Joint paper with Harris Dellas, University of Bern, and Jean-Marc Natal, Swiss National Bank. We extend the small, open economy, DSGE model of Switzerland (Cuche-Curti, Dellas, and Natal, 2009, see below) to include financial frictions and financial shocks. We use the model to study two questions: first, how the pattern of economic activity in Switzerland is affected by financial shocks, and second, how the presence of financial frictions modifies the response of the economy to non-financial disturbances. We find that both an increase in entrepreneurial net worth (positive asset value shock) and a decrease in the riskiness of bank loans (positive shock to average productivity) increase investment. In the later case, the expansionary effect on investment is immediate, while it is delayed in the former case. We also find that financial frictions do not alter significantly the response of the economy to non-financial shocks, such as productivity or monetary policy. This implies that in periods with little financial turbulence, typical DSGE models may be adequate tools for analyzing business cycles and forecasting.
JEL Codes E32, E44, E52
Keywords DSGE, monetary policy, financial frictions, nominal rigidities, price rigidities
Work in progress, file coming soon, in submission