An Estimated Small Open Economy Model with Labour Market Frictions

Abstract

We estimate small open economy models with involuntary unemployment using Australian data from 1993 to 2007, focusing on hiring costs and real wage rigidity. We find a strong preference for models with hiring costs, which account for 0.97% of GDP. The data favor models with real over nominal wage rigidity. Impulse responses to technology shocks reveal no productivity-employment puzzle for the preferred model. In the short run, technology shocks, operating through hiring costs via labor demand, explain most unemployment variance, while labor preference shocks explain most real wage variance. Demand shocks dominate supply shocks in explaining output variance. In the long run, these contributions reverse. Out-of-sample conditional forecasts perform well but cannot predict the confidence effects of the crisis.