Financial frictions in Latvia
This paper builds a dynamic stochastic general equilibrium (DSGE) model for Latvia that would be suitable for policy analysis and forecasting purposes at Bank of Latvia. For that purpose, I adapt the DSGE model with financial frictions of Christiano et al. (J Econ Dyn Control 35:1999–2041, 2011. doi: 10.1016/j.jedc.2011.09.005) to Latvia’s data, estimate it, and study whether adding the financial frictions block to an otherwise identical (‘baseline’) model is an improvement with respect to several dimensions. The main findings are: (1) The addition of the financial frictions block provides more appealing interpretation for the drivers of economic activity and allows to reinterpret their role; (2) financial frictions played an important part in Latvia’s 2008-recession; (3) the financial frictions model beats both the baseline model and the random walk model in forecasting both CPI inflation and GDP.
KeywordsDSGE model Financial frictions Small open economy Bayesian estimation Currency union Forecasting
JEL ClassificationE0 E3 F0 F4 G0 G1
I thank Viktors Ajevskis, Rudolfs Bems, Konstantins Benkovskis, Martins Bitans, Dmitry Kulikov, Karl Walentin, and two anonymous referees for feedback. I also thank Andrejs Kurbatskis and several other colleagues at Bank of Latvia for helping with the data. All remaining errors are my own. I have benefited from the program code provided by Lawrence Christiano, Mathias Trabandt, and Karl Walentin for their model.
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