Conclusion

Understanding the role of financial markets, and financial frictions in particular, is crucial for acquiring a deeper understanding of the nature of aggregate fluctuations. Both the Great Depression of the 1930s and the Great Recession of 2008–2009 appear to have been caused by financial shocks, which propagated through financial and labor market frictions.

The 2008–2009 financial crisis has already led to a change in direction in the modeling of business cycles and views about the role of monetary policy. We shall return to these issues in chapter 20 on the role of monetary policy and chapter 23 on the state of macroeconomics and DSGE modeling.

1. For one of the earlier analyses of the implications of adverse selection and moral hazard in financial markets, see Stiglitz and Weiss [1981].

2. For a comprehensive description and analysis of financial markets, see Mishkin [2016].

3. See Geanakoplos [2010] for the role of leverage in financial crises.

4. A rough proxy for the external finance premium is the interest rate spread between the return on a private debt instrument (such as a corporate bond, a mortgage, or commercial paper) and a similar maturity government bond, which is considered to be the safe asset. These spreads tend to widen across the board during recessions and did so dramatically during the 2008–2009 crisis. Gertler and Gilchrist [2018] is a comprehensive survey of the more recent literature on the relation between financial frictions and financial crises.

5. By assuming an exogenously driven external finance premium, we abstract from the possible interdependence of the external finance premium and the state of the economy. In a more comprehensive general equilibrium model of the determination of the external finance premium, one expects that the state of the economy would also affect it. For example, a recession caused by a rise in the external finance premium would tend to raise it through the induced deterioration of private sector balance sheets.

6. However, this policy may not be feasible in the presence of a zero lower bound on interest rates. In such a case, the central bank cannot reduce nominal interest rates below zero, and thus cannot counteract a large enough contractionary financial shock. We shall discuss this case in chapter 20 on the role of monetary policy.

7. Christiano et al. [2014] introduce agency problems associated with financial intermediation into an extended, empirically estimated new Keynesian model of business cycles. Their estimates suggest that fluctuations in the severity of financial shocks account for a substantial portion of business cycle fluctuations over the past two and a half decades. These results highlight the importance of financial shocks for aggregate fluctuations beyond the financial crisis of 2008–2009.