BIS Working Papers

No 677
Macroeconomic
implications of financial
imperfections: a survey
by Stijn Claessens and M Ayhan Kose

Monetary and Economic Department

November 2017

JEL classification: D53, E21, E32, E44, E51, F36, F44, F65,
G01, G10, G12, G14, G15, G21

Keywords: asset prices, balance sheets, credit, financial

accelerator, financial intermediation, financial linkages,
international linkages, leverage, liquidity,
macrofinancial linkages, output, real-financial linkages
BIS Working Papers are written by members of the Monetary and Economic
Department of the Bank for International Settlements, and from time to time by other
economists, and are published by the Bank. The papers are on subjects of topical
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authors and not necessarily the views of the BIS.

This publication is available on the BIS website (www.bis.org).

Bank for International Settlements 2017. All rights reserved. Brief excerpts may be
reproduced or translated provided the source is stated.

ISSN 1020-0959 (print)

ISSN 1682-7678 (online)
Macroeconomic implications of financial
imperfections: a survey

Stijn Claessens and M. Ayhan Kose

Abstract

This paper surveys the theoretical and empirical literature on the macroeconomic
implications of financial imperfections. It focuses on two major channels through
which financial imperfections can affect macroeconomic outcomes. The first channel,
which operates through the demand side of finance and is captured by financial
accelerator-type mechanisms, describes how changes in borrowers balance sheets
can affect their access to finance and thereby amplify and propagate economic and
financial shocks. The second channel, which is associated with the supply side of
finance, emphasises the implications of changes in financial intermediaries balance
sheets for the supply of credit, liquidity and asset prices, and, consequently, for
macroeconomic outcomes. These channels have been shown to be important in
explaining the linkages between the real economy and the financial sector. That said,
many questions remain.
JEL classifications: D53, E21, E32, E44, E51, F36, F44, F65, G01, G10, G12, G14, G15,
G21
Keywords: asset prices, balance sheets, credit, financial accelerator, financial
intermediation, financial linkages, international linkages, leverage, liquidity,
macrofinancial linkages, output, real-financial linkages

Claessens (Monetary and Economic Department, Bank for International Settlements; CEPR;
Stijn.Claessens@bis.org); Kose (Development Prospects Group, World Bank; Brookings Institution;
CEPR; CAMA; akose@worldbank.org). We are grateful to Olivier Blanchard for his helpful comments
at the early stages of this project of surveying the literature on macrofinancial linkages when we were
with the Research Department of the International Monetary Fund. This paper has a companion,
Asset prices and macroeconomic outcomes: a survey, BIS Working Paper no. 676. We would like to
thank Boragan Aruoba, Claudio Borio, Menzie Chinn, Ergys Islamaj, Jaime de Jesus Filho, Raju
Huidrom, Atsushi Kawamoto, Seong Tae Kim, Grace Li, Raoul Minetti, Ezgi Ozturk, Eswar Prasad, Lucio
Sarno, Hyun Song Shin, Kenneth Singleton, Naotaka Sugawara, Hui Tong, Kamil Yilmaz, Kei-Mu Yi,
Boyang Zhang, Tianli Zhao, and many colleagues and participants at seminars and conferences for
useful comments and inputs. Miyoko Asai, Ishita Dugar and Xinghao Gong provided excellent
research assistance. Mark Felsenthal, Sonja Fritz, Krista Hughes, Serge Jeanneau, Graeme Littler,
Tracey Lookadoo, and Rosalie Singson provided outstanding editorial help. The views expressed in
this paper are those of the authors and do not necessarily represent those of the institutions they are
affiliated with or have been affiliated with.

WP677 Macroeconomic implications of financial imperfections: a survey i

They [economists] turned a blind eye to the limitations of human rationality that
often lead to bubbles and busts; to the problems of institutions that run amok; to the
imperfections of markets especially financial markets that can cause the economys
operating system to undergo sudden, unpredictable crashes
Paul Krugman (2009a)

Hello, Paul, where have you been for the last 30 years? Pretty much all we have
been doing for 30 years is introducing flaws, frictions and new behaviors... The long
literature on financial crises and banking has also been doing exactly the same.
John H. Cochrane (2011)

I believe that during the last financial crisis, macroeconomists (and I include myself
among them) failed the country, and indeed the world. In September 2008, central
bankers were in desperate need of a playbook that offered a systematic plan of attack
to deal with fast evolving circumstances. Macroeconomics should have been able to
provide that playbook. It could not
Narayana Kocherlakota (2010)

What does concern me of my discipline, however, is that its current core by which
I mainly mean the so-called dynamic stochastic general equilibrium (DSGE) approach
has become so mesmerized with its own internal logic This is dangerous for both
methodological and policy reasons To be fair to our field, an enormous amount of
work at the intersection of macroeconomics and corporate finance has been chasing
many of the issues that played a central role during the current crisis However, much
of this literature belongs to the periphery of macroeconomics rather than to its core
Ricardo Caballero (2010)

One can safely argue that there is a hole in our knowledge of macro financial
interactions; one might also argue more controversially that economists have filled this
hole with rocks as opposed to diamonds; but it is harder to argue that the hole is empty.
Ricardo Reis (2017)

The financial crisis made it clear that the basic model, and even its DSGE cousins,
had other serious problems, that the financial sector was much more central to
macroeconomics than had been assumed...
Olivier Blanchard (2017a)

WP677 Macroeconomic implications of financial imperfections: a survey iii

Table of contents

1. Introduction ....................................................................................................................................... 1

2. Financial imperfections: the demand side ............................................................................. 6

A. Basic mechanisms ................................................................................................................. 6
B. Empirical evidence ................................................................................................................ 8

3. Financial imperfections in general equilibrium ................................................................. 11

A. The financial accelerator .................................................................................................. 12
B. Quantitative importance of the financial accelerator ........................................... 13

4. Financial market imperfections in open economies ........................................................ 17

5. Financial imperfections: the supply side .............................................................................. 20

A. Bank lending channel ........................................................................................................ 20
B. Bank capital channel .......................................................................................................... 23
C. Leverage and liquidity channels.................................................................................... 24

6. Evidence relating to the supply side channels................................................................... 26

A. Bank lending channel ........................................................................................................ 26
B. Bank capital channel .......................................................................................................... 28
C. Leverage and liquidity channels.................................................................................... 29

7. Aggregate macrofinancial linkages ........................................................................................ 32

A. Business and financial cycles .......................................................................................... 33
B. Linkages between business and financial cycles .................................................... 35

8. Conclusions ...................................................................................................................................... 38
A summary ...................................................................................................................................... 38
What next? ...................................................................................................................................... 39

Appendix I. Research on macrofinancial linkages: a brief history ...................................... 44

Appendix II. Financial accelerator mechanisms ......................................................................... 50

Appendix III. Understanding liquidity and leverage cycles ................................................... 53

Appendix IV. Linkages between business and financial cycles: an overview of

empirical studies........................................................................................................................... 55
Credit market cycles and business cycles ........................................................................... 55
Cycles in asset (house and equity) prices and business cycles .................................. 55
Synchronisation of financial cycles........................................................................................ 57

Tables and figures ................................................................................................................................. 58

References ................................................................................................................................................ 79

iv WP677 Macroeconomic implications of financial imperfections: a survey

1. Introduction

The Great Financial Crisis (GFC) of 200709 confirmed the vital importance of
advancing our understanding of macrofinancial linkages. The GFC was a bitter
reminder of how sharp fluctuations in asset prices, credit and capital flows can have
a dramatic impact on the financial position of households, corporations and
sovereign nations.1 These fluctuations were amplified by macrofinancial linkages,
bringing the global financial system to the brink of collapse and leading to the
deepest contraction in world output in more than half a century. Moreover, these
linkages have resulted in unprecedented challenges for fiscal, monetary and financial
sector policies.
Macrofinancial linkages centre on the two-way interactions between the real
economy and the financial sector. Shocks arising in the real economy can be
propagated through financial markets, thereby amplifying business cycles.
Conversely, financial markets can be the source of shocks, which, in turn, can lead to
more pronounced macroeconomic fluctuations. The global dimensions of these
linkages can result in cross-border spillovers through both real and financial channels.
The crisis has led to a lively debate over the state of research on the role of
financial market imperfections in explaining macroeconomic fluctuations. Some
argue that the crisis showed that the profession did not pay sufficient attention to
these linkages. Others, by contrast, claim that they have been recognised for a long
time and that substantial progress has been made in understanding them. But most
acknowledge that financial market imperfections can often intensify fluctuations in
the financial and real sectors. Yet, the absence of a unifying framework to study the
two-way interactions between the financial sector and the real economy has limited
the practical applications of existing knowledge and impeded the formulation of
policies.2
This debate can be seen as a natural extension of the long-standing discussion
about the importance of financial market developments for the real economy (as
described in detail in Appendix I).3 The diverging paths followed by the fields of

1
A large literature documents the various macrofinancial linkages that have contributed to the
devastating impact of the GFC. Some of the important books on the topic include Krugman (2009b),
Sorkin (2009), Wessel (2009), Lewis (2010), Kose and Prasad (2010), Paulson (2010), Gorton (2012),
Turner (2012), Bernanke (2013), Blinder (2013), Claessens et al (2014), Geithner (2014), Mian and Sufi
(2014a), Wolf (2014), Farmer (2016), King (2016) and Taylor (2016). Lo (2012) reviews a set of 21 books
on the GFC.
2
We presented some quotes reflecting the flavour of this debate at the beginning of the survey.
Krugman (2009a) criticises the macroeconomics literature for its failure to recognise the strong
relationship between the financial sector and the real economy, while Cochrane (2011, 2017)
responds critically to Krugmans views. Caballero (2010), Kocherlakota (2010), Taylor (2011), Romer
(2016) and Reis (2017) provide varying assessments of research on macroeconomics. Blanchard
(2017a) stresses the need for a broader class of macroeconomic models.
3
Early surveys of the literature on macrofinancial linkages include Gertler (1988), Bernanke (1993),
Lowe and Rohling (1993) and Bernanke et al (1996). Mankiw (2006) and Blanchard (2000, 2009) offer
more general reviews of the state of macroeconomics before the crisis. Recent (but more selective)
updates on macrofinancial linkages include Gilchrist and Zakrajek (2008), Matsuyama (2008),
Solimano (2010), BCBS (2011, 2012), Caprio (2011), Gertler and Kiyotaki (2011), Quadrini (2011), Borio
(2014) and Morley (2016), as well as papers in Friedman and Woodford (2011). Work related to
macrofinancial linkages includes: Cochrane (2006) on financial markets and the real economy;
Brunnermeier (2001) and Cochrane (2005) on asset pricing; and Tirole (2006) on the role and impact

WP677 Macroeconomic implications of financial imperfections: a survey 1

macroeconomics and finance are at the root of recent debates (Figure A1). The
literature has exhibited an oscillating pattern between integration and separation of
financial and real economy issues. Early studies often considered developments in the
real economy and financial sector jointly but they resorted to mostly qualitative
approaches. Later studies, however, emphasised the separation of the real sector from
the financial sector and subscribed to the idea that the financial sector was no more
than a veil to the real economy. The corporate finance and asset pricing literatures
largely adopted the efficient markets paradigm. An influential branch of the
macroeconomic literature (following the real business cycle (RBC) approach) mostly
focused on models that do not account for financial imperfections and their potential
role in shaping macrofinancial linkages.4
Although progress has been slower than hoped for, the literature has been
making a more concerted effort over the past three decades to analyse the
interactions between financial markets and the real economy. A number of studies
have emphasised the critical roles played by financial factors for the real economy.
Starting with Bernanke and Gertler (1989) followed by Carlstrom and Fuerst (1997),
Kiyotaki and Moore (1997) and others rigorous analytical models have been
developed. These models have been used for a variety of purposes, including the
analysis of the impact of monetary and fiscal policies on the real economy and
financial markets.
This paper surveys the rapidly expanding literature on the implications of
financial market imperfections for macroeconomic outcomes. It attempts to
contribute to the research programme in at least four dimensions. First, it presents a
broad perspective on theoretical and empirical studies on the implications of financial
market imperfections for macroeconomic outcomes. Second, it emphasises the global
dimensions of these linkages in light of the rapid growth of international financial
transactions and their critical role in the transmission of cross-border shocks. Third, it
summarises the main empirical features of the linkages between the financial sector
and the real economy. Finally, it attempts to identify gaps in the literature in order to
provide guidance for future studies.

of financial imperfections on corporate finance and other economic variables. Crowe et al (2010) and
Nowotny et al (2014) present collections of papers on macrofinancial linkages. Brunnermeier et al
(2013) provide an analytical review of the literature on macro models with financial frictions. On the
supply side, Adrian and Shin (2010b) survey the literature on the changing role of financial institutions
and the growing importance of the shadow banking system. Gorton and Metrick (2013) and Pozsar
et al (2013) review the role of securitisation and shadow banking; Brunnermeier and Oehmke (2013)
and Scherbina and Schlusche (2014) review the literature on asset price bubbles; and Forbes (2012)
reviews the literature on asset price contagion. Blanchard (2017a) looks at the state of
macroeconomics, focusing on the need to include distortions other than nominal price rigidities,
including financial frictions. Kocherlakota (2016) shows how the predictions of real business cycle
models significantly change in the presence of small nominal rigidities and argues that these types
of models are not useful tools for analysis of business cycles. For a recent discussion of the need to
incorporate financial frictions, labour market frictions and household heterogeneity in benchmark
macroeconomic models, see Ghironi (2017). Obstfeld and Taylor (2017) consider the importance of
finance in the context of the international monetary system. The literature on law and finance also
relates to the broad theme of macrofinancial linkages (see La Porta et al (2013) for a recent review)
but more from a longer-run developmental perspective.
4
Claessens and Kose (2017) review research on the interactions between asset prices and
macroeconomic outcomes in models without financial market imperfections. In these studies,
changes in financial variables, such as asset prices, are associated with individual consumption and
investment decisions but there are no aggregate feedback mechanisms from financial to real
variables and little scope for macrofinancial linkages.

2 WP677 Macroeconomic implications of financial imperfections: a survey

 The survey focuses on two main channels through which financial market
imperfections can lead to macrofinancial linkages. The first channel, largely operating
through the demand side of finance, describes how changes in borrowers balance
sheets can amplify macroeconomic fluctuations. The central idea underlying this
channel is best captured by the financial accelerator an extensively studied
propagation mechanism in a wide range of models. The second channel, associated
with the supply side of finance, emphasises the importance of balance sheets of banks
and other financial institutions in lending and liquidity provision for the real economy.
Given the large number of studies on the macroeconomic implications of
financial imperfections, a survey on the topic comes with a number of caveats. First,
for presentational purposes, we use the rough distinction between the demand and
supply sides of finance, reviewing each separately and analysing how they can lead
to macrofinancial linkages. The demand and supply sides are of course interrelated
as transactions are endogenous outcomes, especially when they are considered in a
general equilibrium framework. Nevertheless, this rough demarcation allows us to
classify many studies in a simple manner. Second, our objective is to provide intuitive
explanations of how financial frictions can lead to macrofinancial linkages. Hence,
rather than delving into the details of certain models, we explain the general ideas
describing the workings of models and then summarise the relevant empirical
evidence for specific channels. In order to present a coherent review of this large body
of work, each section provides a self-contained summary of the specific literature.
Third, macrofinancial linkages ultimately originate at the microeconomic level.
Hence, whenever possible, we draw lessons from the theoretical and empirical work
on the microeconomic factors that are relevant for the behaviour of macroeconomic
and financial aggregates. Fourth, while many of the papers we review have policy
relevance, we largely stay away from directly addressing policy issues, including those
related to monetary, macroprudential, regulatory and crisis management policies.
Finally, while we did our best to include all the major studies on the topic, it is
probably unavoidable that a survey of such a rich literature would miss some
contributions.
Section 2 presents a brief review of the basic microeconomic mechanisms that
could lead to financial market imperfections on the demand side. It starts with a
conceptual discussion of how imperfections (financial frictions) stemming from
information asymmetries and enforcement difficulties affect the amount and costs of
external financing available to firms and households.5 Financial frictions can lead to
deviations from the predictions of the standard complete market models in terms of
how (real and financial) resources are allocated.6 Models incorporating financial
frictions typically predict that access to external finance becomes easier and the
premium charged for such financial transactions decreases with the strength of
borrowers' balance sheets and net worth. This can lead to the amplification of
(monetary, financial and real) shocks as changes in net worth affect access to finance
and the use of that finance and subsequently influence consumption and
investment.

5
Some of the pioneering papers on financial frictions include Akerlof (1970), Jensen and Meckling
(1976), Townsend (1979), Stiglitz and Weiss (1981), Bulow and Rogoff (1989) and Hart and Moore
(1994).
6
Throughout this paper, the terms financial market imperfections and financial frictions are used
interchangeably. Financial frictions in conjunction with a countrys legal, regulatory and tax system
influence the design and evolution of financial contracts, markets and intermediaries.

WP677 Macroeconomic implications of financial imperfections: a survey 3

 The section also reviews the empirical evidence on the importance of financial
market imperfections on the demand side. Studies have employed microeconomic
(firm, household, and sector-level) data to examine the role of imperfections in
explaining the behaviour of households, firms and sectors over the business cycle.
Some also analyse the importance of imperfections in driving macroeconomic
outcomes during specific episodes. Most studies find that these imperfections tend
to affect small firms and households the most, especially during times of financial
stress. Although many studies provide supporting evidence concerning the roles
played by imperfections, there is also a debate about their aggregate quantitative
importance.
Section 3 reviews general equilibrium models that feature amplification
mechanisms operating through the demand side. These models show how financial
accelerator-type effects can arise when small shocks are propagated and amplified
across the real economy through their impact on access to finance. In these models,
the interactions between access to external financing and firms or households net
worth or cash flows (or relevant asset prices) serve as transmission mechanisms
between the financial sector and the real economy. Small, temporary shocks can
amplify and spill over to other segments of the economy and generate large,
persistent fluctuations in consumption, investment and output.
The past two decades have witnessed significant growth in research featuring
financial accelerator mechanisms. This research programme, which often uses
dynamic stochastic general equilibrium (DSGE) models, emphasises the important
role played by shocks to external financing and asset prices in amplifying business
cycles. For example, it models that changes in asset prices and net worth significantly
influence household borrowing and spending through their impact on households
access to finance and the cost of such finance. More recent work highlights how
financial frictions can affect the allocation of resources across a number of dimensions
(firm heterogeneity, project choice, technological change, housing market structure
and the functioning of labour markets). Section 3 also reviews how the financial
accelerator mechanism has been incorporated into the analysis of the transmission
of monetary policy to the real economy.
Section 4 looks at studies on the macroeconomic implications of financial
imperfections in the context of open economies. As is the cases for a household or
firm, imperfections can have an impact on net worth and affect a countrys ability to
borrow. Research has considered the importance of various imperfections using
different types of open economy models. It has found that, with contracts being more
difficult to enforce and information asymmetries being more prominent across
borders, imperfections can be important for macroeconomic outcomes in open
economies. For example, the financial accelerator mechanism has been shown to be
quantitatively important in explaining the real effects of financial stress in open
economy models. Another strand of the literature examines the interactions between
imperfections and exchange rates, and considers the transmission of shocks in open
economies through changes in the external value of the collateral required for
financing. Recent empirical work supports the importance of global shocks to credit
markets in leading to large cross-border spillovers in real activity.
Sections 5 and 6 present a summary of the amplification channels that operate
largely on the supply side of finance and the empirical evidence relating to the
importance of these channels (for discussions of the main functions of the financial
system, see Levine (1997, 2005) and Zingales (2015)). Some of the same financial
sector imperfections that give rise to the financial accelerator mechanism also affect

4 WP677 Macroeconomic implications of financial imperfections: a survey

the operations of financial intermediaries and markets, ie the supply side of finance.
Just as is the case for firms, financial institutions operations are affected by their net
worth. Furthermore, financial intermediaries and markets themselves are subject to
various imperfections and related market failures. Importantly, interactions among
financial market participants can lead to aggregate developments on the supply side
of finance. Together, these observations imply that the supply side can be a source
of shocks, amplification and propagation, leading, in turn, to macrofinancial linkages.7
Developments on the supply side can have a substantial influence on
macroeconomic outcomes through various mechanisms that can be classified under
three major groups, although there are significant overlaps between these groups.
The first two groups focus on banks special role in intermediation. The first includes
the bank lending channel, a mechanism traditionally identified in the literature as
being particularly relevant for the transmission of monetary policy. Notably, changes
in the balance sheets of banks, especially their liquidity, can affect the overall supply
of financing. The second and related group is associated with (changes in) bank
capital. As capitalisation varies over the cycle, banks expand or cut back lending,
leading to aggregate procyclical effects. Both mechanisms matter especially to those
households and firms for which bank credit cannot easily be substituted for.
The third and most recent group of studies focuses on the financial systems
overall leverage and liquidity. The GFC showed that leverage could build up to
excessive levels during upturns and drop sharply in downturns. This has important
implications for the supply of external financing, asset prices and, consequently, for
the real economy. In addition, providing liquidity is an important function of the
financial system. The aggregate supply of financing and liquidity to the private sector
depends, however, on a complex set of interactions between financial institutions,
notably (but not only) through the interbank and other financial markets. Fluctuations
on the supply side can have a significant impact on macroeconomic outcomes, with
cycles of growing leverage, ample liquidity and rising asset prices being followed by
cycles of deleveraging and liquidity hoarding (especially during periods of financial
stress). More generally, a wide range of factors, including balance sheet positions of
households, non-financial enterprises and financial institutions, interactions between
those agents and financial markets, and access to information and ability to process
it, can affect asset prices and the supply of external financing.
Empirical work shows that supply side shocks can affect the evolution of external
financing, asset prices and market liquidity, with the potential for feedback loops
between real and financial markets. A number of recent studies focus specifically on
the linkages arising from the first two supply side channels for the transmission
mechanisms of monetary policy. They document that the supply side can influence
macroeconomic outcomes through an amplification of credit supply and external
financing during boom periods and deleveraging and liquidity hoarding during
periods of financial stress. A more recent strand documents the role of such supply
factors internationally.

7
Important contributions on the supply side include Diamond and Dybvig (1983), Gale and Hellwig
(1985), Calomiris and Kahn (1991), Holmstrm and Tirole (1997), Allen and Gale (1998) and Diamond
and Rajan (2001). More recent work includes Adrian and Shin (2008), Geanakoplos (2008) and
Brunnermeier and Pedersen (2009), Danielsson et al (2011), Gertler and Karadi (2011), Gertler and
Kiyotaki (2011), Goodhart et al (2012), He and Krishnamurthy (2012), Brunnermeier and Sannikov
(2014, 2016), Begenau (2016), Gertler et al (2016), Begenau and Landvoigt (2017) and Piazzesi and
Schneider (2017). Many recent models combine demand and supply side considerations (including
banks, shadow banks and payment and collateral services).

