Canadian Economic Analysis Department,

In this paper, we investigated the importance of financial shocks for the Canadian business cycle employing the financial friction DSGE framework following Bernanke, Gertler, and Gilchrist (1999) with an extension of small-open economy feature. In particular, we explored the importance of ex-ternal finance premium shock and aggregate net worth shock. In order to identify financial shocks in the model, we utilized financial data in estimating our model. Our variance decomposition re-sults showed that external finance premium shock to account about 7.5 % and aggregate net worth shock to account about 5.6 % of the variance of the business fixed investment in Canada. Also, our historical decomposition results and smoothing of the various financial variables showed that data on corporate leverage ratio to be particularly useful in identifying the financial shocks in the model. Finally, when the financial shocks were present in the model, relative importance of the investment-specific technology shock was substantially subdued that it accounted for only 17 % of the variance of the business fixed investment — much lower than the results reported in the former empirical studies