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Financial shocks generate a protracted and quantitatively important effect on real economic activity and financial markets only if the shocks are both negative and large. Otherwise, their role is quite modest. Financial shocks have become more important for economic fluctuations after the 2000 and have contributed substantially to deepening the recessions of 2001 and 2008. The evidence is obtained using a new econometric procedure based on a Vector Moving Average representation that includes a nonlinear function of the financial shock.

We use an estimated monetary business cycle model with search and matching frictions in the labor market and nominal price and wage rigidities to study four countries (the U.S., the U.K., Sweden, and Germany) during the financial crisis and the Great Recession. We estimate the model over the period prior to the financial crisis and use the model to interpret movements in GDP, unemployment, vacancies, and wages in the period from 2007 until 2011. We show that contractionary financial factors and reduced efficiency in labor market matching were largely responsible for the experience in the U.S. Financial factors were also important in the U.K., but less so in Sweden and Germany. Reduced matching efficiency was considerably less important in the U.K. and Sweden than in the U.S., but matching efficiency improved in Germany, helping to keep unemployment low. A counterfactual experiment suggests that unemployment in Germany would have been substantially higher if the German labor market had been more similar to that in the U.S.

We use a standard quantitative business cycle model with nominal price and wage rigidities to estimate two measures of economic ineffciency in recent U.S. data: the output gap - the gap between the actual and effcient levels of output - and the labor wedge - the wedge between households' marginal rate of substitution and firms' marginal product of labor. We establish three results. (i ) The output gap and the labor wedge are closely related, suggesting that most ineffciencies in output are due to the ineffcient allocation of labor. (ii ) The estimates are sensitive to the structural interpretation of shocks to the labor market, which is ambiguous in the model. (iii ) Movements in hours worked are essentially exogenous, directly driven by labor market shocks, whereas wage rigidities generate a markup of the real wage over the marginal rate of substitution that is acyclical. We conclude that the model fails in two important respects: it does not give clear guidance concerning the effciency of business cycle uctuations, and it provides an unsatisfactory explanation of labor market and business cycle dynamics.

We investigate identifiability issues in DSGE models and their consequences for parameter estimation and model evaluation when the objective function measures the distance between estimated and model impulse responses. We show that observational equivalence, partial and weak identification problems are widespread, that they lead to biased estimates, unreliable t-statistics and may induce investigators to select false models. We examine whether different objective functions affect identification and study how small samples interact with parameters and shock identification. We provide diagnostics and tests to detect identification failures and apply them to a state-of-the-art model.