WP677 Macroeconomic implications of financial imperfections: a survey 5

 Section 7 reviews recent empirical studies that analyse aggregate linkages
between the real economy and the financial sector. Using long series of cross-country
data, those studies report a number of salient facts about the features of business
and financial cycles and about the interactions between the two. They document that
financial cycles appear to play an important role in shaping recessions and recoveries.
In particular, recessions associated with financial disruptions are often longer and
deeper than other recessions while, conversely, recoveries associated with rapid
growth in credit and house prices tend to be relatively stronger. These results
collectively point to the importance of the two-way linkages between financial
markets and the real economy.
Section 8 concludes with a summary of the main messages, questions for future
research and policy issues that would require further work.

2. Financial imperfections: the demand side

This section reviews the basic mechanisms through which financial market
imperfections on the demand side can lead to macrofinancial linkages. It starts with
a conceptual discussion of how the state of borrowers balance sheets affects their
access to external financing at the microeconomic level, ie at the levels of households
and corporations. This is followed by a summary of microeconomic and sectoral
evidence supporting the importance of imperfections on the demand side. Although
most demand side studies support the role of imperfections, their quantitative
importance is still under debate.

A. Basic mechanisms

Financial market imperfections often stem from information asymmetries and

enforcement problems. Due to information asymmetries, lenders and investors know
less about the expected rate of return on prospective projects than firm managers or
owners do. Moreover, lenders and investors do not know everything about borrowers;
for example, whether they are well qualified, exerts sufficient effort or selects
economically efficient projects (ie with positive net present value). Since the economic
prospects of projects, the financial position of borrowers and the actual effort
expended by borrowers cannot be observed perfectly ex-ante, adverse selection and
moral hazard problems arise. Lenders and investors may also face difficulty in
enforcing contracts ex-post. In part due to information asymmetries (eg to verify the
exact state of affairs of borrowers such as the actual effort they exerted) but also as
the legal and institutional frameworks may not allow for efficient ex-post settlements
(eg as collateral is hard to repossess) lenders may have to incur large costs and
therefore refrain from lending in the first place.
These information asymmetries lead to transaction costs and incomplete
financial markets in the sense that not every worthwhile project is financed.8 In order

8
As Quadrini (2011) notes in his review, the presence of financial frictions implies the absence of
complete trade in certain risks, that is, models with financial frictions feature missing markets, thus
limiting a full sharing of risk. Models (implicitly or explicitly) also assume heterogeneous agents since
there would otherwise be no reason to trade claims inter-temporally or intra-temporally. The fact
that markets are missing may be exogenously assumed or can arise from financial frictions, that is,

6 WP677 Macroeconomic implications of financial imperfections: a survey

to choose worthwhile projects, avoid adverse selection and prevent shirking, lenders
and investors will have to incur transaction costs. In order to overcome monitoring
problems, savers and principal investors have to rely on agents (such as banks) for
monitoring to be done on their behalf or employ certain ex-post mechanisms (for
example, costly state verification (Townsend (1979)). For this to happen, they need to
incur additional costs. These costs and other imperfections create, in turn, a wedge
between: i) what the expected value of a firm or project would be and how much
external financing it could obtain with no agency costs (ie under perfect information
or run by the principal); and ii) what the value of the firm would be under a particular
external financing arrangement.9 This wedge means a higher cost of external
financing or can even lead lenders to ration the external financing they provide ex-
ante (Stiglitz and Weiss (1981)).
Models incorporating these imperfections typically predict that access to external
finance is related to the strength of borrowers' balance sheets. Because of this link,
most models do not only predict that access to finance differs from what is predicted
by models without imperfections, but also that to the extent that financing is
available, its amount depends on borrowers' net worth the value of assets less
outstanding debt obligations and the collateral value of easily saleable assets,
especially liquid assets (eg cash). Net worth and collateral provides three types of
assurance to investors. First, with skin in the game, borrowers have better incentives
to select profitable projects and work hard to deliver successful results. Second,
borrowers have assets to help repay the loan, ie the simple value of recoverable
collateral. Third, collateral can help investors screen out quality borrowers from low
quality ones or help trustworthy borrowers signal their quality (Bester (1987) and
Besanko and Thakor (1987)).
Lenders may demand a premium over the risk-free rate to provide credit to
borrowers. This external finance premium, ie the difference between the cost of
external funds and the opportunity cost of internal funds, covers the costs incurred
by financial intermediaries in evaluating borrowers' prospects and monitoring their
actions. It can also be seen as compensating investors for the inefficiencies and risks
induced by moral hazard and adverse selection. If borrowers have limited net worth,
their access to external financing can be fully constrained, even if they have profitable
investment projects. This is because lenders have little confidence in their incentives
to perform (and the lenders cannot screen out good projects) and their ability to
repay. This premium and constraint on external financing also imply that deadweight
losses can arise because not all profitable projects can obtain financing.
Changes in borrowers net worth then affect their access to finance. Shocks, such
as fluctuations in asset prices or changes in economic prospects, influence the

forms of market incompleteness due to information asymmetries and limited enforcement. There has
been an extensive theoretical literature on how such imperfections can lead to missing markets or
incomplete contracts, including in financial markets. Seminal corporate finance papers include
Akerlof (1970), Jaffee and Russell (1976), Jensen and Meckling (1976), Rothschild and Stiglitz (1976),
Stiglitz and Weiss (1981) and Myers and Majluf (1984). Tirole (2006) provides a textbook treatment
of the role of imperfections in corporate finance and discusses some of their macroeconomic
implications. Meyers (2015) reviews capital structure theories and how they have been tested.
Samphantharak and Townsend (2009) discuss how finance affects household behaviour. Dewatripont
and Tirole (1994) and Freixas and Rochet (1997) present early analytical overviews of imperfections
as they affect financial institutions (see also Greenbaum et al (2016)).
9
These imperfections also affect the formation of firms since a firm (as an organiser of activities) can
be a mechanism to internalise some of those constraints (Coase (1937)). Aghion and Holden (2011)
present a review of research on incomplete contracts and the theory of the firm.

WP677 Macroeconomic implications of financial imperfections: a survey 7

balance sheets of borrowers. Given financial imperfections, resulting changes in net
worth affect the volume of external financing supplied and its cost. Specifically, as net
worth rises, the volume of external financing increases while its cost declines to a level
that is comparable to the implicit cost of internal funds. Conversely, as net worth
declines, the volume of external financing falls while its cost increases.
The relationship between borrowers' net worth and their access to external
financing (and its cost) implies that the impact of shocks (monetary, real and financial)
can be amplified. This is an expected outcome as borrowers adjust their investment
or consumption plans in the face of changes in the volume and cost of external
financing. However, the effects of financial imperfections can be asymmetric over the
business cycle. In fact, when net worth is high (more likely to be the case during
booms), the problems of adverse selection or moral hazard are less relevant (as
lenders collateral requirements are less binding). Conversely, with adverse shocks,
net worth-related constraints can suddenly become much more significant. The
asymmetric nature of shocks has been exploited by the empirical literature to show
the relevance of macrofinancial linkages.
The key mechanisms described above are also relevant to understanding the
implications of changes in household balance sheets. As is the case for corporations,
the borrowing potential of households also hinges on the strength of their balance
sheets. This means that movements in asset (such as house or equity) prices can lead
to changes in household borrowing and spending that are larger than what is
suggested by conventional life-time wealth and consumption effects (Claessens and
Kose (2017)). Since housing represents a large part of household net worth,
movements in house prices can affect homeowners access to financing and the
external financing premium they face (Mian et al (2017)).

B. Empirical evidence

Numerous studies examine the empirical relevance of financial imperfections. Some

employ microeconomic (firm-, household- and sector-level) data while others
consider specific events or episodes. This section summarises the empirical evidence
provided by microeconomic data (largely focusing on corporate investment and
household consumption). Additional work that considers macroeconomic and time
series evidence is presented in Section 7.
Research documents a strong association between firm cash flow and
investment. Theory predicts that, in environments with no financial market
imperfections, a corporations current cash flow is immaterial to its investment
decision. With imperfections, however, a corporations cash flow can influence
investment decisions because the corporation is subject to an external finance
premium that stems from financing constraints. As the cash flow increases, so can
investment because of the greater availability of internal funds and the lower cost of
such funds relative to external funds. Many studies using panel data report that
corporate cash flows are indeed correlated with investment decisions. This is
especially true for firms that are smaller, do not pay dividends or have poor credit
ratings, exactly those firms that are more likely to be subject to imperfections. The

8 WP677 Macroeconomic implications of financial imperfections: a survey

first influential paper that presents empirical evidence of this link, by Fazzari et al
(1988), has been followed by many others.10
The empirical evidence on the link between internal cash flows and investment
shows that imperfections play a significant role. Although other factors can also lead
to such linkages, studies using various techniques to control for such factors have
confirmed the relevance of imperfections.11 One confounding factor is that firms
current cash flows can be correlated with future profitability. Since prospective returns
are relevant to current investment decisions, this can generate a correlation (even
without financial market frictions). Evidence shows, however, that imperfections
remain important. For example, Blanchard et al (1994) find supporting evidence by
analysing how firms adjust their investment in response to cash windfalls. They
argue that such windfalls are unrelated to future profitability.
Other research, using different approaches, also emphasise the importance of
financial imperfections. Lamont (1997) analyses internal capital markets of oil
companies and finds that, in response to a sudden drop in oil prices, these companies
significantly reduce their non-oil investment compared with other companies. Since
this approach controls for the profitability of investments, it provides evidence of the
importance of cash flows for investment. A number of other studies, including those
on the determinants of inventories and employment, also point to the critical role of
imperfections.12 Another strand of the literature uses information extracted from
CEOs public statements and surveys to assess directly whether firms are credit-
constrained (Graham and Harvey (2001)).
Imperfections are acutely important for small firms, particularly during times of
financial stress. Because such firms have more limited access to financial markets
(because they have less collateral or are less transparent to outside investors),
imperfections are often more relevant to them (Petersen and Rajan (1995)). Fazzari et
al (1988)) find that investment is indeed significantly more sensitive to current cash
flows for new and small firms. In a related study, Gertler and Hubbard (1988) report
an inverse relationship between firm size and sales variability that stems from
imperfections. They also find that the effects of financial market frictions on
investment are asymmetric, with larger impacts during downturns than during
booms. Fort et al (2013) show that young (typically small) businesses are more
sensitive to the cycle than older/larger businesses. Campello et al (2010) and other
papers document the adverse implications of financial constraints during a financial
crisis (see Peek and Rosengren (2016) for a comparison of supply side effects between
the GFC and previous crises).
Other studies also examine the importance of internal cash flow and asset price
movements for the investment undertaken by different classes of firms. Gilchrist and
Himmelberg (1999), for example, document that internal cash flow is critical for
investment, especially for firms that are small, have limited access to credit markets
and have relatively weaker balance sheets. They find that investment is responsive to

10
Other studies include Hubbard (1998), Hoshi et al (1991), Whited (1992), Calomiris et al (1995), Gross
(1995) and Hubbard et al (1995). Stein (2003) presents a survey of theoretical and empirical work
regarding the determinants of firm-level investment dynamics.
11
For example, Kaplan and Zingales (1997) criticise the approach taken by Fazzari et al (1988) because
they do not control for the endogeneity of financing constraints. See further Kaplan and Zingales
(2000) on why investment-cash flow sensitivities are not good indicators of financing constraints.
12
See for additional work, Cantor (1990), Blinder and Maccini (1991), Oliner and Rudebusch (1993),
Carpenter et al (1994) and Guiso et al (2013).

WP677 Macroeconomic implications of financial imperfections: a survey 9

both fundamental and financial factors, as predicted by the theory relating to financial
frictions. Their estimates show that financial factors increase the overall response of
investment to an expansionary shock by about 25% over the first few years following
the initial shock. Chaney et al (2012) and Gan (2007) find a significant impact of asset
(real estate) prices on corporate investment in the United States and Japan (see also
Lin et al (2011) for the role of ownership structures for financing constraints).
Studies also report that small firms are more likely to be credit-constrained
during periods of contractionary monetary policy. Gertler and Gilchrist (1994)
examine the behaviour of small and large manufacturing firms in the United States
during five periods of contractionary monetary policy and one period of credit crunch.
They document that small and large firms behave differently during these periods,
with the former group reducing its debt and the latter one increasing it. Small firms
experience larger declines in their inventories and sales than large firms (Figure 1).
They conclude that because large firms have easier access to credit, the impact of
adverse credit market shocks is less pronounced for them than it is for smaller firms.
Sharpe (1994) provides similar supporting evidence and concludes that the cyclicality
of a firms labour force is inversely related to its size.
The behaviour of households is similarly affected by financial market
imperfections. Due to imperfections, including an inability to borrow against ones
life time income, households can be subject to borrowing constraints and therefore
undertake more precautionary saving. This can make household consumption highly
sensitive to fluctuations in transitory income. A number of empirical studies suggest
that changes in aggregate consumption are significantly correlated with lagged or
predictable changes in income or credit growth (Flavin (1981), Campbell and Mankiw
(1989, 1990) and Deaton (1992); see Jappelli and Pistaferri (2010) for a review).
Ludvigson (1999) shows a statistically significant correlation between consumption
growth and predictable credit growth.
Changes in house prices affect household borrowing and spending substantially
through their impact on household net worth and cost of credit. Home equity is often
a large part of household net worth. A variety of micro-based empirical studies
document that household consumption is affected more by changes in house prices
than what simple life-time consumption models would predict (Claessens and Kose
(2017)). Lamont and Stein (1999) report that US households with weak balance sheets
adjust their housing demand more strongly in the face of income shocks, consistent
with a role for borrowing constraints. Other studies also show that households face
an external finance premium, which is lower when their financial position is stronger
(Almeida et al (2006)).
Financial imperfections associated with housing markets are shown to have
implications beyond their impact on individual households. Using regional-level data
for the United States, Mian and Sufi (2010) show that the local variation in house price
appreciation in the 2000s, and related subprime expansion and securitisation, led to
a disassociation of local mortgage credit from income as borrowing constraints
became (excessively) relaxed. Credit extension was driven by expectations of house
price appreciation but this was followed by a wave of mortgage defaults when prices
started to decline (Figures 2 and 3). In the regions affected, this triggered subsequent
large adjustments in durables consumption (proxied by auto sales) and a rapid
increase in unemployment (Mian and Sufi (2014b) and Loutskina and Strahan (2015);
see also Benmelech et al (2017) on the important role of credit supply shocks in the
auto loan market during the GFC).

10 WP677 Macroeconomic implications of financial imperfections: a survey

 However, some question the potential role of imperfections in explaining the
behaviour of households and firms. They argue that the close association between
income and consumption may not be entirely due to imperfections. Others point out
the general difficulty in separating real effects from balance sheet effects. Factors,
such as the expected rate of return, while difficult to measure, also affect firm and
household access to finance. Some consequently argue that changes in cash flows
represent a set of factors that is different from the strength of balance sheets (Eberly
et al (2008)). Carroll (1997), for example, suggests that the excess sensitivity of
consumption growth to forecastable income growth is explained by non-linearities of
the marginal utility function rather than by borrowing constraints.
The quantitative importance of financial frictions for small firms has been under
scrutiny as well. Chari et al (2008) challenge the findings of Gertler and Gilchrist (1994)
and report that the behaviour of small and large firms is not significantly different
during US recessions than it is during other times. Kudlyak and Snchez (2017)
consider how the debt, sales and inventories of small and large firms evolved during
the third quarter of 2008, a period of elevated financial stress. They report that large
firms experienced bigger declines in sales and short-term debt than small ones (Table
1). They also document similar patterns for earlier recessions. Others argue that even
if smaller firms tend to face significant external finance premia, the role of such firms
in explaining business cycles may be small (Cummins et al (2006)). Srinivasan (1986)
shows that small- and medium-size manufacturing firms depend more on internal
finance than large firms, potentially making the costs of external finance less relevant
in the aggregate.
It has also been shown that large firms are affected by imperfections, especially
during times of financial stress. Even relatively large firms, including publicly-listed
corporations, have been shown to face external finance premia, as predicted by
theories premised upon imperfections (see Levin and Natalucci (2005) and Levin et al
(2004)). When large firms suffer from adverse shocks to their balance sheets, their
investments are also negatively affected, especially during recessionary and stressed
periods (Aguiar (2005) and Gilchrist and Sim (2007)). Almeida and Campello (2010)
find that large firms can also face high external financial costs.
On balance, many studies confirm the role of imperfections for outcomes
associated with the behaviour of firms and households. This is particularly true of
studies based on microeconomic data. However, few studies cover the universe of
firms or households and only a small number of studies analyse the aggregate
quantitative importance of financial frictions in a rigorous fashion. Consequently, they
are less clear about the aggregate impact of imperfections. The next section turns
therefore to studies that focus on the aggregate impact of imperfections and how
such imperfections give rise to the financial accelerator mechanism.

3. Financial imperfections in general equilibrium

This section describes how financial imperfections can lead to more pronounced
macroeconomic fluctuations. It first introduces the financial accelerator mechanism
through which financial imperfections amplify and propagate aggregate cyclical
fluctuations. In general, equilibrium models featuring this mechanism display that
real, monetary and financial shocks can have a magnified effect on the real economy
because borrowers adjust their investment in response to changes in external
financing. The section then presents a summary discussion of the empirical evidence

WP677 Macroeconomic implications of financial imperfections: a survey 11

on the quantitative importance of the various types of financial accelerator
mechanism, mostly in the context of DSGE models.

A. The financial accelerator

How does the financial accelerator work? The relationships described above, between
the amount of external financing and its cost (premium), on one hand, and the
strength of borrowers balance sheets and cash flow positions, on the other, lead to
an amplification mechanism where small shocks can result in large economy-wide
adjustments to investment and consumption. Since wealth is a state (or given)
variable and economic agents cannot quickly (or optimally) adjust their
investment/saving plans (as they face costs of doing so), this mechanism persists over
time, causing short-lived shocks to real or financial variables to have longer-lasting
effects on the real economy. This propagation mechanism can also have general
equilibrium effects as individual agents actions affect other agents behaviour in a
mutually reinforcing fashion (see Figures 4A and 4B).13

The basic mechanism

Although narratives of the propagation mechanisms had been around for a long time,
Bernanke and Gertler (1989) presented the first formal model featuring the financial
accelerator mechanism.14 In their model, a negative productivity shock weakens the
cash flow and balance sheet positions of corporations. In turn, this reduces their
access to external finance and increases the premium on such finance, as in standard
corporate finance models. One of the innovations of their model is the use of a
dynamic framework. In particular, they introduced an overlapping generations model
in which only entrepreneurs could costlessly observe the returns on their individual
projects. But outside lenders have to incur a fixed cost to observe those returns (this
costly state verification mechanism was first developed by Townsend (1979, 1988)).
As firms balance sheets and cash flows worsen, they start facing limits on their access
to external finance in ensuing periods. This, in turn, leads them to reduce investment
even after the initial productivity shock dissipates, thus leading to a persistence of
shocks at the firm level.
While movements in cash flows play a key role in driving changes in access to
credit and corporate balance sheets more generally in the model developed by
Bernanke and Gertler (1989), fluctuations in credit and asset prices can also play
important roles in amplifying shocks over time. For example, Kiyotaki and Moore
(1997) focus on the role of asset prices. In their analysis, declines in asset prices
constrain the ability of corporations to obtain new loans, with subsequent effects on
investment and ultimately on output. They show that by allowing for the endogenous
determination of asset prices, a small negative shock leading to an asset price decline
gets amplified as it reduces the value of collateral for all borrowers and thereby
reduces the aggregate availability of loans. This further depresses demand for the
asset and its price, which then further reduces access to external financing.

13
For surveys describing variants of the financial accelerator mechanism, see Antony and Broer (2010),
BCBS (2011), Coric (2011) and Quadrini (2011).
14
Earlier general equilibrium models often featured incomplete financial markets (rather than market
imperfections). Farmer (1984), for example, presents a setting where a complete set of futures
markets does not exist because traders have finite lives.

12 WP677 Macroeconomic implications of financial imperfections: a survey

 In these models, shocks persist and amplify over time and also spill over to other
corporations or sectors. The interactions between credit limits and cash flows or asset
prices become the transmission mechanism by which small or temporary shocks
whether from technology, or other real factors, policies or income distribution can
generate large, persistent fluctuations. In these models, durable assets play a dual
role: not only are they factors of production but they also serve as collateral.

Many dimensions of the financial accelerator

A number of studies have shown how various types of financial imperfection can lead
to different propagation and amplification mechanisms. Some models provide
complementary explanations of how such mechanisms can operate. In most models,
cash flows, asset prices and balance sheets tend to be depressed during recessions.15
Although the mechanisms (and/or channels) vary running from cash flow, default
risk, capital allocation across firms, technological change and information asymmetry
to the functioning of labour and housing markets the overall impact of amplification
on macroeconomic outcomes is quite similar. Appendix II presents a summary of
these mechanisms.16

B. Quantitative importance of the financial accelerator

Research, using a variety of approaches, documents the quantitative importance of

the financial accelerator mechanism. This sub-section looks at two distinct groups of
studies. The first employs DSGE models to evaluate the quantitative importance of
the financial accelerator for the business cycle. The second group considers the role
of the financial accelerator mechanism within the context of monetary policy. The
sub-section concludes with a discussion of studies that challenge the quantitative
importance of the financial accelerator.

Studies employing DSGE models

In one of the first DSGE models with financial market imperfections, Carlstrom and
Fuerst (1997) show the importance of endogenous agency costs in accounting for
business cycles. They employ a setup featuring a financial accelerator mechanism with
long-lived entrepreneurs. Their model can replicate the empirical observation that
output growth displays a hump-shaped behaviour in response to negative shocks as
households delay their investment decisions until agency costs are at their lowest
(several periods after the initial shock).
Bernanke et al (1999) represent the seminal DSGE model involving the financial
accelerator. They show that endogenous fluctuations in balance sheets can propagate
the impact of relatively small exogenous disturbances and lead to larger and longer-
lasting effects on the real economy. Looking at how monetary policy shocks can get
amplified, they find that the impact on investment of a 25 basis point decline in
interest rates is almost doubled by the financial accelerator because the reduction is

15
Each model has its specific advantages and limitations. Some models assume that agents are short-
lived, as in the overlapping generations model of Bernanke and Gertler (1990) and Suarez and
Sussman (1997). The model by Kiyotaki and Moore (1997) is dynamic with long-lived agents but, as
Suarez and Sussman (1997) highlight, it rules out price indexation as a way of insuring against
unanticipated shocks.
16
See also Bernanke and Gertler (2000) and Cecchetti et al (2000) for a discussion of different
mechanisms, including those working through asset prices.

