An Estimated small open economy model with labour market frictions

Purpose: This paper estimates a small open economy model with labour market friction for Australia. Key literature / theoretical perspective: Unemployment, as a key macroeconomic variable, has not been explicitly built into new Keynesian dynamic stochastic general equilibrium (DSGE) models until Blanchard and Gali (2010). They fill this gap by introducing involuntary unemployment into a model with Calvo type of price stickiness. Unemployment arises from a hiring cost to firms, which is endogenously determined by labour market conditions, in particular unemployment. Since firms internalize this cost when making hiring and firing decisions, it affects the marginal cost incurred by firms. Through Calvo pricing, inflation depends on both expected future inflation and marginal cost, and therefore inflation partially depends on current and expected future unemployment. Riggi and Tancioni (2010) extends this closed economy model by incorporating other new Keynesian features such as habit formation and wage rigidities, and estimates the model using Bayesian methods. In this paper, we further extend the model to a small open economy context, and incorporate additional rigidities such as backward indexation and costly capital adjustment. The performance of the model is then evaluated using Australian data. Design/methodology/approach: We employ Bayesian methods to confront the model with data. In addition, simulation will be provided to show the dynamics of the model.