1. A Discussion on “Introducing Financial Frictions and Unemployment into a Small Open Economy Model” (Christiano, Trabandt, and Walentin) Ichiro Fukunaga Research and Statistics Department Bank of Japan 28 October 2009 in Jerusalem

2. Outline 1.Summary 2.Comments 3.Discussions (questions and suggestions)

3. Summary (1): model overview Based on small open economy model of Adolfson, Laseen, Linde, and Villani. Introducing financial frictions following Bernanke, Gertler, and Gilchrist, and Christiano, Motto, and Rostagno. Introducing labor market search and matching framework of Mortensen and Pissarides, Gertler, Sala, and Triagari, etc.

4. Summary (2): baseline small open economy Calvo price setting in both export & import. Exchange rate shocks take time to pass into domestic prices. Hump-shaped response of output and exchange rate to a monetary policy shock. Uncovered interest rate parity Unit-root investment technology shock Careful treatment of capital income tax

5. Summary (3): financial frictions Asymmetric information between “entrepreneurs” and banks. Entrepreneurs have a special skill in operation and management of capital. Capital stock includes both housing and business capital. Interest rate is nominally not state- contingent. >> Fisher effects

6. Summary (4): labor market frictions Wage setting frictions (Taylor-type) >> not have a direct impact on on-going employment relations but on recruiting. Labor services are supplied to labor market by “employment agencies.” Wage is determined by Nash bargaining. Endogenous separation of employment from their jobs. Symmetry in modeling idiosyncratic shocks

7. Summary (5): estimation results Bayesian estimation using Swedish data from 1995Q1 to 2008Q1. Among 19 shocks, neutral tech. shock is important for both output and inflation, Wealth shock drives 3/4 of investment. Spillover of financial shocks to unemploymt. IRFs of model with unemployment is similar to those of EHL model. Monetary policy shocks are amplified by financial frictions.

8. Comments (1): financial frictions Modest effects of financial frictions. -- Only operation of capital involves frictions. (Working capital loans are frictionless). -- Entrepreneurs don’t have assets. >> In BGG, they have assets and sell output to Calvo-pricing retailers. Too much effects of nominal debt contract? -- It dampens output/investment responses to supply shocks.

9. Comments (1): financial frictions (cont.) External finance premium is not “risk premium.” -- just compensation for monitoring cost. -- Both borrowers and lenders are risk-neutral under debt contract. >> Where’s “true” risk premium? Data for entrepreneurs’ “net worth.” -- could be broader than stock market. -- includes collateral value of illiquid assets.

10. Comments (2): labor market frictions Similar effects to EHL (sticky wage model). -- Little effects of unemployment? -- Passive role of “employment agency.” Alternative formulations of bargaining. -- Which formulation is better? >> can be decided in terms of marginal likelihood. cf. Ichiue, Kurozumi, and Sunakawa (2008, Bank of Japan WP)

11. Comments (3): estimation Real variables are log-differenced and demeaned. -- consistent with two-sector growth model? Measurement errors for most variables. -- really needed? -- identification problems (markup shocks)

12. Discussions (1): practical uses Forecasting performance -- improved compared with Ramses? -- better than BVAR? Policy simulations -- monetary policy rule reacting to credit spread -- tax policies -- welfare evaluation among heterogeneous agents: difficulty?

13. Discussions (2): potential output and output gap In a simple sticky price/wage model, estimated potential (=efficient/natural) output tends to be too volatile. In this model with many real frictions, estimated potential (=efficient) output may be reasonably smooth. --- Output gap, in turn, may be volatile reflecting real frictions.