WP677 Macroeconomic implications of financial imperfections: a survey 13

reinforced by an additional decline in the external finance premium. The initial
response of output to such an interest rate decline is also about 50% greater due to
financial accelerator effects. It is also more persistent because of agency problems
between borrowers and lenders.
DSGE models and their many variants show how adding imperfections can help
explain business cycles. Models including imperfections on the demand side
featuring external finance premia, balance sheet constraints on borrowing and
liquidity shortages are able to replicate to a significant degree the behaviour of key
macroeconomic variables. Christiano et al (2008), for example, show that financial
factors play an important role in explaining business cycles during the past two
decades in the United States and Europe. Von Heideken (2009) documents that the
financial accelerator greatly improves the ability of standard models, even those with
an elaborate set of real and nominal frictions, to mimic the main features of business
cycles in the United States and the euro area. Using the Bernanke et al (1999) financial
accelerator framework, Nolan and Thoenissen (2009) show that shocks to the
efficiency of the financial sector play an important role in explaining business cycles
in the United States.17
DSGE models combining microeconomic and asset price data with
macroeconomic variables, such as investment and consumption, further confirm the
critical role of imperfections. Gilchrist et al (2009) demonstrate the quantitative
importance of imperfections by examining credit spreads on the senior unsecured
debt issued by a large panel of non-financial firms. Estimating a DSGE model that
links balance sheet conditions to the real economy through movements in the
external finance premium (using credit spreads as proxy), they show that rising
external finance premia are related to subsequent declines in investment and output.
They also show that credit market shocks contributed significantly to US economic
fluctuations during 19902008. In related studies, Gerali et al (2010) and Atta-Mensah
and Dib (2008) incorporate credit risk into standard DSGE models and quantify the
role of frictions in business cycle fluctuations.
Studies using DSGE models have also shown how endogenous developments in
housing markets can magnify and transmit shocks. Aoki et al (2004) quantify the
effects of shocks to housing investment, housing prices and consumption in a model
in which houses serve as collateral to reduce borrowing-related agency costs.
Campbell and Hercowitz (2009) investigate the impact of mortgage market
deregulation in a calibrated general equilibrium framework with borrowing-
constrained households. Iacoviello (2005) constructs a model in which households
collateral constraints are connected to real estate, and finds that collateral and
accelerator effects are critical in replicating the changes in consumption resulting
from movements in house prices.18 Aspachs-Bracons and Rabanal (2010) report that,

17
Other papers employing general equilibrium models (with the financial accelerator) discuss how
financial institutions fit into broader real activity, including Christiano et al (2003), Christensen and
Dib (2008) and De Graeve (2008).
18
Guerrieri and Iacoviello (2013) present a model with collateral constraints that displays asymmetric
responses to house price changes. In their model, collateral constraints become muted when housing
wealth is high (shocks to house prices lead to small and positive changes in consumption and hours
worked). However, collateral constraints become tight when housing wealth is low (shocks to house
prices translate into negative and large changes in consumption and hours worked). Kannan et al
(2012) consider the importance of credit constraints in driving the linkages between house prices and
macroeconomic fluctuations. Iacoviello and Pavan (2013) and Iacoviello (2004, 2015) also consider
the role of housing markets in explaining business cycles. Wachter et al (2014) present a collection
of papers on the role of housing markets during the GFC.

14 WP677 Macroeconomic implications of financial imperfections: a survey

while labour market frictions are critical in accounting for the main features of
housing cycles in Spain, financial frictions associated with collateral constraints
appear less important.
Using a framework in which house prices and business investment are linked,
recent studies show how credit constraints affect macroeconomic fluctuations. For
example, Liu et al (2013) study the close relationship between land prices and
business investment. They focus on land prices because most of the fluctuations in
house prices are driven by land prices rather than by the cost of construction (Davis
and Heathcote (2007)). They introduce land as a collateral asset in firms credit
constraints and identify a shock that drives most of the observed fluctuations in land
prices. Since firms are credit-constrained by land value, a shock to housing demand
originating in the household sector triggers competing demands for land between
the household and business sectors. This sets off a financial spiral that drives large
fluctuations in land prices and strong co-movements between land prices and
investment, consumption and hours worked.
Some other studies, using DSGE models, analyse the importance of disturbances
in housing markets in explaining certain features of business cycles. Monacelli (2009)
shows that a borrowing constraint, where durables play the role of collateral asset,
improves on a standard New Keynesian models ability to match the positive co-
movement of durable and non-durable spending and the large response of durable
spending to shocks. Davis and Heathcote (2005) show how a multi-sector growth
model with housing affecting household borrowing and spending matches many
empirical facts: consumption, residential investment and nonresidential investment
co-move and residential investment is more than twice as volatile as business
investment.
Research also shows how disturbances in housing markets can have differential
effects on the real economy depending on institutional and other country-specific
features. Iacoviello and Minetti (2006b) show that the impact of house prices on
borrowing constraints is stronger in countries with more liberalised credit markets.
Iacoviello and Minetti (2008) explain the intensity of the broad credit channel of
monetary policy with variables capturing the efficiency of housing finance and the
type of institutions active in mortgage provision in four European countries. Cardarelli
et al (2008) show how housing finance and house price shocks relate to business
cycles in OECD countries and that spillovers from the housing sector to the rest of
the economy are larger in economies where it is easier to access mortgage credit and
use homes as collateral.

Financial accelerator and monetary policy

The financial accelerator mechanism is also critical in understanding one of the major
channels of monetary policy transmission. In addition to the direct interest rate
channel (ie the effect of interest rate changes on asset prices and, through related
channels, consumption and investment), monetary policy affects the real economy
through its impact on the balance sheets of corporations and households.19 This so-
called balance sheet channel of monetary policy transmission is closely related to
the financial accelerator mechanism. Bernanke et al (1999) and Cordoba and Ripoll

19
For a discussion of these other channels, see Claessens and Kose (2017). For a review of the relevance
of the corporate finance literature for monetary policy, see Trichet (2006).

WP677 Macroeconomic implications of financial imperfections: a survey 15

(2004a), for example, extend the Kiyotaki and Moore (1997) framework to
environments with money and investigate the role of monetary policy.
Changes in monetary policy can have much larger effects on real macroeconomic
aggregates than those resulting alone from traditional, direct interest rate and asset
price channels. Interest rate movements affect the external finance premium and the
severity of financing constraints faced by corporations and households because they
influence cash flows and balance sheets, including net worth (through asset price
effects). To illustrate, contractionary monetary policy is typically associated with a
drop in asset prices and thus results in a decline in the net worth of corporations and
households. This leads to an increase in their external finance premium and weakens
their borrowing ability. This, in turn, constrains their spending on investment and
consumption (Bernanke and Gertler (1995)).
The balance sheet channel of monetary transmission, also called the broad
credit channel, has been studied extensively. A number of papers consider different
dimensions of this channel in various settings (see Boivin et al (2011) for a summary
of this literature).20 These papers typically find that monetary policy has an impact on
the balance sheets of borrowers and on the distribution of income between
borrowers and lenders. A change in policy rates can therefore have an effect on the
real economy that is larger than what would be suggested by the direct channels
alone. Section 5 discusses a similar channel but in relation to the supply side: the bank
lending channel, which refers to the effect of monetary policy on the supply of loans.

Debate about the importance of the financial accelerator mechanism

Some studies question the quantitative importance of the financial accelerator
mechanism and suggest that other mechanisms might be more important. Chari et al
(2007) analyse financial and other frictions with data for the US Great Depression and
the 1982 recession. Their results suggest that labour wedges differences between
what firms are willing to pay given the marginal product of labour and what workers
are willing to accept in wages given their marginal rate of substitution vis--vis leisure
account for most of the fluctuations (see also Buera and Moll (2015)).21 Meier and
Muller (2006) estimate a model with a financial accelerator for the United States,
matching the impulse response functions after a monetary policy shock. They claim
that financial frictions do not play a significant role. Bacchetta and Caminal (2000),
using a stylistic model of credit markets, show that the impact of anticipated
productivity and fiscal or saving shocks on output fluctuations is usually not amplified
but may rather be dampened because of credit market imperfections.
Other researchers also argue that the quantitative relevance of imperfections
associated with credit constraints, such as those studied by Kiyotaki and Moore
(1997), can be small. For example, Kocherlakota (2000) shows that the degree of

20
See, for example, Faia and Monacelli (2007), Iacoviello and Minetti (2008), Christiano et al (2008),
Carlstrom et al (2009), De Fiore and Tristani (2011), Eggertsson and Krugman (2012) and Crdia and
Woodford (2016). Woodford (2011) reviews this abundant literature. Considering balance sheet
effects, Taylor (2008) proposes a modified Taylor rule that adjusts the short-term interest rate to
observed increases in credit spreads. Kannan et al (2012) provide evidence of how the inclusion of
house price movements in the conduct of monetary policy can help stabilise the economy in the face
of pressures in the housing market.
21
Christiano and Davis (2006) claim that the result by Chari et al (2007) is not warranted if spillovers
across wedges are taken into consideration (see also Justiniano et al (2010, 2011)). Ajello (2016) finds
evidence that a significant fraction of US output and investment volatility is driven by shocks to
financial intermediation spreads.

16 WP677 Macroeconomic implications of financial imperfections: a survey

amplification provided by credit constraints depends crucially on the parameters of
the economy. In a related paper, Cordoba and Ripoll (2004b) argue that the
amplification mechanism in Kiyotaki and Moore (1997) relies heavily on their
underlying assumptions. They consider a more standard setting and argue that while
collateral constraints can help amplify small unexpected shocks to the real economy,
their quantitative impact is small. In his review, Quadrini (2011) also highlights the
generally weak amplification of collateral-based financial accelerator models as
regards investment, suggesting instead to focus more closely on how financing
constraints affect working capital rather than investment.
There has also been a vigorous debate about the importance of financial factors
in explaining the Great Depression. While Calomiris (1993) and Bernanke (1995), in
their review of various factors explaining the Great Depression, clearly come out
favouring financial market imperfections, others do not. For example, Cole and
Ohanian (2004) and Ohanian (2009) use general equilibrium models to show that
labour policies can account for about 60% of the drop in economic activity in the
1930s and that these policies began to reverse when the economy resumed
expansion in 1940. This suggests that financial factors did not play such a large role.22
Chatterjee (2006) presents a short summary of recent studies, including those
employing various types of general equilibrium model. A reflection of this intense
debate can also be seen in the discussions on the sources of the post-GFC recession
(eg Ohanian (2010), Woodford (2010) and Caballero (2010)).

4. Financial market imperfections in open economies

The macroeconomic implications of financial market imperfections have also been

studied in the context of open economy models. Similar to the case of a corporation
or household in a closed economy, a countrys ability to borrow is affected by its net
worth because of imperfections. Obstfeld and Rogoff (2002) argue that the relevance
of imperfections is probably even stronger in an open economy context because
contracts are harder to enforce and information asymmetries are greater than is the
case in a closed economy setting. As a result, limited pledgeability of output and
limited verifiability of borrowers credit quality and actions influence access to
international finance more than domestic finance.
The financial accelerator has been shown to be a quantitatively important
mechanism in explaining the real effects of financial stress in open economy models.
Gertler et al (2007) employ an open economy version of the model by Bernanke et al
(1999) to analyse the behaviour of the Korean economy during the 199798 financial
crisis. They report that the financial accelerator mechanism explains half of the
reduction in output and that credit market frictions amplify the adverse effects of the
crisis on investment.
Other research considers the relevance of imperfections in different open
economy contexts. Aghion et al (2004), Aoki et al (2010) and Ferraris and Minetti
(2013) use general equilibrium small open economy models with credit constraints to
investigate the impact of various forms of financial liberalisation (of the capital

22
Using a standard New Keynesian model, Eggertsson (2012) argues that the New Deal policies of the
Great Depression were helpful in promoting the recovery. These policies were expansionary because
they changed expectations (from deflationary to inflationary), thus eliminating the deflationary spiral
of 192933. This made lending cheaper and stimulated demand.

WP677 Macroeconomic implications of financial imperfections: a survey 17

account or credit markets) for fluctuations in output. Caballero and Krishnamurthy
(1998, 2001), Paasche (2001) and Schneider and Tornell (2004) show that sharp
fluctuations in credit and asset markets translate into boom-bust cycles in emerging
market economies (EMEs) because of balance sheet constraints. Matsuyama (2005)
finds that differences in financial market imperfections can lead to capital flowing
from developing economies to advanced economies.
An important channel through which shocks can affect macroeconomic
fluctuations is the external value of collateral required for financing. Mendoza (2010)
constructs a small open DSGE model to examine the implications of a variety of
shocks including imported input prices, the world interest rate and productivity
shocks for real activity through collateral constraints. His model shows that when
borrowing levels are high relative to asset values, shocks can be amplified (as in the
debt-deflation mechanism of Fisher (1933)) and have a large impact on output as the
collateral constraint cuts access to working capital financing (see Korinek and
Mendoza (2014)). These findings help explain why the rapid slowdowns or reversals
of capital inflows observed in EMEs (sudden stops) are often followed by financial
stress (see Claessens and Kose (2014)).23
Another strand of the literature examines the interactions between financial
market imperfections and exchange rates. Krugman (1999) and Aghion et al (2000)
show that the combination of imperfections and currency mismatches can lead to
highly volatile business cycle fluctuations, especially in EMEs. Cspedes et al (2004)
use the financial accelerator construct of Bernanke et al (1999) in an open economy
model, and find that a negative external shock can have a magnified impact on output
because of the effects of a real devaluation on corporate sector balance sheets. In
their model, devaluation lowers the real value of assets and adversely affects
entrepreneurs net worth. This leads to an increase in the cost of external credit and,
in turn, further constrains investment, thereby amplifying the impact of the initial
shock on the broader economy. Cook (2004), using a small open economy model
calibrated to reflect the characteristics of East Asian EMEs, shows that a combination
of currency mismatches and exchange rate depreciation can increase the cost of
capital and reduce investment by adversely impacting firms balance sheets.
Other studies consider the role of different types of financial market imperfection
in general equilibrium multi-country settings. Backus et al (1994), Baxter and Crucini
(1995), Heathcote and Perri (2002), Kose and Yi (2001, 2006) and many others have
built multi-country models of international business cycles. Many such models,
however, feature the assumption of financial autarky (ie countries cannot trade
financial assets). Kehoe and Perri (2002) present a model in which the debt capacity
of a country is tied to the value attributed by the country to its future access to
international financial markets. They show that this mechanism can explain the cross-
country output correlations observed in the data. Heathcote and Perri (2013) review
the literature on various puzzles related to international risk sharing and allocative

23
Since some countries respond to these risks by building up foreign exchange reserves, such
precautionary holdings of foreign, liquid assets could turn sudden stops into low-probability events
nested within normal cycles, as observed in the data (Mendoza et al (2009), Borio and Disyatat (2011)).
Bianchi (2011) studies the implications of credit constraints for overborrowing in a small open
economy DSGE model and concludes that raising the cost of borrowing during tranquil times restores
constrained efficiency and significantly reduces the incidence and severity of financial crises.
Brunnermeier and Sannikov (2015) study a model in which short-term capital flows could be excessive
and be a source of financial stress. Kalantzis (2015) study a two-sector model in which large capital
inflows lead to financial crises.

18 WP677 Macroeconomic implications of financial imperfections: a survey

efficiency across countries and conclude that, even over the long run, allocations
appear inefficient because of capital market imperfections.
The role of financial market imperfections in the transmission of business cycles
has also been a fertile area of study. Gilchrist et al (2002) consider a model in which
firms face credit constraints in borrowing both at home and abroad, which amplify
the international transmission of shocks. Iacoviello and Minetti (2006a) develop a
DSGE model where firms face a degree of slack with respect to credit constraints that
differs according to whether they deal with domestic versus foreign creditors. They
argue that this helps capture the observed co-movements of output. Guerrieri et al
(2012) examine the implications of default in a currency union with a model
comprising banks that are capital constrained.
Recent research also examines the role of financial market imperfections in
explaining the highly synchronised nature of the GFC. Perri and Quadrini
(forthcoming) find that the recession that accompanied the GFC, and its global reach
in particular, can be explained by shocks in credit markets. Using a two-country DSGE
model, they show that positive shocks affect the real sector as they enhance the
borrowing capacity of firms and thereby lead to higher employment and production,
although at a lower level of labour productivity. They document that, when countries
are financially integrated, country-specific shocks to credit markets affect
employment and production in other countries by creating significant business cycle
spillovers (see also Kalemli-Ozcan et al (2013) and Quadrini (2014)).24 Moreover, credit
shocks that are different from productivity shocks, tend to generate asymmetric
business cycles (ie contractions that are sharper than expansions) and more volatile
asset prices.25
Shocks originating in financial markets appear to be important in explaining
global business cycles, especially during periods of global recessions. Helbling et al
(2011) analyse the role of disturbances in global credit markets in explaining business
cycles in G7 countries using a set of VAR models. Their results indicate that these
disturbances can have a significant impact on output and other macroeconomic
variables (Table 2). In their analysis, credit shocks, for example, account for roughly
11% of the variance of global GDP. In addition, they report that credit shocks account
for about as large a share of fluctuations on their own as standard productivity shocks.
Credit shocks explain almost 10% of the variance in global productivity and about
11% of the variations in inflation and interest rates. These shares are also close to
those obtained for productivity shocks.
Helbling et al (2011) also undertake a series of counterfactual simulations to
examine the evolution of global GDP during the GFC and report that credit shocks
played an important role. Figure 5 shows the difference between the actual
cumulative change in the demeaned global GDP factor and the cumulative change in
the simulated value in the absence of a global credit shock during the period ranging

24
Devereux and Yetman (2010) and Dedola and Lombardo (2012) also examine how credit market
shocks in DSGE models with financial market imperfections can generate international business cycle
spillovers. Kollmann et al (2011) introduce a banking sector in an international business cycle model
and study how shocks to this sector can generate global spillovers. Bacchetta and van Wincoop (2016)
show that national business cycles can become highly synchronised when the world economy is hit
by a global panic shock. Rose and Spiegel (2010, 2011) and Kamin and DeMarco (2012) examine this
issue using empirical approaches.
25
Some recent studies emphasise the importance of various imperfections associated with financial
shocks, trade credit, and working capital in explaining the sharp decline of trade relative to output
during the GFC (Amiti and Weinstein (2011), Chor and Manova (2012) and Bems et al (2013)).

WP677 Macroeconomic implications of financial imperfections: a survey 19

from Q3 2007 to Q4 2009. The impact of the shock clearly intensified as the recession
spread from the United States to other advanced economies. For example, without
the credit shock, the global recession would have been about 10% milder, given the
difference between actual and simulated cumulative growth in Q3 2009. The bottom
panel of Figure 5 compares the contributions of credit and productivity shocks to
cumulative global GDP growth based on counterfactual simulations. Credit shocks on
their own accounted for a larger share of the cumulative decline in the global GDP
factor than productivity shocks (for the role of shocks originating in credit markets,
see also Huidrom (2014), Bassett et al (2014) and Lpez-Salido et al (2017)).

5. Financial imperfections: the supply side

The process of financial intermediation arises in part from attempts to overcome

imperfections, but it can itself also create amplification and propagation effects. The
financial accelerator mechanism discussed in the previous sections explains how
changes in borrowers balance sheet and cash flow positions (and certain other
features of borrowers) the demand side of finance can affect their access to
financing and thereby lead to an amplification and propagation of shocks. Some of
the same and other, similar imperfections also affect the operations of financial
intermediaries and markets the supply side of finance. Together, these imperfections
imply that the supply side of finance can by itself be a source of shocks and
propagation, leading to specific macrofinancial linkages.
This section presents the three main supply side channels linking financial
imperfections to the real economy. The first sub-section analyses the role of bank
lending in shaping macroeconomic outcomes. Next, the implications of changes in
bank balance sheets for the real economy are considered. The third one looks at how
the channels associated with leverage, liquidity and other supply factors can affect
real aggregates.

A. Bank lending channel

The bank lending channel, also referred to as the narrow credit channel, arises from
the special role played by banks in credit extension. As explained in the previous
section, certain asymmetric information problems are more likely to be prevalent
among households and small firms. This can limit their access to financial services,
even when households have adequate income or when firms have projects with
reasonably high risk-adjusted returns. Banks invest in information acquisition and
monitoring and can thereby (partially) overcome the problems arising from
information asymmetry (and other contracting problems).26 However, during this
process, some households and smaller firms may become bank-dependent in that
they are unable to substitute with ease other forms of finance for bank loans (or
whatever financial services they obtain from a bank). Larger firms, by contrast, may

26
Many studies examine the special roles of banks (Freixas and Rochet (2008) and BCBS (2016) review
the literature). For example, banks can screen potential borrowers, acquire information on firms
collateral (Rajan and Winton (1995) and Diamond and Rajan (2001)) or directly monitor borrowers
actions in order to prevent problems associated with moral hazard (Repullo and Suarez (2000) and
Holmstrm and Tirole (1997)). Earlier contributions include Brunner and Meltzer (1963) and Bernanke
(1983), and Rajan (1998) provides a comprehensive review of the functions of banks.

20 WP677 Macroeconomic implications of financial imperfections: a survey

be less affected by such lock-in effects because they are less subject to information
asymmetries and do not depend as much on banks. In addition to retained earnings,
they can finance investment by issuing equities and bonds in capital markets or by
raising other forms of external financing.27
Liquidity provision, which takes the form of credit lines and backup facilities
(targeted at firms and including capital market instruments, such as commercial
paper) is another reason for the special role of banks. Indeed, banks play a special
role in maturity transformation and liquidity provision (see Diamond and Dybvig
(1983) and Holmstrm and Tirole (1997)). The traditional function of a bank is to
borrow short (eg collect households deposits) and lend long (eg extend loans to firms
and mortgages to households). In doing so, a bank provides valuable external
financing. Banks also provide liquidity services to firms and households. Through the
raising of wholesale funds, for example, a bank can quickly make liquidity available to
corporations. Although other financial institutions perform similar functions, the
ability of banks to provide liquidity at short notice is not easily matched by other
forms of financial intermediation.
The dependence of firms and households on banks for credit and liquidity has
consequences for the real economy. Since some firms and households cannot easily
substitute for bank loans and liquidity, banks play a central role in the propagation of
economic fluctuations. Real and financial shocks affecting banks ability to lend and
provide liquidity then influence the real sector. Shocks can arise from changes in
regulation, supervision, technology or preferences. For example, a regulatory change
can require banks to keep higher reserves. If they cannot raise funds quickly, banks
may need to adjust their lending, an adjustment that is more likely to affect bank-
dependent borrowers, such as smaller firms and households. When faced with an
adverse shock, a change in lending is also more likely for small banks because of their
limited access to other forms of funding (such as certificates of deposit). Since such
banks are also more likely to have a higher proportion of bank-dependent clients, it
can again disproportionally affect smaller firms and households.
A number of studies have formally analysed the possible general equilibrium
effects of the special role of banks. In Diamond and Rajan (2005), banks create value
added because they have superior skills in assessing entrepreneurs collateral and
commit to using those skills on behalf of investors by issuing demand deposits.28
Negative shocks can undermine this role, shrinking the common pool of liquidity and
thereby creating spill-overs to other banks and exacerbating overall liquidity
shortages. The interbank market, in particular the possibility that it may freeze, is
crucial to their model. Other research develops models that also analyse the
occurrence of interbank market freezes and the role of such freezes in inducing credit
crunches (Freixas and Jorge (2008) and Bruche and Suarez (2010)). Diamond and
Rajan (2011) construct a model showing that the possibility of future fire sales means

27
Bernanke and Blinder (1988) provide a stylised discussion of the lending channel using an IS/LM type
framework. Stein (1998) provides a micro-founded adverse selection model of bank asset and
liability management that generates a lending channel. For an early overview of the theory and
empirical evidence relating to the bank lending channel, see Kashyap and Stein (1994).
28
Holmstrm and Tirole (1998) represents the pioneering study of the special role of banks in a general
equilibrium environment. For models that endogenise the superior skills of banks in collecting
entrepreneurs collateral, see Habib and Johnsen (1999) and Araujo and Minetti (2007).

