A model with financial frictions and a banking system for the Portuguese economy

The recent financial crisis has made clear the importance of the linkages between the financial sector and the macroeconomy, both as a trigger to the crisis but also as having an instrumental role in the propagation of the initial shock to other sectors of the economies. This has led a reassessment of the need to introduce financial frictions into what was then the workhorse macroeconomic structural model and thus to a considerable number of contributions to the literature introducing financial frictions in structural models. The introduction of financial frictions in New-Keynesian DSGE models has led to the possibility to use this models to study new questions but it has also enriched the transmission channels embedded in these models. In this paper we take a large scale open economy dynamic structural model including frictions in the financial sector, called EAGLE-FLI, and calibrate it to the Portuguese economy. The EAGLE-FLI model is built on the New-Keynesian framework and incorporates financial frictions and country-specific banking sectors. The detailed structure of the model makes it an appropriate tool to assess domestic and cross-country macroeconomic effects of financial shocks. We run simulations of several shocks in order to understand their transmission mechanisms in the model and their macroeconomic impact. We analyse not only shocks originating in the financial sector but also explore the way other shocks transmit in this model where financial frictions matter.