Introducing Financial Frictions and Unemployment into a Small Open Economy Model

Lawrence J. Christiano, Mathias Trabandt, and Karl Walentin
CQER Working Paper 10-04
August 2010

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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.

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

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

The authors thank Malin Adolfson, Mikael Carlsson, Ferre De Graeve, Christopher Erceg, Simon Gilchrist, Jesper Hansson, Skander Van den Heuvel, Jesper Lindé, Henrik Lundvall, Massimo Rostagno, Antonella Trigari, Mattias Villani, Peter Welz, and seminar participants at various presentations. The views expressed here are the authors' and not necessarily those of the Executive Board of the Sveriges Riksbank, the European Central Bank, the Federal Reserve Bank of Atlanta, or the Federal Reserve System. Any remaining errors are the authors' responsibility.

Please address questions regarding content to Lawrence J. Christiano, Department of Economics, Northwestern University, 2001 Sheridan Road, Evanston, IL 60208, and NBER, 847-491-8231,; Mathias Trabandt, European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany, and Sveriges Riksbank, 49-69-1344-6321,; or Karl Walentin, Sveriges Riksbank, 103 37 Stockholm, Sweden, 46-8-787-0491,

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