WP677 Macroeconomic implications of financial imperfections: a survey 21

that deep-pocketed investors are willing to buy bank assets only at a low price. With
banks preferring to hold on to their assets, the credit crunch is exacerbated.29
The dependence of firms on bank financing influences how monetary policy is
transmitted to the real economy through the bank lending channel.30 Monetary policy
actions can affect the ability of banks to lend since it influences the supply of funds
that a bank has access to by affecting the availability of deposit funds and its
funding costs more generally and consequently the amount of loans a bank can
make. A monetary contraction, for example will act to increase banks funding costs.
This will then induce banks to reduce their supply of loans. The decline in the supply
of loans, if not offset by firms and households obtaining other forms of financing, in
turn, negatively impacts aggregate output because it constraints households
consumption and (small) firms investment. The bank lending channel can thus
explain why policy rate decisions affect the supply and cost of credit by more than
the sole impact of the policy rate move (see Claessens and Kose (2017) for a
discussion of the interest rate channel).
The credit and liquidity roles of banks also have implications for banks
organisation as well as their regulation and supervision (see BCBS (2016) for a review).
A unique aspect of banks maturity transformation and liquidity provision process is
their use of demand deposits that are redeemable at par and on request.31 This
makes banks vulnerable to liquidity runs (Diamond and Dybvig (1983)). While banks
also have access to wholesale funding, as the GFC has shown, this access can be
subject to sudden withdrawals too (Gertler et al (2016)). These unique credit and
liquidity provision functions and the possibility of runs have implications for the way
banks are organised, governed and treated by the government (including through
regulation and supervision). It also has implications for the provision of public safety
nets and for crisis management.32

29
Gorton and Huang (2004) show how, in an environment in which private investors make inefficient
project choices (eg as they cannot accumulate the liquidity needed to buy the assets of distressed
financial institutions), the government can provide liquidity and help mitigate such inefficient choices.
Lorenzoni (2007) shows that competitive financial contracts can result in excessive borrowing ex ante
and excessive volatility ex post in an economy with financial frictions and hit by aggregate shocks.
30
Early surveys of the literature on the bank lending channel include Bernanke (1993), Bernanke and
Gertler (1995), Cecchetti (1995), Hubbard (1995) and Peek and Rosengren (1995a). As discussed later,
there are also studies highlighting the importance of risk-taking by banks in their lending decisions
(eg Disyatat (2011) and Borio and Zhu (2012)).
31
A number of studies (Calomiris and Kahn (1991), Kashyap et al (2002), Diamond and Rajan (2001) and
Huberman and Repullo (2014)) explain why banks fund themselves with short maturities given those
risks. These models generally rely on the disciplining features of short-term debt and the beneficial
tension between making illiquid loans to borrowers and providing liquidity on demand to depositors.
While other intermediaries, such as money market funds, are also vulnerable to runs, as seen during
the GFC (Schmidt et al (2016) and Covitz et al (2013)), they generally do not lend and take short-term
on-demand deposits at the same time. They are also thought to be less special, in that their
intermediation functions can be more easily replaced, although the GFC raised questions about such
an assumption.
32
Some of these issues are discussed further in Claessens and Kose (2014). Acharya et al (2011a, 2011b)
model freezes in the market for bank assets. In their models, depending on the information
environment and the nature of liquidation costs, small shocks can lead to sudden interruptions in
financial institutions ability to roll over their liabilities. Bank liquidity may also be countercyclical, that
is, inefficiently high during booms but excessively low during crises, making interventions to resolve
banking crises desirable ex post but not ex ante (Farhi and Tirole (2012)). See further Tirole (2011) for
a review of various aspects of illiquidity and Holmstrm and Tirole (2011) for an extensive analysis of
(private and public) forms of liquidity.

22 WP677 Macroeconomic implications of financial imperfections: a survey

B. Bank capital channel

The health of a financial intermediarys balance sheet can influence its lending and
other intermediation activities. Balance sheet positions, especially net worth, matter
for financial intermediaries just as is the case for non-financial corporations. Net
worth has an impact on financial intermediaries access to funds and their liquidity
positions and thereby affects their lending activities. Banks also need to satisfy capital
adequacy requirements (whether market- or regulation-driven). Given the costs
associated with raising new capital quickly on the open market, a banks net worth
depends over the short run on changes in the quality of its loan portfolio and the
value of its other assets, including securities.
Consequently, changes in the value of a banks assets will affect its access to and
cost of funding and its ability to make new loans. A decline in loan quality, for
example, or a fall in the value of tradable assets, can lead to a drop in a banks capital.
This can make its funding more costly or make its capital adequacy requirements
binding, forcing the bank to shrink its loan book. When these shocks take place
simultaneously at many banks, they can lead to systemic consequences, especially
when alternative sources of external financing are limited.
These effects can be a source of aggregate cyclical fluctuations through what has
been called the bank capital channel (Greenwald and Stiglitz (1993); see Borio and
Zhu (2012) for further references). When many banks are affected by the same capital
shock, aggregate effects can occur. For example, during a recession, the quality of
bank loan portfolios tends to weaken, adversely impacting banks balance sheets. In
order to shore up their relative capital positions (as desired by the market or to satisfy
regulatory requirements) but unlikely to be able to raise capital quickly banks may
need to tighten their lending standards and reduce the volume of risky credit they
provide.33 Since borrowers who rely on banks for their external funding needs have a
limited set of alternatives, this can lead to a slowdown in economic activity, or even a
recession, with a higher proportion of non-performing loans and deteriorating bank
balance sheets. The decline in bank lending induced by such a capital crunch can
affect (and interact with) economic activity through various channels (see Bernanke
and Lown (1991), Holmstrm and Tirole (1997), Repullo and Suarez (2000) and Van
den Heuvel (2006, 2008)). With this mechanism, a strong link can arise between bank
capital, the supply of bank financing and macroeconomic outcomes.
The interaction between bank capital and firm liquidity matters in various ways,
especially when firms are locked into credit relationships with banks. Den Haan et al
(2003) and Minetti (2007) show that a capital crunch can induce firms to abandon
high quality projects or break up credit relationships. Thus, a capital crunch depresses
not only the volume of investment but also its average productivity. Chen (2001)
shows that a capital crunch can cause a drop in asset prices (eg real estate), which
can, in turn, have feedback effects, including a contraction in bank capital. Minetti and
Peng (2013) investigate the mechanics of the bank capital channel in an open
economy model (calibrated for Argentina) and show that real interest rate shocks
generate large fluctuations in output and real estate prices.
Some recent studies employing DSGE models help gauge the quantitative
importance of the bank capital channel. Gertler and Kiyotaki (2011, 2015) and Gertler

33
Repullo and Suarez (2013) provide a model in which banks are subject to regulatory capital
requirements and have limited access to equity markets. Gorton and Winton (2017) present a general
equilibrium model to study the private and social costs of bank capital.

WP677 Macroeconomic implications of financial imperfections: a survey 23

and Karadi (2011, 2013) develop models that exhibit moral hazard in the financial
sector and thus provide a role for bank capital. They find that, under reasonable
assumptions about efficiency costs, banks limit their deposit taking in response to a
decline in net worth. These studies also explore how unconventional monetary policy
(UMP) specifically direct intervention in credit markets can attenuate the bank
capital channel. Christiano and Ikeda (2013) show how these and other models with
financial frictions allow for quantitative analyses of the channels by which
unconventional policies can affect financial and economic outcomes in times of
financial stress. They find that the net welfare benefits of such intervention during a
financial crisis is large and increases with the severity of a crisis.34
The bank capital channel also matters for the conduct of monetary policy.
Monetary policy may have a limited impact (including through the bank lending
channel) when shortfalls in bank capital constrain loan supply and already dampen
economic activity. The potency of the bank capital channel also hinges on the degree
to which non-bank financial institutions may be capital-constrained (or otherwise)
themselves and the extent to which firms and households are bank-dependent
(Gilchrist and Zakrajek (2012)). Even well developed and adequately capitalised non-
banks may not be able to offset a decline in banks supply of loans since their
financing can be imperfect substitutes for bank loans. This means that, in practice,
central banks consider the state of all intermediaries balance sheets (even though
they tend to focus on those of banks).

C. Leverage and liquidity channels

Leverage, defined as the ratio of total assets to shareholder equity, has received much
attention recently because of its role in the GFC. Fluctuations in the leverage of
financial institutions (and other agents) relate to changes in asset prices through both
simple accounting and the behaviour of agents. The basic accounting relationship
between movements in asset values and changes in leverage is negative, ie rising
asset prices boosts net worth and thereby makes measured leverage drop, ie leverage
is countercyclical. Similar to the financial accelerator mechanism, this means that
financial institutions and other agents can fund themselves easier in times of rising
asset prices, and consequently lend more to others, even without raising their
leverage.
In practice, as Adrian and Shin (2008) show, leverage is not countercyclical (or
even acyclical), but procyclical, at least for broker-dealers; it increases when asset
prices rise and falls when asset prices decline. And, in financial markets, as
Geanakoplos (2010) shows, margins (or haircuts), which dictate the share of financing
available for a unit of collateral, are procyclical too, ie lower during booms and higher
in busts. While the exact mechanisms remain unclear, many attribute this
procyclicality to perverse incentive structures, incomplete corporate governance
arrangements, herding behaviour and other agency issues (see Borio et al (2001);
Claessens and Kodres (2017)).
As leverage fluctuates, it affects the supply of financing. When leverage is high,
supply can be expected to be more ample since it means that intermediaries face

34
There is a large literature on the effectiveness of UMPs that uses various approaches, see Eggertsson
and Woodford (2003), Krishnamurthy and Vissing-Jorgensen (2011), Farmer (2012), Woodford (2012),
Bauer and Rudebusch (2014), Baumeister and Benati (2013), Swanson and Williams (2014), Arteta et
al (2015, 2016), Farmer and Zabczyk (2016), and Borio and Zabai (2016).

24 WP677 Macroeconomic implications of financial imperfections: a survey

fewer constraints in credit extension. Conversely, when leverage is low, financing
tends to be more constrained. When a number of financial institutions exhibit acylical
or procyclical leverage rather than countercyclical leverage, aggregate financing and
liquidity conditions are affected. This behaviour leads to a feedback effect: stronger
balance sheets fuel greater demand for assets and this, in turn, raises asset prices and
further strengthens balance sheets and demand for assets.
Consequently, since there is more, rather than less as in other markets buying
of an asset when its price rises, leverage does not necessarily decrease during an asset
price boom and can even increase (Drehmann and Juselius (2012) document that,
while in practice increases in market values outstrip debt increases at the aggregate
and sectoral level, there is procyclicality). Conversely, during a bust, the mechanism
works in reverse, balance sheets weaken due to asset price drops, leverage decreases
and pressures arise to curtail the supply of financing. In turn, this leads to additional
declines in asset prices, possibly affecting a broader array of institutions and activities,
further weakening balance sheets and reducing leverage. These reductions in
leverage can also be associated with increases in asset price volatility, which is in part
related to the arrival of adverse information (Fostel and Geanakoplos (2012)). Figures
6A and 6B summarise conceptually the mechanisms and dynamics of the leverage
cycle during upward and downward phases.35
The leverage channel operates in ways that are very similar to the bank capital
channel (see Adrian and Shin (2011a)). The difference is that the aggregate leverage
channel is not limited to banks or related to the special nature of banking. Rather, it
can operate at the level of the overall financial system, when the various actors
(including hedge funds, institutional and other investors) experience limits on their
ability to undertake transactions. It can also affect the so-called shadow banking
system.36
The leverage channel can lead to more pronounced financial and business cycles,
possibly associated with bubbles and other asset price anomalies. Because of the net
worth and other related balance sheet channels, changes in leverage affect asset
prices and influence the availability of external financing for all types of borrower. In
other words, the degree of leverage becomes an indicator of the buoyancy of external
financing and risk-taking. Through feedback effects, such as changes in asset prices,
the leverage channel can then lead to stronger two-way linkages between the real
and financial sectors. The leverage channel is also closely related to the overall state

35
The leverage cycle can relate to the presence of asset price bubbles, which can be rational or
irrational. Either type can be welfare enhancing or reducing (see further Claessens and Kose (2017)
on asset bubbles). Nuo and Thomas (2017) document that leverage has contributed more than
equity to fluctuations in total assets and that it is positively correlated with assets and GDP but
negatively correlated with equity (see also Halling et al (2016)). He and Krishnamurthy (2013) develop
a model of financial intermediaries to study the linkage between risk premia and leverage.
36
See Adrian and Ashcraft (2016) for an overview of the shadow banking system, its growth and
functioning; Claessens et al (2012b) for a review of the functions performed by shadow banking
systems; Gennaioli et al (2013), Gertler et al (2016) and Begenau and Landvoigt (2017) for analytical
models of shadow banking; and Gorton and Ordoez (2013) on how an economy can become fragile
if it relies extensively on privately-produced safe assets, such as those generated by shadow banking.
See further Gorton (2016) and Golec and Perotti (2017) for reviews of the literature on safe assets
with a domestic focus and Gourinchas and Rey (2016) for an analysis of the role and effects of safe
assets globally.

WP677 Macroeconomic implications of financial imperfections: a survey 25

of liquidity, with asset prices possibly deviating from fundamentals over the
leverage cycle (see Shleifer and Vishny (1997) and further Appendix III).37
Recent studies examine the interaction between leverage and boom-bust cycles
through the lens of externalities. Lorenzoni (2008) and Jeanne and Korinek (2010)
model how firms that set leverage during booms do not account for the impact that
their leverage has on the price of collateral assets during busts (see also Dvilla and
Korinek (2017)). Such externalities can, in turn, lead to excess leverage. Other studies
emphasise the role of strategic interactions and complementarities among banks in
pursing collectively risky strategies ex ante (Farhi and Tirole (2012)) and inducing
credit crunches ex post (Rajan (1994) and Gorton and He (2008)).38

6. Evidence relating to the supply side channels

The supply side of finance can have a significant influence on macroeconomic

outcomes through various mechanisms. Empirical evidence suggests that the
behaviour of financial institutions can have an impact on the supply of external
financing and overall liquidity. Studies also show that supply side factors can affect
the evolution of asset prices, with the potential for virtuous and vicious feedback
loops between real and financial markets. In addition, recent research documents that
the supply side can influence macroeconomic outcomes through deleveraging and
liquidity hoarding, especially during periods of financial stress. While it is hard to
separate empirically the roles of different channels liquidity shortfalls, for example,
are often related to adverse shocks to capitalisation this section attempts to survey
the empirical literature relating to these three channels.

A. Bank lending channel

The bank lending channel has been extensively studied empirically, at least as regards
the effect of changes in bank liquidity conditions. There is intense debate about
whether this channel can be identified with macroeconomic data given the difficulty
of separating factors driving demand from those driving supply. Some studies look
at credit market indicators, such as the ratio between bank lending and commercial
paper, showing that tighter monetary policy leads to a decline of the ratio (Kashyap
et al (1993) and Ludvigson (1998)). Oliner and Rudebusch (1996) argue that a change
in the mix of finance can capture the bigger decline in the amount of credit granted
to small firms compared with large firms. Others question the potency of the bank
lending channel in relation to monetary policy, especially for the United States. Some
studies argue that since banks can accumulate deposits by issuing money market

37
Bruno and Shin (2015) study the dynamics linking monetary policy and bank leverage. They construct
a model of the risk-taking channel of monetary policy in an international context. The model rests on
a feedback loop between global banks increased leverage and capital flows amid currency
appreciation for capital recipient economies. It shows that adjustments to leverage act as a linchpin
between fluctuations in risk-taking and monetary transmission.
38
Other research aimed at understanding how externalities can carry the seeds of ensuing busts
includes DellAriccia and Marquez (2006) who show how lending standards tend to weaken during
booms as adverse selection is less severe and lenders find it optimal to weaken screening and lending
standards (with the objective of trading quality for market share). This leads to deteriorating
portfolios, lower profits and a higher probability of a downward correction.

26 WP677 Macroeconomic implications of financial imperfections: a survey

liabilities, such as certificates of deposits, monetary policy has a limited impact on
bank lending (see Romer and Romer (1989) and Ramey (1993)). A number of studies,
though, find evidence supporting the relevance of the bank lending channel.39
Other work finds that the bank lending channel plays a role for small banks but
has a limited overall impact. Kashyap and Stein (2000), using US bank data, find the
impact of monetary policy on lending to be stronger for banks with less liquid balance
sheets, with the pattern largely attributable to smaller banks. This evidence supports
the bank lending channel since these banks are likely to have fewer external financing
options. Others question this view (Bernanke (2007)). Given the growing depth and
variety of capital markets, they argue that even small banks have gained access to a
multitude of funding sources in addition to retail deposits. Moreover, even if the bank
lending channel is important for smaller banks, these banks constitute only a minor
share of total US lending. Consistently, Lown and Morgan (2002) report results
suggesting that while bank lending may play an important role in macroeconomic
fluctuations, the magnitude of the bank lending channel for monetary policy changes
may be quite small.
Empirical evidence also suggests that the importance of the transmission
channels varies by type of loans and changes over time. Recent studies of the bank
lending channel attempt to establish which types of bank loan are more likely to be
affected by nominal or real shocks. Den Haan et al (2007), employing a reduced-form
VAR model to identify monetary policy shocks, find that after a monetary tightening,
real estate and consumer loans decline sharply while commercial and industrial (C&I)
loans respond positively and often significantly. By contrast, after a non-monetary
negative shock, C&I loans decline sharply, while real estate and consumer loans
display no decrease. Boivin et al (2011) report that US transmission channels have
evolved over time due to structural changes in the economy, particularly in credit
markets, and changes in the relationship between monetary policy and expectations
formation. As a consequence, monetary policy innovations have had a more muted
effect on real activity and inflation in recent decades relative to before 1980.
The potency of this channel also varies across countries and appears to be more
influential in bank-dominated systems. In market-based systems, such as those of the
United States and the United Kingdom, where the role of capital markets is relatively
important, firms and households enjoy a variety of external financing alternatives
whereas in bank-based systems, such as those of Germany and Japan, fewer options
exist. This implies that the bank lending channel is expected to be more influential.
Evidence from outside the United States appears indeed to be more clearly
supportive of the bank lending channel. Research relating to some European
countries show that banks play a more prominent role in financial intermediation (see
Ehrmann et al (2003) and Iacoviello and Minetti (2008)). Jimnez et al (2012) use
Spanish data on loan applications and loans granted and find that tighter monetary
conditions and worse economic conditions weaken loan extension (especially to
firms). This is also the case for lending from banks with lower capital or liquidity ratios.
Their results suggest that firms cannot offset the impact of credit restrictions by
simply switching to other banks (or other forms of financing). The channel might be
weakening over time though, as many financial systems have become more market-
based (Altunbas et al (2010), Claessens (2016)).

39
See Gertler and Gilchrist (1993, 1994), Friedman and Kuttner (1993), Kashyap and Stein (1995), Peek
and Rosengren (1995b) and Kakes and Sturm (2002).

WP677 Macroeconomic implications of financial imperfections: a survey 27

B. Bank capital channel

A number of studies find empirical support for the bank capital channel, especially
during periods of substantial capital shortage, leading to so-called credit crunches.
For example, Lown and Morgan (2006) show for the United States that surveys of
senior loan officers, which partly reflect supply conditions, provide significant
explanatory power for US real activity. De Bondt et al (2010) show how similar lending
surveys, especially those relating to enterprises, are a significant leading indicator of
bank credit and real GDP growth in the euro area. Some studies report that credit
losses at commercial banks had some, albeit not large, regional effects on the US
recovery from the 199091 recession (Bernanke and Lown (1991), Hancock and
Wilcox (1993, 1994), Berger and Udell (1994) and Peek and Rosengren (1994)).40 These
studies found multipliers, that is the effect of a 1% change in bank capital on the
percent change in lending, ranged from 1.5 to 2.7. Ashcraft (2006) also found some
small effects of variations in commercial bank loans on real activity in normal times.
Gambacorta and Marques-Ibanez (2011) show that weaker banks in the United States
and Europe restricted loan supply more strongly during the GFC than other banks.
Other studies document varying effects. Bayoumi and Melander (2008) employ a
VAR model and report that an exogenous fall in the bank capital/asset ratio of one
percentage point reduces real US GDP by some 1.5% through weaker credit
availability. Moreover, an exogenous fall in demand of 1% of GDP is gradually
magnified to about 2% through financial feedback effects. Greenlaw et al (2008)
regress the log difference of GDP on the lagged four quarter (log) change of domestic
non-financial debt, using as instruments TED spreads and lending standards. They
find a change in credit growth of 1% to affect real GDP growth by about 0.34% in the
short run and 0.47% in the long run. By contrast, Berrospide and Edge (2010), who
update studies from the early 1990s using panel regression techniques, find a modest
effect on lending: capital shortfalls affect the extension of new loans with a range of
0.7% to 1.2% and not significant changes in GDP growth (however, in a VAR setting
they do find bank capital shocks to affect GDP growth up to 2.75%). Francis and
Osborne (2010) also report a smaller effect for UK banks.
Effects can vary by bank capitalisation and by the state of the business/financial
cycles. Bernanke (1992) and Meh and Moran (2010) find that the health of banks plays
an important role during recessions and subsequent recoveries because bank capital
can (or cannot) cushion shocks (see also Berger and Bouwman (2013)). Other studies
also find a greater role for bank capital during periods of significant credit losses or
outright shortages of bank capital. Some report that during such periods, weakly
capitalised banks limit their lending much more than highly capitalised banks (Peek
and Rosengren (1995b) and Woo (2003)). In a related paper, Ashcraft (2005) finds,
however, that it is the closure of commercial banks rather than shocks to their capital
base that leads to large and persistent negative effects on real output. He reports a
decline in real income growth of about 3% to 6% in counties where subsidiaries of
failed US banks are located.
Sectoral and event-based studies provide more direct (and sometimes clearer
causal) evidence linking bank capital to economic fluctuations. Calomiris and Mason
(2004) find that bank loan supply shocks have an impact on local area income over

40
Hancock and Wilcox (1994) investigate the impact of the bank capital channel on the US housing
market and find significant effects of the early 1990s capital crunch on commercial and residential
real estate activity.

