Scandinavian Working Papers in Economics

Working Paper Series,
Sveriges Riksbank (Central Bank of Sweden)

No 214: Introducing Financial Frictions and Unemployment into a Small Open Economy Model

Lawrence J. Christiano (), Mathias Trabandt () and Karl Walentin ()
Additional contact information
Lawrence J. Christiano: Department of Economics, Postal: Northwestern University, 2001 Sheridan Road, Evanston, Illinois 60208, USA
Mathias Trabandt: Research Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden
Karl Walentin: Research Department, Central Bank of Sweden, Postal: Sveriges Riksbank, SE-103 37 Stockholm, Sweden

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-codes: E00; E30; F00; F40; G00; G10; J60

83 pages, First version: November 1, 2007. Revised: June 1, 2011.

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