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? What drives the variation in the intensive and extensive margin of labor supply? What are the spillover effects of financial market disturbances to unemployment? In order to address these questions we extend the small open economy model presented in Adolfson, Laséen, Lindé and Villani (2008) 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 (2007). Second, we include the search and matching framework of Mortensen and Pissarides (1994) and Gertler, Sala and Trigari (2009) into a small open economy model. We make a theoretical contribution by incorporating endogenous job separiation in this rich framework. Finally, we estimate the full model using Bayesian techniques and illustrate the importance of the various frictions. -- small open economy ; DSGE ; financial frictions ; labor market frictions ; unemployment