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Financial Frictions in Macroeconomic Fluctuations

The financial crisis that developed starting in summer 2007 has made it clear that macro economic models need to allocate a more prominent role to the financial sector for understanding the dynamics of the business cycle. Contrary to what has been often reported in popular press, there is a long and well established tradition in macroeconomics adding financial market frictions in standard macroeconomic models and showing the importance of the financial sector for business cycle fluctuations. Bernanke and Gertler (1989)is one of the earliest studies. Kiyotaki and Moore (1997) provide another possible approach to incorporate financial frictions in a general equilibrium model. These two contributions are now the classic references for most of the work done in this area during the last 25 years.

Although these studies had an impact in the academic field, formal macroeconomic models used in policy circles have mostly developed ignoring this branch of economic research. Until recently, the dominant structural model used for analyzing monetary policy was based on the New Keynesian paradigm. There are many versions of this model incorporating several frictions such as sticky prices, sticky wages, adjustment costs in investment, capital utilization and various types of shocks.

However, the majority of these models are based on the assumption that markets are complete, and therefore, there are no nancial market frictions. After the nancial crisis hit, it became apparent that these models were missing something crucial about the behavior of the macro-economy. Since then there has been many attempts to incorporate financial market frictions in otherwise standard macroeconomic models.

What I would like to stress here is that the recent approaches are not new in macroeconomics. They are based on ideas already formalized in the macroeconomic eld during the last two and a half decades starting with the work of Bernanke and Gertler (1989). In this article I provide a systematic description of these ideas.

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Financial Frictions in Macroeconomic Fluctuations