28 WP677 Macroeconomic implications of financial imperfections: a survey

the 193032 period, using as instrument variables measured at the end of 1929
(before the Great Depression produced changes in bank loan foreclosures and net
worth). Peek and Rosengren (1997, 2000) find a response of up to 3% in semiannual
lending growth by Japanese branches in the United States in response to a decline of
one percentage point in the capital of parent banks, which, in turn, has consequences
for real activity. Since they also use instrumental variables for lending (asset quality
and bank capitalisation of Japanese parent banks as well as changes in land prices in
Japan), they can claim evidence of causality (see also Haltenhof et al (2014)).
Firm-focused and other microeconomic research also lends support to the
important role played by bank capital. In particular, loans from banks that have a weak
capital base are more sensitive to changes in market interest rates than loans from
better capitalised banks (Kishan and Opiela (2000, 2006) and Gambacorta (2005)).
Conversely, bank capital matters for the conduct of monetary policy (Gambacorta and
Shin, forthcoming). In addition, evidence suggests an inverse relationship between
bank capital and the interest rate charged on loans, even after accounting for the
characteristics of borrowers, banks and various contract terms (Hubbard et al (2002)).
Using firm-specific data on the use of bank debt and public bond financing from 1990
to 2014, Becker and Ivashina (2014) show that the close link between bank credit
supply and business cycle evolution is driven by external financing/supply effects and
especially impacts small firms. Conversely, Laeven and Valencia (2013) and Giannetti
and Simonov (2013) find important positive effects of bank recapitalisations on the
growth of firms real value added and borrowing.
Some recent studies with DSGE models have incorporated capital shortfall shocks
to the supply of finance. Jermann and Quadrini (2012), after documenting the cyclical
properties of US firms' financial flows, show how adding financial shocks to a model
with standard productivity shocks can much better explain movements in real and
financial variables, including during periods of financial stress. Financial imperfection
arises in their setup from the limited ability of firms to borrow (due to an enforcement
constraint). Gilchrist and Zakrajek (2011) show in a DSGE model how credit spreads
for financial institutions, likely related to their soundness, significantly impact US
business cycles during the period 19852010 (Figure 7).41

C. Leverage and liquidity channels

Financial system leverage is often procyclical. There is much empirical evidence

relating to leverage and liquidity mechanisms during booms, including the recent
ones in advanced countries. During the early to mid-2000s, the rapid increase in asset
prices in the United States and in other advanced countries led to more abundant
liquidity and allowed for greater financial sector leverage. This, in turn, led to a greater
supply of external financing and further asset price increases, creating a virtuous cycle,
with increasing asset prices and higher collateral values. For the United States, Adrian
and Shin (2008, 2011b) show that this procyclical behaviour of leverage was more

41
The potency of the bank capital channel also depends on accounting standards and the recognition
of capital losses. In particular, the speed at which loan losses are recognised in banks balance sheets
and, consequently, their capital positions, determines in part the pace at which banks may amplify
negative aggregate shocks by cutting back on lending. At the same time, the lack of prompt
recognition of loan losses may distort banks incentives, inducing them to direct funds to inefficient
borrowers. Caballero et al (2008), for example, find evidence that the limited recognition of capital
depletion in Japanese banks slowed Japans recovery from the early 1990s recession.

WP677 Macroeconomic implications of financial imperfections: a survey 29

prevalent among broker-dealers, while households, non-financial non-farm firms and
commercial banks exhibited less or no cyclicality (Figure 8).
Some of these effects also operate in an international context. Shin (2012),
Gourinchas (2011) and Rey (2015) highlight how changes in liquidity intermediated
globally by banks (and interacting with global imbalances and monetary policy in key
countries, notably the United States) can lead to more pronounced and synchronised
national cycles, as witnessed very clearly before, during and after the GFC.42
There is also ample evidence pertaining to the leverage cycle during busts, which
relates to the increase in margins (haircuts) charged on collateralised lending. In the
fall of 2008, as the cycle swung down, asset prices declined and financial institutions
incurred large capital losses. Funding and leverage constraints forced institutions to
sell off (securitised) assets. Not just investment banks, but also commercial banks that
relied less on core deposits and equity financing, had to cut back lending as their
funding and balance sheet positions were strained (Cornet et al (2011)). These fire
sales were associated with higher margins (or haircuts). Geanakoplos (2010) shows
that haircuts on repurchase agreements (repos) increased from 10% at the end of
2006 to more than 40% when the GFC started (see also Gorton and Metrick (2010)).
The sharp increase in haircuts meant that banks had less collateral to offer and had
to absorb more losses. In turn, this forced banks and other financial institutions to
shed assets, further depressing prices, which led to even greater capital and funding
problems.43
Variations in the supply of external financing can also show up in the debt and
equity issuance of non-financial firms. Covas and Den Haan (2011) document that
most size-sorted categories of US firms display a procyclical issuance pattern of debt
and equity, with the procyclicality decreasing with firm size.44 Research also reports
that initial public offering (IPO) markets can be hot, with periods of heavy issuance
or cold, with a dearth of offerings (see Ritter (1984)). This cyclicality seems in part
related to the state of investor supply. Helwege and Liang (2004) show that hot
markets are largely driven by greater investor optimism rather than by changes in
adverse selection costs, managerial optimism or technology. More generally, the
supply of external financing, with related effects on asset prices, seems to vary for
reasons that are unrelated to the real economy. While often not explicitly
investigated, some of these variations seem to have large real consequences (see
Titman (2013), for an overview of how various shocks to debt and equity markets and
other market segments can affect real activity, among others, through corporate
investment-related externalities).

42
See also Cerutti et al (2017a) on the role of global factors in driving capital flows and Cerutti et al
(2015) on how dependence on specific lenders and investors can affect countries exposure to such
global factors. See also Cerutti et al (2017b) for a recent empirical assessment. Landau (2013) and
Hartmann (2017) provide general reviews of global and international liquidity, as provided by the
private sector or by central banks, and how it relates to the designs of the international monetary
and financial systems.
43
A fire sale spiral, as first pointed out by Stiglitz (1982) and Geanakoplos and Polemarchakis (1986),
creates a negative externality and a possible rationale for regulation. Because each institution does
not bear the full cost of its own actions, it will not fully take into account the price impact of its own
fire sales on asset prices. See further Brunnermeier and Pedersen (2009), Gorton (2010) and Choi and
Cook (2012) for models of fire sales. Brunnermeier and Oehmke (2013) review the related literature
on bubbles.
44
More generally, heterogeneity among firms (and households) and specific patterns of external
financing are likely to be important factors in explaining why financial frictions can lead to relatively
large effects on business cycles (Zetlin-Jones and Shourideh (2017)).

30 WP677 Macroeconomic implications of financial imperfections: a survey

 The impact of procyclical leverage on the real economy can be especially
perverse in times of stress, when financial institutions and markets cut back on
financing and asset prices drop sharply. Almeida et al (2012) show how the GFC led
to a reduction in investment for firms for which long-term debt happened to mature
in the third quarter of 2007 (of several percentage points relative other firms). Using
a DSGE model, Mendoza (2005) shows that as leverage drops from 15% to 11% during
a crisis, a 2% wealth-neutral shock leads to about a 4% drop in consumption and
investment and a 1.3% decline in output (see also Adrian et al (2012) and Adrian and
Shin (2014)).
These variations seem to relate to countries institutional environment. For
example, countries, with market-based financial systems tend to exhibit greater
cyclicality in leverage. In market-based systems, the effective use of collateralisation
and the development of more sophisticated risk management and information-
sharing mechanisms mean that leverage can be increased with greater ease. In bank-
oriented systems, in contrast, leverage is more restricted, in part due to regulations.
Consequently, leverage and asset price cycles more likely arise in market-based
systems (IMF (2009)). As changes in leverage and liquidity within the financial system
affect the real economy, shocks to asset prices can consequently have a greater real
impact.
Because short-term collateralised borrowing is the chief tool used by financial
institutions to adjust their leverage, the leverage channel relates to (and affects)
monetary policy. Adrian and Shin (2008) show that repos and reverse repos
transactions, in which borrowers provide securities as collateral, are used heavily to
adjust leverage. Since the growth of repo transactions is closely associated with the
ease or restrictiveness of monetary policy, a strong connection arises between
monetary policy and liquidity. When monetary policy is loose (tight), there is more
likely to be rapid (slow) growth in repos and financial market liquidity tends to be
high (low). Furthermore, as Geanakoplos (2003) shows, not only does leverage display
endogenous cycles but the interest rate becomes endogenous. With both leverage
and interest rates adjusting, this can lead to further procyclical supply side behaviour
(see Geanakoplos (2010) for a review).
Both monetary policy and macroeconomic conditions appear to affect the risk
appetite of financial intermediaries and their supply of credit. Adrian et al (2010b)
study the links between the growth of financial intermediaries balance sheets, the
macroeconomic risk premium and output in the United States. The empirical
behaviour of the macroeconomic risk premium tracks closely that of the term spread
of interest rates and of the premium charged to more risky credits. They also develop
a measure of intermediary risk appetite using changes in balance sheet quantities. In
response to shocks to risk appetite, the macroeconomic risk premium and output
exhibit significant and persistent changes. Higher risk appetite is associated with a
decline in the risk premium and a pick up in output (Figure 9).45 Adrian and Duarte
(2016) model how these interactions can make the financial system more vulnerable
to negative shocks and lead to highly nonlinear dynamics that can adversely affect
the real economy (see also Aikman et al (2016) for a review of the various possible

45
See further Adrian et al (2016) on the relevance of leverage for macroeconomic modelling (and
macrofinancial linkages). They show that a parsimonious model using detrended dealer leverage as
a price-of-risk variable performs well in time series and cross-sectional tests for a wide variety of
equity and bond portfolios (at least better than models that use intermediary net worth as a state
variable) and in comparison to benchmark asset pricing models.

WP677 Macroeconomic implications of financial imperfections: a survey 31

links between financial vulnerabilities, monetary policy and macroeconomic
developments).
However, the relationship between the monetary policy stance and risk-taking is
complex. De Nicol et al (2010) model how monetary policy easing can induce greater
risk-taking through a search for yield. At the same time, they show that there can be
another effect at work if financial intermediaries operate with limited liability. In their
model, at least in the short run when bank capital is fixed, high charter-value (well
capitalised) banks increase risk-taking if the policy rate is low and low charter-value
(poorly capitalised) banks do the opposite as they try to preserve their capital. On
balance, the effects of monetary policy on risk-taking depend on intermediaries
degree of limited liability and financial health. Empirical evidence, while still partial,
supports these complex interactions. For example, empirical evidence for the United
States by De Nicol et al (2010) broadly supports the prediction that a low policy rate
is associated with greater risk-taking by banks as the riskiness of their loans is higher
when interest rates are lower (Figure 10).46

7. Aggregate macrofinancial linkages

The previous sections documented that imperfections on the demand and supply
sides of finance could be associated with pronounced fluctuations in the real
economy. Complementary to this literature has been long standing research that
provides important insights into the general patterns of aggregate macrofinancial
linkages (see the overview of this literature in Appendix IV). Since it is hard to identify
the direction of causality between changes in financial markets and fluctuations in
real activity, and whether demand or supply channels are the main factors, many of
these studies have taken a largely agnostic approach.
Until recently, this research programme did not present a comprehensive
perspective on business and financial cycles. This was for at least two major reasons.
First, most studies consider only selected aspects of business and financial cycles. For
example, many examined the implications of booms in asset prices or credit only
rather than considering the full financial cycle. Second, research tended to focus on
case studies or used small country samples. Although the literature on financial crises
has employed broader samples, the identification of crises has often suffered from

46
For the effects of monetary policy on risk-taking, including when interest rates are particularly low,
see further DellAriccia and Marquez (2013), DellAriccia et al (2014), Jimenez et al (2014), Valencia
(2014), Ioannidou et al (2015), and Borio and Hofmann (2017). Posen (2009), Bean et al (2010) and
Bernanke (2010) argue otherwise. Adrian and Shin (2008, 2011a) and Adrian et al (2010a) analyse how
the risk-taking channel works in the United States. Some other recent studies providing further
microeconomic evidence for the presence of the risk-taking channel domestically and internationally
include Maddaloni and Peydro (2011), Altunbas et al (2014), Bruno and Shin (2015, 2017), Morais et
al (2015), DellAriccia et al (2017), and Domanski, Shin and Sushko (2017). See also Rajan (2005) and
Hanson and Stein (2015) for arguments and models linking low interest rates to search-for-yield
motives for investors other than banks. For a review of studies of the effects of low interest rates on
financial institutions' profitability and capitalization and risk-taking, see European Systemic Risk
Board (2016).

32 WP677 Macroeconomic implications of financial imperfections: a survey

analytical drawbacks and the analysis has limited itself to a single phase of the cycle,
the aftermath of a crisis.47
Some recent studies, however, document the major features of macrofinancial
linkages using rich cross-country databases covering a long period of time. In this
section, we present a summary of the findings of this work.48 The section begins with
an overview of the methodology and data sets used in these studies. This is followed
by a discussion of the stylised facts that emerge from the data. The last sub-section
considers the main properties of the linkages between business and financial cycles.
A number of salient facts emerge about the features of business and financial
cycles and their interactions over different phases. First, financial cycles are often
more pronounced than business cycles, with financial downturns deeper and more
intense than recessions. Second, financial cycles can build on each other and become
amplified. For example, credit downturns that overlap with house price busts tend to
be longer and deeper than other credit downturns. Third, financial cycles appear to
play an important role in shaping recessions and recoveries. In particular, recessions
associated with financial disruptions, notably house price busts, are often longer and
deeper than other recessions. Conversely, recoveries associated with rapid growth in
credit and house prices tend to be stronger than other recoveries.

A. Business and financial cycles

A number of methodologies have been developed to characterise business cycles.

The findings reported in this section are based on the classical definition of a
business cycle, which focuses on changes in levels of economic activity. The definition
goes back to the pioneering work of Burns and Mitchell (1946) who laid the
methodological foundations for the analysis of business cycles in the United States.
Moreover, it constitutes the guiding principle of the Business Cycle Dating
Committees of the National Bureau of Economic Research (NBER) and the Centre for
Economic Policy Research (CEPR) in determining the turning points of US and
European business cycles.49

47
Claessens and Kose (2014) review a number of studies that focus specifically on periods of financial
stress and crisis and the behaviour of real and financial variables during such events. Reinhart and
Rogoff (2008, 2009a, 2009b, 2014) review the characteristics of various types of financial crisis for
many countries over a long period. Boissay et al (2016) analyse the links between credit booms,
(interbank) liquidity and banking crises (see also Allen et al (2011)).
48
The notion of financial cycles was empirically documented in early studies for smaller samples of
countries and periods of time, such as Borio et al (1994) and Borio and Lowe (2002), and refined in
subsequent work, including Drehmann et al (2012), Aikman et al (2015) and Juselius and Drehmann
(2015). This section draws on Claessens et al (2009, 2011, 2012a) which provide detailed empirical
analyses of the interactions between business and financial cycles.
49
An alternative methodology would be to consider how economic activity fluctuates around a trend
and then to identify a growth cycle as a deviation from this trend (Stock and Watson (1999)). While
several studies have use detrended series (and their second moments, such as volatility and
correlation) to study the various aspects of cycles, it is well known that the results of these studies
have depended on the choice of detrending methodology (Canova (1998)). The advantage of turning
points identified by using the classical methodology is that they are robust to the inclusion of newly
available data. In other methodologies, the addition of new data can affect the estimated trend and
thus the identification of a growth cycle. Fatas and Mihov (2013) analyse different approaches for the
dating of recoveries using US data. See also Ng and Wright (2013) for a survey of business cycles
facts and methodologies.

WP677 Macroeconomic implications of financial imperfections: a survey 33

 The classical dating methodology distinguishes three phases of cycles:
recessions, expansions and recoveries. It assumes that a recession begins just after
the economy reaches a peak and ends as it reaches a trough. An expansion begins
just after a trough and ends at the next peak. A complete business cycle has two
phases, recession (from peak to trough) and expansion (from trough to peak).
Together with these two phases, recoveries from recessions have been studied. The
recovery phase is the early part of an expansion and is usually defined as the time it
takes for output to return from its lowest point to the level it reached just before the
decline began. An alternative definition considers the increase in output four quarters
after the trough. Given the complementary nature of these two definitions of the
recovery phase, both of them are used here.
Financial cycles are identified by employing the same methodology. However,
different terms are used to describe them: the recovery phase is called an upturn
and the contraction a downturn. These two phases provide rather well defined time
windows for considering the evolution of financial cycles. In what follows, we study
the main features of business and financial cycles, considering, in particular, their
duration, amplitude and synchronisation.50

Business cycles
Recessions can be long, deep and costly. A typical recession lasts close to four
quarters while a recovery last about five quarters (Figure 11).51 The typical decline in
output from peak to trough, the recessions amplitude, is about 3% for the full sample
and the typical cumulative output loss amounts to about 5%. The amplitude of a
recovery, defined as the increase in the first four quarters following the trough, is
typically about 4%. Although most recessions (recoveries) are associated with
moderate declines (increases) in output, there can be much larger changes in activity
as well.
Business cycles in EMEs are more pronounced than those in advanced
economies. In particular, the median decline in output during recessions is much
larger in EMEs (4.9%) than in advanced economies (2.2%) and recoveries in EMEs are
twice as strong as those in advanced countries. In terms of cumulative loss, recessions
in EMEs are almost three times more costly than those in advanced economies. These
findings suggest that macroeconomic developments, policy factors and institutional
characteristics, including possibly the degree of financial frictions, potentially affect
the evolution of business cycles in different countries.
Business cycles are highly synchronised across countries. For some observers, the
global nature of the GFC, during which many economies experienced a recession at
the same time, was surprising. However, this is not so unusual because recessions and

50
The results reported in this section are based on a large database that comprises a total of 44
countries: 21 advanced OECD economies and 23 EMEs. For the former group, the data coverage
ranges from Q1 1960 to Q4 2010 while for the latter it ranges from Q1 1978 to Q4 2010 (because
quarterly data series are less consistently available prior to 1978). In order to study business cycles,
GDP is used because that variable is the best available measure of economic activity. Financial cycles
are studied considering three distinct but interdependent market segments: credit, housing and
equity. See further Claessens et al (2012a).
51
Claessens et al (2012a) identify 243 recessions and 245 recoveries. The number of recessions and
recoveries differs slightly because of the timing of events. There are 804 complete financial cycles
over the period Q1 1960 to Q4 2010. The sample features 253 downturns in credit, 183 in house
prices and 443 in equity prices; and 220, 155 and 429 upturns in credit, house and equity prices,
respectively. Since equity prices are more volatile than credit and house prices, they feature naturally
more often in downturns and upturns than the other financial variables.

34 WP677 Macroeconomic implications of financial imperfections: a survey

recoveries are often synchronised across countries. Recessions in many advanced
economies, for example, were concentrated in four periods over the past 40 years
the mid-1970s, the early 1980s, the early 1990s and 200809 and often coincided
with global shocks, such as increases in oil prices and interest rates (Figure 12). Such
synchronised recessions tend to be deeper than other types of recession.

Financial cycles
Financial cycles are often longer and more pronounced than business cycles, with
financial downturns particularly deeper and longer than recessions. Downturns
(upturns) of financial cycles tend to be longer than recessions (recoveries) (Figures 13
and 14). Episodes of house price downturns, in contrast, persist for about eight
quarters and other financial downturns last around six quarters. A typical financial
downturn corresponds to about a 6% decline in credit, 6%7% fall in house prices
and 30% decline in equity prices. Upturns are often longer than downturns, with the
strength of upturns to differ across financial markets. Equity price upturns are the
sharpest, some 26%. Financial cycles are also more intense than business cycles, ie
financial variables adjust much more quickly than real ones, as shown by their slope
coefficient. These findings are consistent with various studies documenting that asset
prices are more volatile than economic fundamentals (see Shiller (1981, 2003) and
Campbell (2003)).
The main features of financial downturns vary across EMEs and advanced
economies. While not necessarily longer, financial downturns in EMEs are much
sharper than in advanced countries. Credit contractions last about the same in both
groups but are one-third deeper in EMEs. Equity downturns last as long in both
groups but upturns are much shorter in EMEs. Comparisons between mean and
medians show that the distributions of duration and amplitude of the phases of
financial cycles are also more skewed to the right in EMEs than in advanced
economies. These differences indicate that factors possibly related to the presence of
financial frictions could affect financial cycles.
Financial cycles also tend to feed off of each other and become amplified. The
likelihood of a credit downturn (or upturn) taking place goes up substantially if there
is also a disruption (or boom) in house prices. There are also strong interactions
between financial cycles. Credit downturns that overlap with house price busts tend
to be longer and deeper than other credit downturns. Similarly, a typical credit upturn
becomes 30% longer and twice as large when it coincides with a housing boom. This
suggests that feedback effects play a role as disruptions in one market aggravate the
problems in another, probably because of collateral constraints and
complementarities between credit and housing finance. Moreover, globally
synchronised financial downturns are often longer and deeper, especially for credit
and equity markets. During highly synchronised equity market downturns, for
example, prices drop by about 30% compared with some 18% for other downturns.

B. Linkages between business and financial cycles

Recent research using cross-country data has revealed important links between
business and financial cycles. Claessens et al (2012a) use a comprehensive database
for a large sample of advanced economies and EMEs over a long period of time to
provide a broad empirical characterisation of macrofinancial linkages. They report
three main results. First, business cycles are more closely synchronised with credit and
house price cycles than with equity price cycles. Second, financial cycles appear to

WP677 Macroeconomic implications of financial imperfections: a survey 35

play an important role in determining recessions and recoveries and shaping the
features of business cycles more generally. In particular, recessions are more likely to
coincide with financial disruptions while recoveries are more likely to be associated
with booms. Third, recessions associated with some forms of financial disruption,
notably house price busts, are often longer and deeper than other recessions.
Conversely, recoveries associated with rapid growth in credit and house prices tend
to be stronger. These results collectively highlight the importance of macrofinancial
linkages, especially those involving developments in credit and housing markets, for
the real economy.

Synchronisation and likelihood of cycles

Business cycles often move in tandem with financial cycles, especially with credit and
house price cycles. One can study the degree of synchronisation between business
and financial cycles by using the concordance statistic (Table 3).52 Cycles in output
and credit appear to be the most highly synchronised, with a median (mean)
synchronisation of 0.81 (0.78). This means that cycles in output and credit are typically
in the same phase about 80% of the time. The concordance statistic for cycles in
output and house prices, 0.68 (0.64), is lower than that for output and credit but still
slightly higher than that for output and equity prices, 0.58 (0.60). This reinforces the
common finding that developments in credit and housing markets could be key in
driving macrofinancial linkages.
There are also differences in concordance between advanced economies and
EMEs. Advanced economies typically display a higher degree of synchronisation of
output, credit and house prices than EMEs. This may reflect the more developed
nature of advanced country financial markets with the result that fluctuations in credit,
house prices and other financial variables are more important to the real economy. It
may also indicate that EMEs are more often affected by global shocks operation
through international capital flows, including through actions of their residents (see
for example Forbes and Warnock (2012) and Caballero and Simsek (2016)).
The likelihood of recessions and recoveries varies with the presence of financial
disruptions or booms. The unconditional probability of being in a recession or a
recovery in any given quarter is about 19%. However, if there is a financial disruption
episode in the same quarter, the probability of a recession increases substantially, to
35% to 38%. Similarly, if a credit (house price) boom is already underway, the
probability of experiencing a recovery rises to roughly 57% (43%). Rapid growth in
equity prices is, however, not associated with greater likelihood of a recovery in the
real economy.

