Assessing labor market frictions in a small open economy

We estimate small open economy models with involuntary unemployment using Australian data from 1993 to 2013, assessing whether nominal or real wage rigidity and hiring costs matter. Nominal wage rigidity with hiring costs (accounting for 1.58% of GDP) are strongly preferred. Using the preferred model, technology shocks explain most short-run unemployment and long run real wage variance. External shocks have important lasting effects on inflation and consumption, and on long-run investment and interest rates, but little on the labor market. Out-of-sample conditional forecasts perform well but cannot predict the confidence effects of the crisis in 2008.