Financial Frictions and Shocks in an Estimated Small Open Economy DSGE Model

This paper examines the importance of financial frictions and shocks for macroeconomic fluctuations using an estimated small open economy DSGE model. In doing so, a small open economy DSGE model with unemployment, financial frictions and financial shocks is developed. To quantify effects, the model is estimated using Bayesian methods on Australian and the United States (US) data. The main results are (i) the presence of financial accelerator improves the model fit, and (ii) financial shocks (i.e., credit supply and financial wealth shocks) are important for explaining investment and output fluctuations, (iii) including financial data in the analysis changes the model dynamics and influences the significance of the financial and marginal efficiency of investment (MEI) shocks, and (iv) financial shocks play an important role in generating business cycle fluctuations in both Australia and the US.