margin of labor supply respectively? What is the estimated Frisch elasticity in a model that allows for both an intensive and an extensive margin of labor supply? In order to address these questions we extend what is becoming the standard new Keynesian model in three important dimensions. First, we incorporate …nancial 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. We make a theoretical contribution by incorporating endogenous job separation in this rich framework. Finally, we estimate the full model using Bayesian techniques and illustrate the importance of the various frictions.

The anatomy of standard DSGE models with financial frictions

“…15 The first three have their natural empirical counterparts, which we match exactly. The target value for the last share is consistent with Christiano et al (2011) and identical in both extensions. As a result, our calibration implies that in the steady-state the rates of return on capital, and hence the excess return on capital defined by Eqs.…”

“…Finally, it should be mentioned that financial frictions have recently been added to models used for policy purposes at several central banks. This includes the Riksbank's model RAMSES (Christiano et al, 2011) and the European Central Bank's NAWM (Lombardo and McAdam, 2012).…”

The time-varying cost channel of monetary transmission

“…Allowing for explicit financial frictions along the lines of Bernanke et al (1999) to affect the decision to borrow and lend working capital would certainly be a fruitful extension. Christiano et al (2007) and Faia (2008) take a step in this direction. In their models, working capital loans are subject to credit frictions due to lenders' idiosyncratic productivity shocks.…”

Forecasting using DSGE models with financial frictions

“…One of very few exceptions is the study by Christiano, Trabandt, and Walentin (2011), who demonstrate that augmenting a medium-sized DSGE model of the Swedish economy with frictions á la Bernanke, Gertler, and Gilchrist (1999, chap. 21) increases the accuracy of point forecasts.…”