Assessing labor market frictions in a small open economy

• We provide Bayesian estimates for small open economy models for Australia, 1993–2013.
• Nominal wage rigidity is strongly preferred to real, and hiring costs matter.
• Technology shocks account for most unemployment and long-run real wage variance.
• External shocks matter for in ation, consumption, investment and the interest rate.
• External shocks play a limited role in driving labour market variables.

We estimate small open economy models with involuntary unemployment using Australian data from 1993 to 2013, assessing whether nominal or real wage rigidity and hiring costs matter. Nominal wage rigidity with hiring costs (accounting for 1.58% of GDP) are strongly preferred. Using the preferred model, technology shocks explain most short-run unemployment and long run real wage variance. External shocks have important lasting effects on inflation and consumption, and on long-run investment and interest rates, but little on the labor market. Out-of-sample conditional forecasts perform well but cannot predict the confidence effects of the crisis in 2008.