Interactions between cycles

Recessions accompanied by financial disruptions tend to be longer and deeper than
other recessions. In particular, recessions associated with asset price busts are
significantly longer than recessions without such disruptions (Figure 15). Recessions
with severe asset price busts as well as credit crunches result in significantly larger

52
The concordance statistic provides a measure of the fraction of time that the two series are in the
same phase of their respective cycles. The series are perfectly procyclical (countercyclical) if the
concordance index is equal to unity (zero).

36 WP677 Macroeconomic implications of financial imperfections: a survey

drops in output and, correspondingly, greater cumulative output losses relative to
those without such episodes.53
A recession associated with one type of financial disruption is often accompanied
by broader stress in other financial markets. For example, recessions accompanied by
credit crunches result in a significant decline in credit as well as substantial drops in
house and equity prices. One can also analyse recessions accompanied by
combinations of credit crunches and asset busts. Although the number of such
episodes is small, a recession associated with a credit crunch and an asset price bust
often leads to a larger cumulative output loss than a recession with only a credit
crunch or an asset price bust.
Just as recessions associated with financial disruptions are longer and deeper,
recoveries associated with credit or house price booms are shorter and stronger. With
respect to duration, recoveries coinciding with house price booms tend to be
significantly shorter (Figure 16). Moreover, recoveries associated with credit and
house price booms are often stronger and faster than those without such booms. By
contrast, recoveries combined with booms in equity markets do not appear to be
different from those without such episodes, confirming the somewhat limited role of
equity markets in macrofinancial linkages.
These stylised facts describing the aggregate linkages between business and
financial cycles are also supported by the results of panel regressions incorporating a
wide range of explanatory variables. In particular, changes in house prices tend to
play a critical role in determining the duration and cost of recessions (Claessens et al
(2012a)). The results are also consistent with the findings of recent empirical studies
emphasising the importance of house price dynamics in shaping business cycles
(Cecchetti (2008), Leamer (2007), IMF (2008), and Muellbauer (2007)).54
Why are recessions associated with house price busts more costly? First, housing
represents a large share of wealth for most households and, consequently, price
adjustments affect consumption and output more strongly (Claessens and Kose
(2017)). By contrast, equity ownership is relatively less common and typically more
highly concentrated among wealthy households who likely make much smaller
adjustments to their consumption during the various phases of the financial cycle
(and recessions and recoveries). Housing wealth has indeed been found to have a
larger effect on consumption than equity wealth (Carroll et al (2011)). Second, equity
prices are more volatile than house prices, implying that changes in house prices are
more likely to be (perceived to be) permanent than those of equity prices (Cecchetti
(2008) and Kishor (2007)). With more permanent wealth changes, households adjust
their consumption more strongly when house prices increase (decline), leading to
larger increases (declines) in output during recoveries (recessions) that are associated
with house price booms (busts).

53
For a deeper perspective, it is useful to consider additional measures of credit and asset prices. For
example, some papers (Chari et al (2008) and Cohen-Cole et al (2008)) highlight the importance of
going beyond aggregate measures (for example, by differentiating credit to corporations from credit
to households) to study the dynamics of credit markets. Unfortunately, such disaggregated series are
not available for a large number of countries over long periods.
54
Analytical models also support this notion. Using the financial accelerator mechanism presented in
Section 5, for example, some studies (Aoki et al (2004) and Iacoviello (2005)) use DSGE models to
show specifically how endogenous developments in housing markets can magnify and transmit
various types of shock to the real economy and find quantitatively large effects. Mian and Sufi (2010,
2014) provide empirical evidence at the regional level for the real economy effects of mortgage credit
expansion in the United States.

WP677 Macroeconomic implications of financial imperfections: a survey 37

8. Conclusions

The GFC was a painful reminder of the importance of macrofinancial linkages. These
linkages centre on the two-way interactions between the real economy and the
financial sector. Imperfections in financial markets can intensify these linkages and
lead to gyrations in the financial sector and the real economy. Global dimensions of
these linkages can result in spillovers across borders through both real and financial
channels.
Research on macrofinancial linkages has a long tradition, but has become a
central topic only over the past three decades. This paper reviews this rich literature
and presents a broad perspective on theoretical and empirical work. The survey
considers the two channels the demand and supply sides through which financial
imperfections can affect macroeconomic outcomes. The demand side channel, largely
captured by financial accelerator-type mechanisms, describes how, through changes
in the balance sheets of borrowers, financial markets can amplify macroeconomic
fluctuations. The supply side channel emphasises the importance of changes in
financial intermediaries balance sheets for the availability of external financing and
liquidity, the role of financial markets in the determination of asset prices and the
implications of those factors for the real economy.

A summary

The literature has made significant progress in understanding the demand side of
macrofinancial linkages. Many models now feature amplification mechanisms
operating through the demand side. These models show how a financial accelerator-
type mechanism can lead to the propagation and amplification of small (real or
financial) shocks across the real economy (through their impact on access to finance).
A number of models that incorporate financial accelerator mechanisms show the
importance of changes in asset prices and other financial shocks in driving
movements in borrowers net worth and access to finance, leading to fluctuations in
aggregate activity.
These analytical findings are also supported by empirical studies. In particular,
extensive evidence documents how the state of borrowers balance sheets affects
their access to external finance. Demand side imperfections in financial markets have
been shown to lead to an amplification of shocks (monetary, real and financial)
because changes in the net worth of borrowers affect their access to finance and,
therefore, to consumption, investment and output. Empirical studies confirm that
these imperfections tend to affect small firms and households particularly strongly,
especially during periods of financial stress. Although most findings support the roles
played by financial imperfections, there is nevertheless an ongoing debate about the
quantitative importance of the financial accelerator.
The GFC has shifted attention to the critical role played by amplification channels
operating through the supply side of finance. Earlier theoretical work on the bank
lending channel analysed the possible general equilibrium effects arising from the
special role of banks in financial intermediation. Empirical studies documented how
the dependence of some firms on bank financing influences the transmission of
monetary policy to the real economy. Since the GFC, there has been a broader
recognition that the supply side of finance (beyond the specific role played by banks
for some firms) can be a source of shocks, amplification and propagation.

38 WP677 Macroeconomic implications of financial imperfections: a survey

 This recognition has led to a number of studies on modelling the supply side of
finance. Although the literature is still in its early stages, recent work has analysed the
roles played by bank lending, bank capital and financial markets more generally
inter alia through their impact on asset prices, liquidity and leverage in shaping
macroeconomic outcomes. This work has brought out the critical role importance of
the leverage channel in leading to more pronounced financial and business cycles.
Related, given the importance of banks credit and liquidity provisioning roles, studies
have provided insights into how to consider and adapt banks internal organisation,
and their regulation and supervision in general equilibrium settings.
Recent empirical studies confirm that shocks associated with the supply side of
finance can affect the evolution of external financing and asset prices, with the
potential for feedback loops between real and financial markets. New tests of the
bank lending channel based on variables, like the size of banks, types of loan, and
certain other specific features of the financial system, show its importance as a
channel of monetary transmission. Other work shows that the potency of the bank
capital channel varies over business and financial cycles (especially during credit
crunches). Recent work also examines the procyclical nature of financial system
leverage, asset prices and liquidity, providing evidence relating to their impact on real
aggregates, especially in times of financial stress.
In addition, a number of empirical studies on aggregate macrofinancial linkages
document the importance of developments in financial markets for the real economy.
In particular, cycles in various financial market segments (equity, housing and credit)
appear to play an important role in shaping recessions and recoveries. Recessions
associated with financial disruptions are often longer and deeper than other
recessions while, conversely, recoveries associated with rapid growth in credit and
house prices tend to be relatively stronger.

What next?

The topic of macrofinancial linkages promises to remain an exciting area of research,

given the many open questions and significant policy interest. A list of potential future
areas of research, by no means exhaustive, is provided next.
Data issues. There are large data gaps. The lack of adequate time series data on
important financial and macroeconomic variables has been a severe limitation for
researchers. Although the prices of many traded assets are widely available (including
for equities and bonds), gaps remain with respect to higher frequency and longer-
dated series relating to the housing market and aggregate credit. Comprehensive
cross-country databases pertaining to business and financial cycles have only recently
been constructed. Researchers would also benefit from better access to granular data
on external financing and credit, and on the balance sheets of firms, banks and other
financial intermediaries. Such data are essential to the exploration of the links
between the financial sector and the real economy and to the assessment of the
systemic risks that can arise from these linkages (see the papers collected in
Brunnermeier and Krishnamurthy (2014) on the general data needs required for
research on macrofinancial linkages).
Data deficiencies are especially significant at the international level. There is a
dearth of information at the aggregate and granular levels about bilateral exposures
between two countries as well as between two financial institutions, the cross-
border activities of banks, institutional investors, hedge funds and other market
participants (see further Cerutti et al (2014), Borio (2013), Tarashev et al (2016) and

WP677 Macroeconomic implications of financial imperfections: a survey 39

Heath and Bese Goksu (2017)). Moreover, existing data sources are often not
comparable because they are compiled under different regimes. While some recent
data collection efforts have been underway, such as those under the G20 Data Gap
Initiative (FSB-IMF (2016)), progress in this area has been slow, including on obtaining
data on the worlds largest financial institutions, the so-called global systemically
important financial institutions (G-SIFIs).
Demand side channels. Although research on the demand side channels is
much richer than that on the supply side, many questions remain open. DSGE models,
including those with financial market imperfections and financial accelerator-type
amplification mechanisms, have been widely used by policy institutions. Yet, when
calibrated with reasonable parameters and tested with realistic shocks, the
quantitative importance of the financial accelerator in explaining real activity appears
to be limited. Models still face difficulties in accounting for heterogeneity among
agents and for the asymmetries and non-linearities that arise from macrofinancial
linkages, especially when adverse shocks hit borrowers net worth and curtail their
access to external financing. Little attention has been devoted to the role of the debt
service ratio as leading indicators of household consumption (Juselius and Drehmann
(2015) and Drehmann et al (2017)).55
Some fundamental aspects associated with the demand side channels are still
being debated. For example, questions surrounding the quantitative importance of
financial market imperfections for small firms should be answered, as some argue
that there is little difference between small and large firms. While many empirical
studies find that the effects of financial conditions vary by type of economic agent,
including households, firms, financial intermediaries and sovereign entities, many of
those do not present rigorous tests for specific financial imperfections. To illustrate,
the GFC has highlighted the role of house prices in affecting consumption and
broader macroeconomic outcomes, but the exact channels by which this takes place
are not yet well established. Consequently, the implications of empirical findings for
regulation, institutional reform or other policy design issues require additional work.
Supply side channels. Since the GFC, few question the relevance of supply side
factors for macroeconomic outcomes. That said, the theoretical literature still falls
short of providing realistic models. While some models show how supply side
dynamics can lead to macrofinancial linkages, they are still rudimentary in their
treatment of the financial system. They tend to focus on banks rather than on the
financial sector as a whole. And even when banks are included, their treatment is
highly stylised. For example, many models simply assume the presence of banks, but
do attempt to justify their existence, eg whether banks arise to overcome information
asymmetries or because they are special in other ways.
Models often assume that banks are homogenous while in practice large banks
operate very differently from small ones. There is often no distinction between
liquidity and solvency risks, and the interaction between such risks is not always
explicitly modelled. Moreover, the banks choice of assets, including which sectors
they lend to, is often imposed a priori rather than being endogenously determined.

55
Several surveys discuss advances in the modelling of heterogeneous agents, news shocks, financial
crises, bubbles and systemic risk (Heathcote et al (2009), Lorenzoni (2011, 2014), and Brunnermeier
and Oehmke (2013)). Another strand of the literature uses ad hoc borrowing constraints to model
financial imperfections in environments with a continuum of households (Huggett (1993), Aiyagari
(1994), Krusell and Smith (1998)), which is particularly useful in studying distributional issues. Moll
(2014) studies an environment in which financial frictions lead to misallocation of resources.

40 WP677 Macroeconomic implications of financial imperfections: a survey

Models typically ignore many parts of the financial system (other than banking) and
are unable to account for gross positions or intra-financial system transactions (such
as interbank claims or transactions between banks and capital markets).56
A more realistic representation of the supply side of finance requires richer
models that account for the heterogeneity of banks and capture the behaviour of
other financial intermediaries. It also means modelling how banks, non-bank financial
institutions and markets are linked to each other (such as through shadow banking
activities) as well as how such institutions and markets are linked to the international
financial system. Furthermore, more sophisticated approaches to modelling of the
intricate linkages between financial imperfections, labour markets and real activity are
sorely needed. Any advances in this area would require, among others, overcoming
the general linear structure of DSGE models, which has proved to be a hindrance to
the analysis of financial turmoil given that non-linear effects, such as liquidity
shortages, fire sales and deleveraging, are prevalent.
More empirical work is also needed on the roles of various asset markets,
including credit, housing and equity markets. Empirical studies need to provide a
better understanding of the potential role of supply side channels through the
operations of bank, non-bank financial institutions and financial markets. The roles
played by institutional and other factors (such as benchmark-based compensation
contracts, competition among financial institutions and the states of general liquidity
and capitalisation) in driving the leverage cycle of banks and other financial
institutions are in great part a mystery. The roles of collateral and margin constraints
during boom and fire sale periods need deeper analysis. Interbank markets, especially
during periods of financial turmoil, are surprisingly little analysed. Research also
needs to focus on identifying the best measures (price, quantity or a combination of
both) that characterise the linkages between supply side financial market
imperfections and macroeconomic outcomes. This could also help answer some basic
questions, such as which quantitative variables are better in predicting fluctuations in
macrofinancial linkages and systemic risk.
Global implications of financial imperfections. The rapid spread of disruptions
from US financial markets to other countries during the GFC has led to a number of
questions about the cross-border transmission of real and financial shocks.
Understanding the reasons for the collapse of global trade and financial flows during
the height of the crisis and the implications of this for the real sector is likely to be a
significant area of research. More work on the international spillovers of financial
shocks, the roles played by multinational financial intermediaries and the
synchronisation of business and financial cycles is also needed. On the theory front,
open economy models could do a better job in assessing the cross-border
implications of financial imperfections, considering the influence of both demand and
supply side channels.
Policy challenges. As noted in the introduction, the GFC has generated an
intense debate in the economics profession about the state of research on the
importance of financial market imperfections in explaining macroeconomic
fluctuations. Some argue that the crisis showed that the profession had not paid
sufficient attention to these linkages. Others claim that these linkages had been

56
See Acemoglu et al (2015) and Boissay et al (2016) for analysis focusing on effects of networks and
links among financial institutions, including through the interbank market. See Freixas et al (2011) for
analysis on monetary and prudential policies in the interbank markets. See Dou et al (2017) for a
review of the role of macrofinancial interactions in dynamics models used at central banks.

WP677 Macroeconomic implications of financial imperfections: a survey 41

recognised for a long time and that substantial progress had been made in
understanding them. Our survey shows that the profession has indeed produced
valuable research spanning a wide spectrum of issues. However, challenges remain,
notably with respect to how the findings may best translate into policy. More research
is required in order to arrive at a solid understanding of the issues and help guide
policy decisions.57
Policy challenges stemming from the GFC require a much better integration of
core research with empirical findings and the operational aspects of policy design.
Since the GFC, many new regulations have been adopted (FSB (2017)). Questions
remain, however, about what may be the optimal design of the financial system
(Claessens (2016)). And related to this is the preferred design of the regulatory
infrastructure, an issue that is not often formally addressed when adopting new
regulations (see Claessens and Kodres (2017) for a review). One set of questions, for
example, relates to the best configuration of capital adequacy and liquidity
requirements for commercial banks.58 Other questions focus on how to best monitor
and, perhaps, regulate the shadow banking system (see Claessens et al (2015) for a
collection of papers on the subject).
The interactions between monetary policy and financial imperfections also
require work. For example, the conduct monetary policy in the presence of financial
frictions and the zero lower bound demands further analysis (eg Brunnermeier and
Sannikov (2016) and Rogoff (2017)). A better assessment of the role played by
monetary policy during a liquidity trap and the implications of UMPs are of strong
policy interest (eg Korinek and Simsek (2016) and Del Negro et al (2017)). Related is
the need for a better understanding of the role of financial factors in determining the
real interest rate, including in the context of a possible global secular stagnation
scenario. Some work on this has pointed at debt overhang in driving low interest
rates, including for open economies.59 While recent research has advanced our
understanding of the basic issues, more work is warranted.
A broad area of further research involves the design of macroprudential policies
(see Claessens (2015) and Adrian (2017) for analytical reviews and IMF-FSB-BIS (2016)
for a review of policies). Following initial work at the BIS (see Galati and Moessner
(2013)), there is now a widespread recognition of the importance of imperfections,
externalities and specific market features as motivating factors for macroprudential
policy.60 While progress is being made, the conceptual frameworks underpinning

57
Bernanke (2010), Blanchard et al (2010, 2013), Caballero (2010), Kocherlakota (2010), Woodford
(2010), Turner (2012), Claessens et al (2014), Kose and Terrones (2015), Blanchard and Summers
(2017) and several papers in the Fall 2010 issue of the Journal of Economic Perspectives look at how
the GFC may have influenced research, including the literature on the intersection between
macroeconomics and finance. Blanchard et al (2012, 2016) and Akerlof et al (2014) discuss how
economic policies have been reassessed by economists since the GFC. Gopinath (2017) provides a
review of the recent macroeconomic policy-related work in international economics.
58
See, for example, Dewatripont and Tirole (2012), Stein (2012), Goodhart et al (2013), Admati and
Hellwig (2014), Fender and Lewrick (2016), Kara and Ozsoy (2016) and Kashyap et al (2017).
59
See Eggertsson and Krugman (2012) and Eggertsson et al (2016); see also Borio (2017) on the possible
role of monetary policy in affecting the real interest rate.
60
See the early contributions by Crockett (2000), Borio (2003) and Knight (2006) (see also Clement
(2010)). Subsequently, the BIS and other related entities have conducted much research on various
aspects of macroprudential policy. The Committee on the Global Financial System (CGFS), for
example, reported on operational aspects in 2010, 2011 and 2012 (CGFS (2010, 2012) and CGSG
(2011)). An influential, post-GFC take was Brunnermeier et al (2009). Recent work on macroprudential

42 WP677 Macroeconomic implications of financial imperfections: a survey

proposals for specific policies still require much more work, particularly given the
non-linearities involved (see Mendoza (2016)).
Furthermore, the empirical work to date has often used aggregate data, which
does not always allow for specific policy recommendations incorporating all relevant
trade-offs, notably the costs of macroprudential policies and the possibility of
regulatory adaption and arbitrage. For example, empirical studies on how specific
macroprudential policy tools, such as borrowing limits on housing finance or
countercyclical capital buffers, may affect banks overall risk-taking have been limited
and their results are still preliminary (see Acharya et al (2017) and Auer and Ongena
(2017) for early work). More research could help in guiding the design of
macroprudential policies.
There is also a vigorous debate on the effectiveness of macroprudential policies
and other regulatory measures to cope with large fluctuations in asset and credit
markets, and whether monetary policy is perhaps also needed, as reflected in the
contrasting views on the costs and benefits of leaning against the wind (compare
Svensson (2016, 2017) and Adrian and Liang (2016)). More research on the linkages
between monetary policy and asset price dynamics, and related financial systemic
risks, is thus definitely needed. The global dimension of financial cycles is also an area
that is subject to debate, with varying views of the quantitative importance of the
global financial cycle (Rey (2015), Cerutti et al (2017b) and Ha et al (2017)). Related,
more work on the global consequences of monetary policies is needed to help guide
the design of such policies, including for small open economies, which often use a
combination of exchange rate, foreign exchange reserves, macroprudential and
capital flow management policies.61 Future research also needs to focus on the
interaction between financial policies and fiscal policy.

policy includes Bianchi et al (2012, 2016), Farhi and Werning (2016) and Bianchi and Mendoza
(forthcoming).
61
See Jeanne (2014, 2016), Pereira da Silva (2016) and Agnor et al (2017).

