Financial frictions in small open economy: DSGE model of the Czech economy

In the aftermath of 2008 global financial crisis that provoked subsequent global economic slowdown and recently in some countries even debt crisis the economists around the world realize that there exist important relations between the financial sector end the real economy.  Current experience of worldwide economic difficulties shows that it can be the banking sector that can to certain extent cause and exacerbate economic recessions. Notably, it was increasing default rates and extraordinary number of bank failures that accompanied swift downturn of U.S. aggregate product in 2008. Idea of frictionless banking sector therefore seems no longer tenable.

Several financial frictions mechanisms were considered in academia as well as in central banks in past years in order to enhance current workhorse macroeconomic models. Edwards and Végh (1997) propose banking sector modeling with banking services modeled as costly services. Kiyotaki and Moore (1999), on the other hand, model limited contracts enforcement and collateralized debt. Finally, Bernanke et al. (1999) introduce concept of financial accelerator with costly state verification and default risk.

In our paper we estimate a DSGE model of Czech economy to evaluate the importance of financial frictions in this small open economy in period 1999 to 2011. We use the model framework developed by Shaari (2008) that includes financial accelerator mechanism proposed by Bernanke, Gertler and Gilchrist (1999). This appropriately complex medium-sized model incorporates important real as well as nominal rigidities and allows us to describe Czech economy in reasonable detail. Using this model framework we employ method of shock decomposition to analyze historical development of endogenous variables and to evaluate particular effects of individual exogenous shocks. We study the behavior of model economy using impulse response functions. Also, we estimate Taylor rule coefficients of Czech monetary authority – the Czech national bank. To be able to evaluate the benefits of financial accelerator concept we estimate alternative specification of the model with deactivated financial frictions as well.

Our preliminary results suggest that the Czech economy is closely interconnected with its neighbours, especially with European Union, which is not a surprise since the Czech republic is its member state. Aggregate product is driven mainly by exogenous shocks in uncovered interest parity, law of one price, foreign interest rate and also by domestic monetary policy shock. The dynamics of domestic inflation are explained mainly by exogenous shocks in domestic factor productivity, uncovered interest parity and domestic monetary policy. Sharp slowdown of Czech economy in the end of 2008 is predominantly explained by foreign interest rate shock and by shock in law of one price. Since effects of domestic shocks are rather negligible in this period it seems that the economic crisis was imported from abroad.

Estimated parameters of Czech national bank's Taylor rule suggest that domestic interest rate is smoothed with coefficient of 0.6324. Weight of inflation rate in Taylor rule is in line with Taylor principle and it is approximately 1.385 while the weight of output gap is estimated around 0.55.