Search frictions and the business cycle in a small open economy DSGE model

Abstract

A labor market specification featuring search frictions and unemployment within an otherwise standard New Keynesian small open economy model significantly improves its ability to explain and predict both labor market data and other macroeconomic variables. We estimate the model with Chilean data and find that variations along the extensive margin of labor supply (i.e., employment) play a crucial role in the propagation of shocks, whereas the intensive margin (i.e., hours) is not important. Furthermore, foreign shocks are the key drivers of the business cycle, which is consistent with the empirical literature on open emerging economies. We conclude that a medium-scale DSGE model with this richer labor market specification is superior to one featuring the standard assumption of a labor market that always clears at a sticky nominal wage (à la Calvo) through variations along the intensive margin.