Given the on-going financial crisis precipitated by the sub-prime loan problem in the U.S. financial sector, there has been an increased interest in the linkage between financial activity and real economic activity. In particular, there is a heightened interest in how the shock occurring in direct and/or indirect financial market can affect the real economic activity. Although the Canadian banking sector seems to be weathering the current financial crisis (Northcott et al. (2009)) or have not experienced a major financial turmoil in recent decades, there is no guarantee that the Canadian economy will be free from a large shock in the financial sector in a near future. In order to help the policy makers to understand the consequences of such contingency and to facilitate them in forming a counter-measure, it is crucial to assess how vulnerable (or robust) is the Canadian economy to the shocks originating in the financial sector. As such, we ask the following question in this paper; how important are financial shocks for the Canadian business cycle?

To answer the above question, we need to decide how to model the financial friction and financial shocks. In modeling the financial friction in a general equilibrium setting, there are mainly two approaches. One way is to impose collateral constraint as in Kiyotaki and Moore (1997). This collateral constraint approach is becoming a popular choice, especially when modelling the financial friction in mortgage loan market where residential asset is customary withheld as a collateral until the mortgage loan is repaid in full. Another approach is to model external finance premium as in Bernanke and Gertler (1989), Carlstrom and Fuerst (1997), and Bernanke, Gertler, and Gilchrist (1999). This approach proved extremely useful in modelling the standard debt contract between the corporate sector and financial intermediary which allows us to analyze the relationship between business fixed investment and external financing cost. Both types of financial friction — collateral constraint and external finance premium — are useful in addressing the linkage between financial market and real economic activity such as financial acceleration mechanism in residential investment and business fixed investment. However, since we are more interested in the fluctuation of the business fixed investment — the most important factor in output fluctuation, we will be adopting the external finance premium as the choice of financial friction mechanism in this paper. In particular, we construct a medium-scale dynamic stochastic general equilibrium (denoted DSGE, hereafter) model with financial friction ? la Bernanke, Gertler, and Gilchrist (1999) (denoted BGG, hereafter). Further, reflecting the Canadian context, we extend the model to incorporate the small-open economy feature.