Introducing Financial Frictions and Unemployment into a Small Open Economy Model

Abstract: How important are ?nancial and labor market frictions for the business cycle dynamics of a small open economy? In order to address this question we extend the small open economy model presented in Adolfson, Laséen, Lindé and Villani (2005, 2007a, 2007b) in three important dimensions. First, we introduce the feature that exports are produced by using imported goods in addition to domestically produced goods. Second, we incorporate ?nancial frictions in the accumulation and management of capital similar to Bernanke, Gertler and Gilchrist (1999) and Christiano, Motto and Rostagno (2003, 2007). Third, we include the search and matching framework of Mortensen and Pissarides (1994), Gertler, Sala and Trigari (2006) and Christiano, Ilut, Motto, and Rostagno (2007) into a small open economy model. As a ?rst step, we calibrate the model and analyze the effects of a monetary tightening. It turns out that the introduction of ?nancial and labor market frictions allow for additional interesting insights about the effects of monetary policy.

Keywords: small open economy, DSGE, ?nancial frictions, unemployment

Authors: Lawrence J. Christiano, Mathias Trabandt, Karl Walentin

6 Christiano, Trabandt & Walentin 2007.pdf