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.