Introducing Financial Frictions and Unemployment into a Small Open Economy Model

How important are financial and labor market frictions for the business cycle dynamics of a small open economy? What are the quantitative effects of increased financial risk on output and inflation? How important are variations in the intensive vs. the extensive margin of labor supply? What are the spillover effects of financial market disturbances to unemployment and vice versa? In order to address these question we extend the small open economy model presented in Adolfson, Laséen, Lindé and Villani (2005, 2007a, 2007b) in two important dimensions. First, we incorporate financial frictions in the accumulation and management of capital similar to Bernanke, Gertler and Gilchrist (1999) and Christiano, Motto and Rostagno (2003, 2007). Second, 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. We estimate the full model using Bayesian techniques.