WP677 Macroeconomic implications of financial imperfections: a survey 43

Appendix I. Research on macrofinancial linkages: a brief
history

Research on macrofinancial linkages has a long history. The Great Depression created
much interest in such linkages but this interest faded away over the next few decades.
There has been a resurgence of interest since the early 1980s, with the introduction
of rigorous general equilibrium models that have provided rich theoretical insights.
Such insights have been complemented by the results of empirical studies at the
macroeconomic and microeconomic levels. This appendix provides a brief review of
the evolution of this literature (see Figure A1 for a schematic presentation).
The study of credit cycles, which precedes that of business cycles, goes back at
least to Mills (1867) but, as just mentioned, the Great Depression was the primary
motivation for the early qualitative work on the role of financial factors in shaping
macroeconomic outcomes. Fisher (1933) provided a descriptive account of the
relationship between the high leverage of borrowers and the severity of the downturn
during the Great Depression. His debt-deflation mechanism was the first elegant
narrative showing how a decline in net worth induced by a drop in prices, ie deflation,
could lead borrowers to reduce their spending and investment, which, in turn, could
cause activity to contract and result in a vicious cycle of falling output and deflation.
Haberler (1937) reviewed early studies of business cycle fluctuations, focusing on the
so-called monetary, over-investment, under-consumption, and psychological
theories.
The literature that followed, however, turned its attention to the role of money,
rather than credit, as the critical financial variable. While Keynes (1936) also brought
out financial developments, eg as he discussed how the confidence of borrowers and
lenders could changes in ways nor easily explained with economic models (animal
spirits). He focussed more on the importance of money for the real economy. Armed
with insights from the liquidity preference hypothesis, the early Keynesian models
paid special attention to the mechanisms linking money to real activity, including the
multiplier mechanism and the role of fiscal policy (Hicks (1937), Modigliani (1944) and
Tobin (1958)). The monetarist school, on the other hand, insisted on the importance
of monetary rather than real factors (Friedman (1956), Friedman and Schwartz (1963)
and Tobin (1969)).
Later studies documented the critical role of financial intermediation in economic
development and macroeconomic fluctuations but these did not lead to a
fundamental shift in thinking. Gurley and Shaw (1955) showed that economic
development and financial sophistication go hand in hand. Others, including
Cameron (1961), Shaw (1973) and McKinnon (1973), also highlighted the importance
of finance for development, contrasting among others the East Asian and Latin
American experiences. Their main argument was that a countrys overall financial
capacity, ie its financial systems ability to provide credit, was more relevant to the
real economy than money. In the early stages of financial development, money could
be important but it becomes less relevant in more developed systems, particularly as
a measure of credit availability. Instead, banks increasingly use non-deposit sources
of funding and non-bank intermediaries provide alternative sources of financing. This
view, while also advanced by many financial historians (eg Goldsmith (1969)), did not
prevail and research on finance and macroeconomics followed separate paths.
New analytical insights were gained during the 1950s with the applications of
portfolio theory. A major breakthrough was the introduction of portfolio theory by

44 WP677 Macroeconomic implications of financial imperfections: a survey

Markowitz (1952), which inspired a large literature. However, it did not pay much
attention to financial frictions. Tobin (1969) improved the understanding of how asset
valuation, a key area of finance, affects investment. Through his concept of the q
valuation ratio, he established a direct relationship between developments in equity
markets and investment. With few exceptions, however, these contributions paid little
attention to the various forms of financial intermediation or to their imperfections.
The separation of finance and macroeconomics became increasingly pronounced
after the introduction of the irrelevance of financing structure theorem of
Modigliani and Miller (1958). The theorem provided a case for the independence of
firm valuation and investment from financing structures and suggested more
generally a decoupling of real economic activity from financial intermediation. A
number of developments accelerated this separation. First, the Arrow-Debreu
theorem (which shows that, in the presence of contingent claims that span every
possible state of the world, allowing agents to insure against any event, it becomes
much easier for agents to make choices), upon which Modigliani and Miller based
their work. Second the methodological advances of the 1970s, notably with respect
to asset pricing (Merton (1973)) and derivatives modelling (Black and Scholes (1973)).
And, lastly, the emergence of the rational expectations paradigm (see below).
Together they gave traction to the concept of efficient financial markets (Fama
(1970, 1991)). This work put less emphasis on the role of banks as markets were
thought to be able to efficiently provide most financial services (notably, of the twenty
chapters in the Handbook of the Economics of Finance (2003), only one
(Constantinides et al (2003)) was on financial intermediation).
The growing popularity of work based on the assumption of efficient and
frictionless financial markets coincided with a shift in the macroeconomic literature.
Researchers focused increasingly on the real side of the economy, using models with
little role for financial variables (see Chari and Kehoe (2006) for a review). The
precursor in macroeconomics to efficient financial markets was the rational
expectations paradigm (Muth (1961) and Lucas (1976)), which assumes agent make
choices consistent with models involving uncertainty and full information. It further
reinforced the drive for quantitative models with fully optimising agents acting mostly
in frictionless worlds. Although the widely used vector autoregression (VAR) models,
first proposed by Sims (1972), partially shifted attention back to money as a key
financial aggregate, at least in applied policy work, the broader literature
concentrated mainly on real variables (Lucas (1975) and Kydland and Prescott (1982)).
Research on monetary policy stressed the importance of central bank independence
(Sargent and Wallace (1976)) and focused on inflation targeting (Bernanke and
Mishkin (1997) and Clarida et al (1999)).
Contributions to the macroeconomic literature over this period paid little
attention to financial intermediation. The class of so-called New Keynesian
macroeconomic models (ie using microeconomic foundations that assume some
price or wage "stickiness", leading to a slow adjustment of real variables to shocks)
that emerged included various real and nominal frictions but did not properly account
for financial imperfections (Smets and Wouters (2003)). Indeed, Gertler (1988) began
his overview of the subject with a powerful observation: most of macroeconomic
theory presumes that the financial system functions smoothly and smoothly enough to
justify abstracting from financial considerations. This dictum applies to modern theory
(see also Blanchard (1990)).
Some authors paid attention to the banking system, but mostly because it issued
money, not because of its financial intermediation function. Bank runs (Diamond and

WP677 Macroeconomic implications of financial imperfections: a survey 45

Dybvig (1983)) and asset price bubbles (Blanchard and Watson (1982)) were studied
but these did not become central to macroeconomic research. Minsky (1982, 1986)
drew attention to the endogenous build-up of financial vulnerabilities. However, his
work was largely qualitative and remained peripheral (see also Kindleberger (1996)
and Borio and Lowe (2004)). Overall, the lack of interest in banking and finance seems
to have been related to the less volatile nature of business cycle, especially after the
mid-1980s, the era of the Great Moderation (Blanchard (2009)).
That said, interest in macrofinancial linkages slowly picked up in the early 1970s.
On the microeconomic theory front, research on the effects of asymmetric
information and incentives, building on earlier work, notably Akerlof (1970), provided
new insights. Many authors analysed the nature of optimal contracts with
unobservable information, principal-agent problems or other imperfections (Jensen
and Meckling (1976), Townsend (1979), Stiglitz and Weiss (1981), Williamson (1987));
including specifically for financial institutions (Gale and Hellwig (1985), Calomiris and
Kahn (1991) and Holmstrm and Tirole (1997)). Following Shiller (1981), some
researchers focused on deviations from the efficient markets hypothesis. Fazzari et al
(1988) documented how corporate cash flows correlate with investment decisions,
contradicting the q theory and providing evidence of financial imperfections.
Following work by pioneers in behavioural economics (eg Kahneman and Tversky
(1979)), Thaler in a series of influential papers (eg De Bondt and Thaler (1985)) started
the field of behavioural finance. This branch analyses how investor psychology, in
conjunction with limits to arbitrage, can affect prices in financial markets. Building on
Thalers insights, Shleifer and Vishny (1997), drew attention to the limits to arbitrage
in asset markets. Many contributions since then have showed how individuals
behaviour deviates from the standard paradigm (see Barberis and Thaler (2003),
Thaler (2005) and Hirshleifer (2015) for reviews).
New empirical work also studied the importance of macrofinancial linkages.
Notably, Mishkin (1978) and Bernanke (1983) documented the critical role of financial
factors in explaining the severity and persistence of the Great Depression. Mishkin
argued that household balance sheet positions significantly impact consumer
demand and Bernanke showed that a worsening of bank and corporate balance sheet
positions leads to a more severe debt crisis. Other empirical studies put greater
emphasis on the role of financial markets and institutions in shaping aggregate
economic outcomes (Eckstein and Sinai (1986) and Brunner and Meltzer (1988)).
Bernanke and Blinder (1988), Kashyap et al (1993) and others demonstrated the
importance of the bank lending channel. A number of studies considered specific
episodes of credit crunches in the United States and other countries and analysed the
role of financial institutions in driving business cycles (Sinai (1992)). Importantly, with
better data, the (causal) links between financial development and longer-term
macroeconomic outcomes were documented (Goldsmith (1987), Fry (1988) and King
and Levine (1993)).
Over the past three decades, more rigorous analytical models have investigated
the linkages between financial markets and the real economy. Some of these focus
on amplification mechanisms, collectively known as the financial accelerator, which
operates through the demand side of financial transactions (Bernanke and Gertler
(1989), Carlstrom and Fuerst (1997), Kiyotaki and Moore (1997) and Bernanke et al
(1999)). These models show how accelerator effects arise when small shocks, real or
financial, are propagated and amplified across the real economy as they lead to
changes in access to finance. More recent theoretical and empirical research has
illustrated the importance of amplification channels operating on the supply side,

46 WP677 Macroeconomic implications of financial imperfections: a survey

including through financial institutions and markets (Brunnermeier and Pedersen
(2009), Adrian and Shin (2008) and Geanakoplos (2008)). New models that include
both demand and supply types of macrofinancial linkage (Brunnermeier and Sannikov
(2014), Gertler and Kiyotaki (2011), Williamson (2012) and Dvila and Korinek (2017))
have been developed.

WP677 Macroeconomic implications of financial imperfections: a survey 47

 Figure A1. Evolution of research on macrofinancial linkages
48

Macroeconomics Finance
Studies Approach Approach Studies

Mills (1867)
Fisher (`33) Qualitative discussions of macrofinancial linkages
Haberler (`37)
Keynes (`36) Narratives of debt-deflation
Marschak (`38)
WP677 Macroeconomic implications of financial imperfections: a survey

Gurley-Shaw (`55)
Hicks (`37) Financial
Goldsmith (`69)
Modigliani (`44) Keynesian approach intermediation
Shaw (`73)
Tobin (`58) Financial repression
Cameron (`67)

Portfolio theory
Markowitz (`52)
Friedman-Schwartz Capital structure
Monetarist approach Modigliani-Miller (`58)
(`63) irrelevance
Tobin (`69)
Q ratio

Sims (`72, `80) VARs

Lucas (`76) Lucas critique
Efficient markets Fama (`70)
Sargent-Wallace (`75) Monetary arithmetic
Asset pricing Merton (`73)
Sargent (`81) Rational expectations
Derivatives-arbitrage Black-Scholes (`73)
Kydland-Prescott (`82) Real business cycle
King-Plosser-Rebelo (`88) models
 Macroeconomics Finance
Studies Approach Approach Studies

Mishkin (`78); Minsky (`82)

Bernanke (`83)
Lessons from the Information Akerlof (`70)
Abel-Blanchard (`86)
WP677 Macroeconomic implications of financial imperfections: a survey

Goldsmith (`87) Great Depression asymmetry Jensen-Meckling (`76)

Fry (`88) Rational bubbles Agency issues Townsend (`79)
Mankiw and Romer (`91) Role of money and Enforcement Stiglitz-Weiss (`81)
King-Levine (`93) banks for economy Optimal contracts
Kindleberger (`96)

Bernanke-Blinder (`88) Diamond-Dybvig (`83)

Corporate finance
Bernanke-Gertler (`89) Financial accelerator Williamson (`88)
Financial
Kashyap-Stein-Wilcox (93) theories Calomiris-Kahn (`91)
intermediation Holmstrm-Tirole
Carlstrom-Fuerst (`97) Bank lending channel
Private public liquidity (`97, `98)
Kiyotaki-Moore (`97)

Kahneman-Tversky (`79)
Brunner-Meltzer (`88) Bubbles, crises Shiller (`81)
New Keynesian DSGE
Bernanke-Gertler-Gilchrist (`99) Market imperfections Minsky (`86)
models
Smets-Wouters (`03) Limits of arbitrage Fazzari-Hubbard-Petersen (`88)
Inflation targeting Shleifer-Vishny (`97)
Woodford (`03) Behavioural finance
Thaler (`05)

Financial frictions in Leverage and supply Adrian-Shin (`08)

Mendoza (`10); Woodford (`10) Geanakoplos (`08)
DSGE models Leverage cycles
Gertler-Kiyotaki (`11)
Models with money, Liquidity, asset prices, Brunnermeier-Pedersen (`09)
Brunnermeier-Sannikov (`16)
liquidity, leverage fire sales He-Krishnamurthy (`13)

Notes: This diagram presents a rough representation of the evolution of research on macrofinancial linkages. Early interest in such linkages was triggered by the Great Depression. However, it
remained largely qualitative. Although research became more analytical over time, it moved away from the analysis of financial market imperfections, especially over the period 195080. Since then,
the literature has made significant progress in capturing the effects of microeconomic imperfections. More recently, it has combined theoretical insights from macroeconomics and finance in
general equilibrium models. It has also produced many empirical studies at the micro- and macroeconomic levels. This diagram includes only a select set of studies because of space constraints.
We summarize many other studies in the main text.
49
Appendix II. Financial accelerator mechanisms

Although there are many variants of the financial accelerator mechanism, they tend
to describe similar channels of transmission and propagation. A number of theoretical
studies show that the mechanism can play an important role in accentuating
macroeconomic fluctuations. This appendix presents a summary of the various
mechanisms found in the literature (see Quadrini (2011) for a systematic analytical
review of the causes of financial frictions and the types of accelerator model; Gerke
et al (2013) also compare the various models that feature a financial accelerator
mechanism and collateral constraints).
One mechanism works through changes in cash flows that depend on the overall
state of the economy. Greenwald and Stiglitz (1993) develop a dynamic model in
which changes in corporate cash flows play a critical role in propagating financial
market disturbances to real sector variables, including employment and inventories.
Another mechanism acts through changes in the intensity of adverse selection in
credit markets. Azariadis and Smith (1998) show that the presence of adverse
selection can create indeterminacy, with the economy fluctuating between Walrasian
and credit rationing regimes, and with cyclical downturns exhibiting declines in real
interest rates and increases in credit rationing (see also Mankiw (1986)).
Changes in default probabilities over the cycle can also amplify cyclical
fluctuations. During the upswing of a cycle, default probabilities decline, allowing
investors to lend greater sums of money, as predicted by the Stiglitz-Weiss model
(1981) of lending under asymmetric information and moral hazard. This fuels the
upswing. On the downswing, the mechanism works in reverse, leading to sharp
declines in available external financing. The general equilibrium implication of this
mechanism is modelled by Suarez and Sussman (1997) using an overlapping
generations model. In particular, during booms old entrepreneurs sell larger
quantities and prices fall, implying that young entrepreneurs must rely to a greater
extent on external sources of financing. Since external financing can generate
excessive risk-taking, booms are often followed by higher failure rates. Fire sales by
bankrupt corporations during such periods then lead to asset price declines, which,
in turn, generate macroeconomic fluctuations.
The allocation of capital across heterogeneous firms can, in the presence of
financial imperfections, also create procyclicality. Bernanke and Gertler (1989) and
Kiyotaki and Moore (1997) focus on the impact of financial imperfections on
aggregate investment and employment but neglect the effects of the reallocation of
inputs across heterogeneous firms. Recent studies try to fill this gap. Eisfeldt and
Rampini (2006) find that the costs of capital reallocation, such as those induced by
financial frictions, need to be countercyclical to be consistent with the cyclical
dynamics of capital reallocation and productivity dispersion. Moll (2014), in a model
where entrepreneurs are subject to borrowing constraints and idiosyncratic
productivity shocks, shows with plant-level panel data that financial frictions can
explain aggregate productivity losses in two EMEs that are 20% larger than in the
United States. In related research, Khan and Thomas (2013), using a DSGE model in
which capital reallocation across firms is distorted by frictions, show that a shock can
be amplified and propagated through disruptions to the distribution of capital across
firms. Herrera et al (2011), in their study of US firms and the dynamic properties of
gross credit flows relative to macroeconomic variables, find that financial frictions can
impact aggregate productivity by hindering the inter-firm reallocation of credit.

50 WP677 Macroeconomic implications of financial imperfections: a survey

 Project choice and technological change can also lead to financial accelerator
mechanisms. The literature on the accelerator often emphasises the impact of
imperfections on the volume of investment or consumption. However, imperfections
can also propagate and amplify shocks by triggering changes in the quality and
productivity of projects undertaken. Some studies argue that financial frictions that
are made worse by recessions induce firms to switch to lower quality and lower
productivity projects (Barlevy (2003)). Aghion et al (2010) show how recession-
induced credit constraints can make firms choose short-term investments with low
liquidity risk, making the share of long-term but more productive projects procyclical.
In other studies, though, recessions have a cleansing effect, stimulating the adoption
of more productive technologies. Araujo and Minetti (2011) document that, while
firms' collateral and credit relationships ease their access to credit and investment,
such relationships can also inhibit restructuring activity (ie the transition to new and
more productive technologies).
Financial imperfections affecting large firms also can result in accelerator-type
effects. While the literature generally stresses that small firms are especially exposed
to financial imperfections, frictions can also affect large firms. As is well documented
in the corporate finance literature, large firms, especially those that are widely held,
face more acute agency problems. Managers of large firms can have incentives to
allocate cash inefficiently, for example, by empire building (Jensen and Meckling
(1976) and Jensen (1986)). Dow et al (2005) integrate this problem into a dynamic
equilibrium model and show how cash flow shocks can affect investment and be
propagated over time.
Philippon (2006) models how managers tend to overinvest and how shareholders
show greater tolerance for such behaviour more during booms, with the cyclical
behaviour related to the quality of governance. Martin and Ventura (2011) consider a
financial accelerator model in which bubbles in asset prices drive changes in
borrowers net worth and the tightness of credit constraints (see also Martin and
Ventura (2015)). Note also that firm demand for external financing appears to deviate
from the behaviour predicted by standard models (Baker and Wurgler (2013) survey
theory and evidence on behavioural corporate finance).
Information asymmetries can be a source of asset price booms, bubbles and
busts. Models la Kiyotaki and Moore (1997) assume that agents participating in
asset markets are equally informed. However, financial frictions can also generate
confusion about the fundamental value of assets. When agents are asymmetrically
informed about the fundamental value of assets, Yuan (2005) shows that credit
constraints can contribute to uncertainty and exacerbate the volatility of asset prices.
Iacoviello and Minetti (2010) show that opening an economy to foreign agents (such
as lenders) that have less information about traded collateral assets, can lead to
higher volatility of asset prices, credit and output. Gorton and Ordoez (2013, 2014)
show that when an economy relies on informationally-insensitive debt, a credit boom
can follow during which firms with low quality collateral start borrowing. Since this is
associated with a more fragile environment, a small shock can trigger a large change
in the information set, leading to a drop in asset prices and a sharp decline in output
and consumption. A distinct but related area of research explores the role of
distortions, such as moral hazard or weak corporate governance, in generating asset
price bubbles (Allen and Gale (2000) and Barlevy (2014)).
Moreover, financial imperfections can propagate adverse shocks through labour
markets, for instance, by hindering the job search process. Motivated by the GFC,
Sterk (2015) presents a business cycle model in which a fall in house prices reduces

WP677 Macroeconomic implications of financial imperfections: a survey 51

geographical mobility because credit-constrained homeowners experience a decline
in their home equity, creating distortions in the labour market. The model can explain
much of the joint cyclical fluctuations in US housing and labour market variables,
including the events that took place in 2009. Andrs et al (2010) explore a similar
propagation channel involving credit frictions and labour markets. They are able to
explain the co-movements of US house prices with output, investment and
consumption. Burnside et al (2016) provide a model in which agents interactions
create "fads" about asset price prospects. This process, in turn, generates boom-busts
cycles or protracted booms that are similar to those observed for house prices.

52 WP677 Macroeconomic implications of financial imperfections: a survey

Appendix III. Understanding liquidity and leverage cycles

Liquidity, a key concept for macroeconomic and financial developments, is difficult to

define, in part as it is multi-faceted (see further Holmstrm and Tirole (2011) and
Tirole (2011)). Liquidity is often considered in relation to the price of credit. It can
correspondingly be measured by short-term interest rates, with lower rates being
associated with ampler liquidity. While the underlying theoretical motivations are not
always entirely clear, some studies also employ quantity-based measures such as
the aggregate quantity of money or excess money growth (money growth less
nominal GDP growth). Both concepts tend to move in the same direction. They are
also closely related to the monetary transmission channels of interest rates and asset
prices.
Narrower definitions of liquidity in the finance literature relate to the tradability
of specific assets while broader definitions refer to banks role in liquidity provision.
A liquid asset is said to have the following features: it can be sold rapidly, with minimal
loss of value (close to the true present value of its discounted cash flows) within a
short period of time (minutes or hours). Conversely, an illiquid asset is not readily
saleable. This type of liquidity depends on various factors. For example, an asset can
be illiquid because of uncertainty about its value or because there is no market in
which it can easily be traded. Liquidity creation is also seen as a core function of banks
(see Bouwman (2014) for a review of the literature on (private) liquidity creation by
commercial banks and its regulation).
Recently, the literature has introduced new classifications of liquidity formally.
Specifically, Brunnermeier and Pedersen (2009) categorise liquidity into two forms:
market and funding liquidity (among practitioners these concepts had been familiar
for some time; see for example Borio (2000, 2004)). Market liquidity is defined as the
ease with which money can be raised by selling assets at reasonable prices. A liquid
(or deep) market is one with willing buyers and sellers at all times for large quantities
and with orders that are not strongly influencing prices (the probability that the next
trade is executed at a price equal or close to the last one is high; see Vayanos and
Wang (2013) for a review of the theoretical and empirical literature on market
liquidity).
Funding liquidity describes the ease with which financial institutions, investors or
arbitrageurs can obtain funding. It is high, ie markets are awash with liquidity, when
it is easy to raise money. Funding liquidity is affected by the strength of fund-seekers
balance sheets and cash flows. This strength is, in turn, affected by asset prices: when
collateral values are high (and/or rising) and margins are low, funding liquidity can be
ampler (as in the case of repos). As such, market and funding liquidity are closely
related. And, there is a strong parallel to the financial accelerator mechanism of
Kiyotaki and Moore (1997) that focuses on how changes in asset prices affect firms
ability to raise external financing.
Liquidity can be influenced by two distinct leverage spirals: the valuation and the
margin/haircut spirals, both of which relate to the soundness and funding positions
of financial institutions. The valuation spiral is driven by asset price effects. If many
financial institutions suffer a similar shock say a drop in the value of mortgage-
backed securities all of them have to cut back their asset positions. This depresses
asset prices further, leading to an additional erosion of capital, which then forces
institutions to cut back on their positions even more. With mark-to-market
accounting rules and market discipline, leveraged financial institutions cannot defer

WP677 Macroeconomic implications of financial imperfections: a survey 53

these losses individually. Moreover, when markets are illiquid, selling assets depresses
prices further.
The margin/haircut spiral can come on top of the valuation spiral. It arises when
many institutions finance their asset positions with (short-term) borrowed money
(repos) and have to put up margins in cash or are imposed a discount (haircut) on the
assets they provide as collateral. These margins/haircuts increase in times of price
declines as lenders want better protection and thereby lead to a general
tightening of lending conditions (margins and haircuts implicitly determine the
maximum leverage that a financial institution can adopt). The margin/haircut spiral
then reinforces the valuation spiral in forcing institutions to reduce their leverage.
These mutually reinforcing effects create virtuous or vicious cycles, with real
economic impacts. Brunnermeier and Pedersen (2009), Adrian and Shin (2008, 2010a)
and Geanakoplos (2010) point out how these mechanisms can affect liquidity and
leverage, which, in turn, affect financial and economic cycles. During a virtuous cycle,
these mechanisms can lead to rising asset prices (even bubbles). In a vicious cycle,
they can create fire sales. Importantly, these cycles can be triggered by relatively small
shocks. In particular, even a temporary lack of liquidity may create adverse effects for
a highly leveraged financial institution. Liquidity shocks can also be aggravated
through various channels, including the hoarding of funds, runs on financial
institutions and network effects (via counterparty credit risk). Because of these spirals,
small shocks can force the economy into a process of deleveraging and fire sales. This
can have a substantial impact on the real economy, as happened during the Asian
financial crisis of the late 1990s and the GFC (see Shleifer and Vishny (2011) for a
review of the literature on fire sales and macroeconomics).

54 WP677 Macroeconomic implications of financial imperfections: a survey

Appendix IV. Linkages between business and financial
cycles: an overview of empirical studies

Using various methodologies and measures to proxy cycles, a number of studies have
examined the features of business and financial cycles and the aggregate linkages
between such cycles. They have pointed out the procyclical nature of financial markets
and provided the broad patterns describing the linkages between business and
financial cycles. This Appendix reviews these studies for the three most important
market segments: credit, equity and housing.62

Credit market cycles and business cycles

The study of credit cycles has a history that goes back to Mills (1867) at least. Most
of the early work in this area employed qualitative approaches and considered the
extreme versions of these cycles: booms and busts (or crunches) (see Keynes (1936),
Galbraith (1954), Shiller (1989, 2000) and Sinai (1993); Niehans (1992) reviews very
early work on credit cycles (Juglar (1862)). A number of studies also consider specific
credit crunches in the United States and other countries (see Wojnilower (1980, 1985),
Owens and Schreft (1995), Cantor and Wenninger (1993) and Helbling et al (2011)).
Using US data going back to 1875, Bordo and Haubrich (2010) document that credit
disruptions appear to exacerbate cyclical downturns. A number of studies also
consider the important role played by credit in driving business cycles. Using VAR
models, Meeks (2012) examines the role of credit shocks in explaining US business
cycles and finds that such shocks play an important role during financial crises but a
somewhat smaller role during normal business cycles.
Recent studies apply a variety of quantitative approaches to cross-country data
to analyse episodes of credit booms and crunches. Mendoza and Terrones (2008), for
example, use a thresholds method to identify credit booms in 48 countries over the
period 19602006. They find that booms generally coincide with above-trend growth
in output, consumption and investment during the build-up phase and below-trend
growth of those variables in the unwinding phase. During the build-up phase, a surge
in private capital inflows is accompanied by a deterioration of current account
positions (see also Gourinchas et al (2001), Schularick and Taylor (2012)). Other
researchers (such as Castro and Kubota (2013) and DellAriccia et al (2016)) also study
the determinants of credit booms length.

