alexa How Important are Financial Shocks for the Canadian Business Cycle?

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How Important are Financial Shocks for the Canadian Business Cycle?

In this paper, we have investigated the importance of financial shocks for the Canadian business cycle employing the dynamic stochastic general equilibrium framework à la BGG with an extension of small-open economy feature. In particular, in the spirit of Smets and Wouters and CMR, we explored the importance of the external finance premium shock and the aggregate net worth shock as two financial shocks in the model.

In order to answer the question ‘how important are financial shocks’, it requires caution when choosing the specification of the shock structure. Or to rephrase the statement, we need to validate that both financial shocks – external finance premium shock and aggregate net worth shock – are quantitatively important for the business cycle. As such, we estimated the model under four specifications of financial shocks – 1) the model without financial shocks, 2) the model with only aggregate net worth shock, 3) the model with only external finance premium shock, and 4) the model with both financial shock. It turned out that the specification of the financial shocks matters more or less for the estimation of the parameters and, hence, for the estimated impulse response functions. Further, it turned out that the result of the variance decomposition and historical decomposition can dramatically change depending on which shock specification is adopted. Thus, the shock specification does matter when making inference with the estimation results.

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