Abstract
In this paper, we investigate the importance of financial shocks for the Canadian business cycle employing the financial friction DSGE framework following Bernanke, Gertler, and Gilchrist with an extension of a small-open economy feature. In particular, we explored the importance of an external finance premium shock and an aggregate net worth shock. In order to identify financial shocks in the model, we utilized financial data in estimating our model. Our variance decomposition results showed that the external finance premium shock to account about 7.5% and the aggregate net worth shock to account about 5.6% of the variance of the business fixed investment in Canada. Also, our historical decomposition results and smoothing of the various financial variables showed that data on corporate leverage ratio to be particularly useful in identifying the financial shocks in the model. Finally, when the financial shocks were present in the model, relative importance of the investment-specific technology shock was substantially subdued that it accounted for only 17% of the variance of the business fixed investment –much lower than the results reported in the former empirical studies.
Highlights
For the sake of comparison, the estimation results for three alternative versions of the model are reported as well – i.e., 1) the model without ...nancial shocks, 2) the model with only aggregate net worth shock as ...nancial shock, and 3) the model with only external ...nance premium shock as ...nancial shock
In order to illustrate the consequences from ill-identi...cation of the ...nancial shocks, we show the historical decomposition of business ...xed investment under version A, B, and C
We have investigated the importance of ...nancial shocks for the Canadian business cycle employing the dynamic stochastic general equilibrium framework à la BGG with an extension of smallopen economy feature
Summary
Since the main objective of this paper is to assess the link of ...nancial variables and shocks to real economic activity in the Canadian business cycle, it is imperative that we include some additional ...nancial data to identify the shocks and, further, to assess the ...nancial shock propagation mechanism more accurately
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