Economists such as Fisher (1933), Keynes (1936) and Minsky (1986) have attributed the economic downturn of the Great Depression to the failure of financial markets. Kindleberger (1993) documents that financial crises are common in history having occurred at roughly 10-year intervals in Western Europe over the past four centuries. The current financial crisis has underscored once again the importance of the financial frictions for the business cycles.
These facts motivate questions about financial stability. How resilient is the financial system to various shocks? At what point does the system enter a crisis regime, in the sense that market volatility, credit spreads and financing activity change drastically? To what extent is risk exogenous, and to what extent is it generated by the interactions within the system? How does one quantify systemic risk? Does financial innovation really destabilize the financial system? How does the system respond to various policies, and how do policies affect spillovers and welfare?
The seminal contributions of Bernanke and Gertler (1989), Kiyotaki and Moore (1997) (hereafter KM) and Bernanke, Gertler, and Gilchrist (1999) (hereafter BGG) uncover several important channels how financial frictions affect the macroeconomy. First, temporary shocks can have persistent effects on economic activity as they affect the net worth of levered agents, and financial constraints. Net worth takes time to rebuild.
Second, financial frictions lead to the amplification of shocks, directly through leverage and indirectly through prices. Thus, small shocks can have large effects on the economy. The amplification through prices works through adverse feedback loops, as declining net worth of levered agents leads to drop in prices of assets concentrated in their hands, further lowering these agents’ net worth.