Cycles in asset (house and equity) prices and business cycles

Booms and busts in asset prices have also been a major area of research. Borio and
Lowe (2002), using an aggregate index of asset price (equities, and residential and
commercial property), define booms as periods during which asset prices deviate
from their trends by specified amounts. They also consider the interaction between
developments in asset prices and credit. They report that there are substantial
declines in house prices and residential investment during housing busts (after

62
For additional references on the literature covering the linkages between business and financial cycles
see Rebelo (2005), Claessens et al (2009, 2011, 2012a), Siregar and Lim (2011), Guarda and Jeanfils
(2012), Hubrich et al (2013), Borio (2014), De Rezende (2014), Groe Steffen (2015), Hubrich and
Tetlow (2015), Kose and Terrones (2015), Hartmann et al (2015), Abbate (2016), Abildgren (2016),
Jord et al (2016, 2017), Bluwstein (2017) and Gandr (2017).

WP677 Macroeconomic implications of financial imperfections: a survey 55

episodes of booms) in 16 advanced economies. This work builds on earlier
contributions, including in Bank for International Settlements (1993), and Borio et al.
(1994), and has since been deepened in a number of ways (see further Hofmann
(2001) and Davis and Zhu (2004)). Similarly, Detken and Smets (2004) identify between
1970 and 2002 38 house price booms in 18 OECD countries on the basis of prices
exceeding trend growth rates by at least 10% (see also Adalid and Detken (2007)).
They emphasise the importance of joint fluctuations in house prices and credit over
the boom-bust cycles in asset prices.
Others have focused on boom and bust episodes in house and equity prices.
However, because they employed different methodologies and data sets, their
findings have been difficult to compare. Bordo and Jeanne (2002) analysed episodes
of booms and busts in house and equity prices for OECD countries and documented
that more than one in every two house price booms ended up with a bust, against
one for every six equity price booms. Using OECD data for 18 countries from 1970 to
2009, Burnside et al (2016) found that the amplitude of typical house price booms
and busts was 54% and 29%, with a median length of four and five years, respectively.
They also report that booms are not always followed by busts.
A number of other studies have borrowed methods widely employed in the
business cycle literature to study financial cycles. Following Harding and Pagan
(2002), rigorous approaches to documenting financial cycles have been used. For
example, Pagan and Sossounov (2003) identify bear and bull phases in equity
markets using formal methods of business cycle dating for US monthly data over the
18351997 period. They report that while the duration of bear markets is about 15
months, it is around 25 months for bull markets. Bear markets are characterised by
about a 30% decline in equity prices and bull markets by about a 40% increase.
Ohn et al (2004) examine the duration dependence exhibited by bull and bear
markets in the United States and report that both phases show positive dependence.
Using the same methodology, Edwards et al (2003) find that the cyclical properties of
equity prices in EMEs change following periods of financial liberalisation. Kaminsky
and Schmukler (2008) report that equity price cycles in EMEs tend to become more
volatile after liberalisation. Drehmann et al (2012) show that the length and amplitude
of financial cycles have increased markedly since the mid-1980s and that cyclical
peaks are very closely associated with financial crises.
Other research focuses on the cyclical properties of house prices. Although
cyclicality is common, the duration and amplitude of housing cycles vary widely
across geographical areas and time (Cunningham and Kolet (2011) and Hall et al
(2006)). This, in turn, reflects variations in demand and supply conditions, the
characteristics of housing finance and the sources of linkage between housing and
real activity. Igan and Loungani (2012) study the characteristics of house price cycles
in advanced economies and find that long-run price dynamics are mostly driven by
local fundamental factors, such as demographics and construction costs, although
movements in such fundamentals and credit conditions can create short-run
deviations from equilibrium paths.
Some studies consider the linkages between business and asset price cycles
(Breitung and Eickmeier (2014), Cicarelli et al (2016) and Prieto et al (2016)). A central
finding of these studies is that house price cycles tend to have an especially close
relationship with business cycles. Based on evidence for 27 countries, Cecchetti (2008)
finds that housing booms worsen growth prospects while equity booms have little
impact on the expected mean and variance of macroeconomic performance
(although they do aggravate adverse outcomes). Cecchetti and Li (2008) study the

56 WP677 Macroeconomic implications of financial imperfections: a survey

impact of booms in equity and house prices on extreme fluctuations in output and
the price level. They find that equity and housing booms are both associated with
significantly worse growth and inflation prospects over a three-year horizon. Leamer
(2007) finds that there are strong linkages between various aspects of housing market
and business cycles in the United States. Ha et al (2017) find evidence of global cycles
specific to financial variables. They also find that shocks to house and equity prices
have spillover effects on macroeconomic aggregates (see also Cotter et al (2017)).

Synchronisation of financial cycles

Some studies document the extent of cyclical synchronisation and lead-lag

relationships in the financial markets of various countries. Goodhart and Hofmann
(2008) analyse the degree of synchronisation between house prices and credit
movements where these two variables may comove because a change in housing
wealth has collateral effects which affect both credit demand and supply or changes
in credit supply affect house price fluctuations. They show that the effects of shocks
to money and credit are stronger when house prices are booming. Borio and McGuire
(2004) report that peaks in housing prices lag peaks in equity prices by up to two
years, with the lag length negatively related to changes in short-term interest rates.
Hirata et al (2012) analyse the synchronisation of house prices across countries and
their interactions with other financial variables (see also Cesa-Bianchi (2013)). Using a
dynamic factor model, Rey (2015) and Miranda-Agrippino and Rey (2015) find that a
common factor drives a sizeable portion of variations in asset prices globally and
capital flows. Cerutti et al (2017a), however, question the quantitative importance of
global factors for capital flows.

WP677 Macroeconomic implications of financial imperfections: a survey 57

 Table 1. Behaviour of small and large firms during recessions and
tight money periods
(in percent change)
Sales Inventories Short-term Debt

Large Small Large Small Large Small

2007-2009 Recession1/ -24.62 -20.24 -14.18 -15.36 -38.24 -19.83

2001 Recession2/ -14.64 -6.92 -12.65 -9.28 -35.95 -12.13

All Recessions pre-20013/ -7.59 -10.15 -5.67 -9.11 -24.48 -12.62

Tight Money Dates 4/ -5.5 -9.39 -3.3 -7.78 -14.15 -11.45

Source: Kudlyak and Snchez (2017).

Note: The table shows the difference between the minimum value of the detrended series in an interval of 12
quarters following the episode and the peak value of the series.
1/
The peak of the recession is Q4 2007.2/ The peak of the recession is Q1 2001.
3/
The peaks of the recessions covered are: Q4 1969, Q4 1973, Q1 1980, Q3 1981 and Q3 1990.
4/
The periods of tight money are Q2 1966, Q4 1968, Q2 1974, Q3 1978, Q4 1979, Q4 1988 and Q2 1994.

58 WP677 Macroeconomic implications of financial imperfections: a survey

 Table 2. Variance decomposition: VAR with global factors
(fraction of variance explained by respective shock, in percent)
Forecast
Interest Credit Default
Shocks horizon GDP Productivity Inflation Credit
Rates Spread Rates
(quarters)

Credit 1 8.9 6.5 6.8 9.9 14.6 9.2 15.7

4 9.7 8.8 9.2 10.1 13.9 9.5 14.9
8 10.6 10.3 10.6 10.5 12.5 10.9 14.2
12 10.8 10.4 10.9 10.8 12.1 11.1 13.9

Productivity 1 9.3 7.1 23.5 9.1 9.1 8.5 10.7

4 10.5 9.4 19.6 10.3 11.4 9.9 12.2
8 12.1 11.0 16.6 11.8 13.3 11.4 12.5
12 12.3 11.4 16.3 12.3 14.5 11.8 12.5

Source: Helbling et al (2011).

Note: The roles of credit and productivity shocks in explaining global business cycles are shown using a VAR
model that includes the estimated global factor of each variable and US credit spreads and default rates. The
table reports the fraction of the forecast error variance of these variables that is explained by global credit and
productivity shocks for different forecast horizons. Though both shocks are identified simultaneously, the
variance decompositions need not add up to 100% because other potentially unidentified shocks make up the
rest of the variance. Credit is measured by the aggregate claims on the private sector of deposit money banks
and is obtained from the International Financial Statistics (IFS) of the IMF. The default rate series correspond
to the monthly rates for US speculative-grade corporate bonds rated by Moody's Investor Service. GDP data
are chained volume series from the OECD. The interest rates correspond to nominal short-term government
bill rates and are taken from IFS. Labour productivity is defined as real GDP per hours worked and is obtained
from the OECD. Inflation corresponds to the change in each country's CPI. The sample includes G7 countries
for the period Q1 1988 to Q4 2009.

WP677 Macroeconomic implications of financial imperfections: a survey 59

 Table 3. Synchronisation of business and financial cycles
(concordance index)
All Advanced Emerging
Countries Economies Markets

Output and Credit Cycles

Mean 0.78 0.82** 0.74
Median 0.81 0.83 0.76
Standard Deviation 0.10 0.06 1.13

Output and House Price Cycles

Mean 0.64 0.67** 0.54
Median 0.68 0.70 0.50
Standard Deviation 0.12 0.15 0.15

Output and Equity Price Cycles

Mean 0.59 0.57*** 0.62
Median 0.58 0.57*** 0.64
Standard Deviation 0.06 0.08 0.05

Note: Each cell represents the concordance statistic for the corresponding two cycles. Concordance
is calculated as the fraction of time that two cycles are in the same phase. *** and ** imply
significance at the 1% and 5% levels, respectively. Significance refers to the difference between
advanced economy and emerging markets (means and medians only).

60 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 1. Behaviour of large and small firms
(around periods of tight money)
0

-3

-6

-9

-12
Large Small

-15
Sales Inventories Short-term Debt
Source: Kudlyak and Snchez (2017).
Note: The figure presents the difference between the minimum value of the detrended series in an interval of
12 quarters following an episode of tight money and the peak value of the series. Tight money periods are:
Q2 1966, Q4 1968, Q2 1974, Q3 1978, Q4 1979, Q4 1988 and Q2 1994 based on the historical record analysed
in Romer and Romer (1989). Small firms are defined as those at or below the 30th percentile of assets and
large firms as those above the 30th percentile.

WP677 Macroeconomic implications of financial imperfections: a survey 61

 Figure 2. Default rates and growth of house prices in countries with
low and high leverage growth

Source: Mian and Sufi (2010).

Note: High-leverage growth counties are defined as the top 10% of counties in terms of the increase in the
debt to income ratio from Q4 2002 to Q4 2006. Low-leverage growth counties are in the bottom 10% of the
same measure. The left panel plots the change in the default rate for high- and low-leverage growth countries
and the right panel plots the growth rate for high- and low-leverage growth countries.

62 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 3. Auto sales, new home building and unemployment rates in
high- and low-leverage growth countries

Source: Mian and Sufi (2010).

Note: High-leverage growth countries are defined as the top 10% of countries by the increase in the debt to
income ratio from Q4 2002 to Q4 2006. Low-leverage growth countries are in the bottom 10% based on the
same measure. The left panel plots the growth in auto sales, the middle panel plots the growth in new housing
permits, and the right panel plots the change in the unemployment rate.

WP677 Macroeconomic implications of financial imperfections: a survey 63

 Figure 4A. Financial accelerator mechanism: demand side
(virtuous circle)

Note: The chart depicts the financial accelerator mechanism by which shocks to the economy may be amplified
by changes in access to external financing, which then translates into changes in economic agents investment
and consumption spending. In turn, these changes are propagated and reinforced as asset prices and
economic activity fluctuate, which then affects the demand and availability of external financing. This creates
further feedback loops that are propagated through financial markets and the real economy.

64 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 4B. Financial accelerator mechanism: supply side
(virtuous circle)

Note: The chart depicts both the demand (as in Figure 4A) and the supply sides of the financial accelerator
mechanism. As financial institutions balance sheets and profitability increase and asset prices rise, the
assessment of economic prospects is viewed more positively and the supply of external financing expands.
This then translates into changes in investment that enhance the feedback loops between financial markets
and the real economy.

WP677 Macroeconomic implications of financial imperfections: a survey 65

 Figure 5. Evolution of global GDP: 2007:32009:4
A. Role of credit shock
5

-5

-10

-15

-20
Actual Counterfactual

-25
2007:3 2007:4 2008:1 2008:2 2008:3 2008:4 2009:1 2009:2 2009:3 2009:4

B. Contributions of credit and productivity shocks

2.5

2.0
Credit
1.5 Productivity

1.0

0.5

0.0

-0.5
2007:3 2007:4 2008:1 2008:2 2008:3 2008:4 2009:1 2009:2 2009:3 2009:4
Source: Helbling et al (2011).
Note: Panel A compares the results of counterfactual simulations for the global GDP factor during the GFC.
The solid line represents the actual global GDP factor and the dashed line represents the counterfactual when
the global credit shock is set to zero during the period considered. Panel B compares the contributions of
credit and productivity shocks to cumulative global GDP growth based on the counterfactual simulations. The
bars represent the median difference. A positive (negative) bar captures how the decrease in the global GDP
factor would have been smaller (greater) in the absence of the respective shocks. Credit is defined as the
aggregate claims on the private sector by deposit money banks and is obtained from the IFS. Labour
productivity is defined as real GDP per hours worked and is obtained from the OECD.

66 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 6A. Conceptual representation of liquidity and leverage cycles:
gains
(virtuous circle)

Source: Brunnermeier and Pedersen (2009).

Note: The figure depicts a situation where initial gains trigger a virtuous loop of increased asset prices and
further gains. The underlying mechanism is similar to that of the financial accelerator where higher asset prices
lead to increases in capitalisation, which then enhances the demand for assets, (further) driving up prices. The
mechanism is in part reinforced by lower margins/haircuts on assets used as collateral, which allows for greater
leverage.

WP677 Macroeconomic implications of financial imperfections: a survey 67

 Figure 6B. Conceptual representation of liquidity and leverage cycles:
losses
(vicious circle)

Source: Brunnermeier and Pedersen (2009).

Note: The figure depicts a situation where initial losses initiate a vicious circle of declining asset prices and
losses. The underlying mechanism is that of a fire sale, which is essentially the forced sale of an asset at a
dislocated, low price. It is in part triggered by an increase in the margins/haircuts on assets used as collateral,
which allows for reduced leverage.

68 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 7. Macroeconomic implications of financial shocks

Source: Gilchrist and Zakrajek (2011).

Note: The figure depicts the impulse response function of a nine variable VAR model to a one standard
deviation orthogonalised shock to the financial bond premium over the period Q1 1985 to Q2 2010. Shaded
bands denote 95% confidence intervals based on 1000 bootstrap replications.

WP677 Macroeconomic implications of financial imperfections: a survey 69

 Figure 8. Total assets and leverage
(leverage and asset growth move together for securities brokers and dealers)
B. Non-financial non-farm
A. Households corporations
8 6

Total Assets Growth (Percent Quarterly)

Total Asset Growth (Percent Quarterly)

5
6
4
4
3

2 2

1
0
0
-2
-1

-4 -2
-1 -0.5 0 0.5 1 1.5 -2.5 -1.5 -0.5 0.5 1.5 2.5
Leverage Growth (Percent Quarterly) Leverage Growth (Percent Quarterly)

C. Commercial banks D. Securities brokers and dealers

6 40
Total Asset Growth (Percent Quarterly)

5
Total Asset Growth (Percent Quarterly)

30

4
20
3
10
2
0
1
-10
0

-1 -20

-2 -30
-50 -30 -10 10 30 50 -60 -40 -20 0 20 40
Leverage Growth (Percent Quarterly) Leverage Growth (Percent Quarterly)

Source: Adrian and Shin (2008).

Note: Panel A plots the quarterly changes in total household assets to quarterly changes in household leverage
as extracted from the US Financial Accounts (formerly called Flow of Funds). Panel B plots the change in
leverage and change in total assets of non-financial, non-farm corporations drawn from the US Flow of Funds
Accounts. Panel C plots the changes in leverage against the changes in the total assets of US commercial
banks. Panel D plots the same for US securities brokers and dealers. The data are from 1963 to 2006.

70 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 9. Impulse responses to a risk appetite shock
(in percent)

Source: Adrian et al (2010b).

Note: Stronger risk appetite leads to an expansion of intermediaries balance sheets and a compression of
credit spreads. The response of the macroeconomic risk premium peaks at four quarters and then subsequently
reverts slowly towards zero. However, the significance of the risk appetite shock on the macroeconomic
premium is fairly persistent and only becomes insignificant after about six quarters.

WP677 Macroeconomic implications of financial imperfections: a survey 71

 Figure 10. Monetary conditions and bank risk-taking

Source: DellAriccia et al (2014).

Note: Simple OLS regression of a risk measure of bank lending and the real federal funds rate for all banks.
The dependent variable is the risk of bank loans, which is based on an index ranging from 1 to 5. The measure
is based on quarterly data over the period Q2 1997 to Q3 2009 and is taken from the Federal Reserves Survey
of Terms of Business Lending.

72 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 11. Recessions and recoveries:
duration, amplitude and cumulative loss
Duration
(in quarters)
8
Recessions

6 Recoveries

**
4

0
Full Sample Advanced Economies Emerging Market Economies

Amplitude
(in percent)
8
Recessions
6
Recoveries
4 ***
2
0
-2
-4 ***
-6
Full Sample Advanced Economies Emerging Market Economies

Cumulative loss from recessions

(in percent)
0

-2

-4
***
-6

-8

-10
Full Sample Advanced Economies Emerging Market Economies
Source: Claessens et al (2012a).
Note: All the statistics except for those relating to duration correspond to sample medians. For duration, the
means are shown. The duration of a recession is the number of quarters that have elapsed between the peak
and the trough. The duration of a recovery is the time taken to attain the level of output reached at the previous
peak. The amplitude of a recession is the decline in output from peak to trough. The amplitude of a recovery
is the one-year change in output after the trough. The cumulative loss combines information about the
duration and the amplitude to measure the overall cost of a recession. ***, ** and * imply significance at the
1%, 5% and 10% levels, respectively. Significance refers to the difference between advanced economies and
EMEs.

WP677 Macroeconomic implications of financial imperfections: a survey 73

 Figure 12. Synchronisation of recessions
(in percent)
100

80

60

40

20

0
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
Source: Claessens et al (2012a).
Note: The share of countries experiencing a recession is presented. The figure includes completed as well as
ongoing episodes. The sample contains quarterly data for 21 advanced economies over the period Q2 1960
to Q4 2010.

74 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 13. Financial downturns:
duration, amplitude and slope
Duration
(in quarters)
21
Downturns
18 ***
Crunches/Busts
15
12 *** ***
9
6
3
0
Credit House Price Equity Price

Amplitude
(in percent)
0
-10
-20
-30
*** ***
-40
-50 Downturns
-60 Crunches/Busts
***
-70
Credit House Price Equity Price

Slope
(in percent)
0

-2
***
-4 ***

-6
***
Downturns
-8
Crunches/Busts
-10
Credit House Price Equity Price
Source: Claessens et al (2012a).
Note: the amplitude and slope statistics correspond to sample medians. For duration, the means are shown.
Duration is the number of quarters between peak and trough. Amplitude is based on the decline in each
variable during the downturn. Slope is the amplitude divided by the duration. Busts (crunches) are the worst
25% of downturns calculated by the amplitude. ***, ** and * imply significance at the 1%, 5% and 10% levels,
respectively. Significance refers to the difference between busts (crunches) and other financial downturns.

WP677 Macroeconomic implications of financial imperfections: a survey 75

 Figure 14. Financial upturns:
duration, amplitude and slope
Duration
(in quarters)
21
18
Upturns Booms
15
12
9 * ***

6
3
0
Credit House Price Equity Price

Amplitude
(in percent)
70
***
60
Upturns Booms
50
40
30
20 ***
***
10
0
Credit House Price Equity Price

Slope
(in percent)
12
***
10
Upturns Booms
8
6
4 ***
***
2
0
Credit House Price Equity Price
Source: Claessens et al (2012a).
Note: The amplitude and slope correspond to sample medians. For duration, the means are shown. Duration
is the time it takes to attain the level of the previous peak. Amplitude is the change in one year after the trough
of each variable. Slope is the amplitude from the trough to the period where the financial variable reaches its
last peak, divided by duration. Booms are the top 25% of upturns calculated by the amplitude. ***, ** and *
imply significance at the 1%, 5%, and 10% levels, respectively. Significance refers to the difference between
financial booms and other financial upturns.

76 WP677 Macroeconomic implications of financial imperfections: a survey

 Figure 15. Recessions with financial disruptions:
duration, amplitude and cumulative loss
Duration
(in quarters)
6
Recessions associated with Recessions associated without
5 ***
**
4
3
2
1
0
Credit Crunches House Price Busts Equity Price Busts

Amplitude
(in percent)
0

-1

-2

-3 **

-4 * ***
Recessions associated with Recessions associated without
-5
Credit Crunches House Price Busts Equity Price Busts

Cumulative loss
(in percent)
0

-2

-4

-6

-8 *** ***
**
Recessions associated with Recessions associated without
-10
Credit Crunches House Price Busts Equity Price Busts
Source: Claessens et al (2012a).
Note: The amplitude and cumulative loss statistics correspond to sample medians. Duration corresponds to
the sample mean. Disruptions are the worst 25% of downturns as represented by the amplitude. ***, ** and *
imply significance at the 1%, 5% and 10% levels, respectively. Significance refers to the difference between
recessions with and without financial disruptions. For other definitions, see the notes to Figures 13 and 14.

WP677 Macroeconomic implications of financial imperfections: a survey 77

 Figure 16. Recoveries with financial booms:
duration, amplitude and slope
Duration
(in quarters)
6
Recoveries associated with Recoveries associated without
5
4
3
***
2
1
0
Credit Booms House Price Booms Equity Price Booms

Amplitude
(in percent)
10
*** Recoveries associated with
8
Recoveries associated without
***
6

0
Credit Booms House Price Booms Equity Price Booms

Slope
(in percent)
3
Recoveries associated with
*** Recoveries associated without
2
***
1

0
Credit Booms House Price Booms Equity Price Booms
Source: Claessens et al (2012a).
Note: The amplitude and slope correspond to the sample medians. Duration corresponds to the sample means.
Booms are the highest 25% of upturns by amplitude. ***, ** and * imply significance at the 1%, 5% and 10%
levels, respectively. Significance refers to the difference between recoveries with and without booms. For other
definitions, see the notes to Figures 13 and 14.

78 WP677 Macroeconomic implications of financial imperfections: a survey

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118 WP677 Macroeconomic implications of financial imperfections: a survey