Before the 2008 crisis, financial market frictions were relatively downplayed in dynamic macroeconomics. The underlying assumption in most macroeco- nomic models, including the models we have analyzed in previous chapters, is that there are two financial assets, non-interest bearing money and inter- est bearing one period bonds. The central bank is assumed to be able to control the interest rate on bonds through open market operations. This assumption essentially implies that all interest bearing financial assets are perfect substitutes, and that all interest yields move together with the rate determined by monetary policy.

The financial crisis made it clear that this view is too simplistic. The financial system consists of a multitude of financial instruments (securities) with different risk characteristics and different maturities. In addition, finan- cial intermediaries like banks are heavily leveraged, especially in a fractional reserve banking system. The bulk of the liabilities of financial intermediaries are in relatively safe short term securities, whereas their assets are in riskier and longer term securities. In addition, despite the increase in efficiency implied by the presence of financial intermediaries, frictions associated with transaction costs, risk sharing and asymmetric information between borrow- ers and lenders persist. As a result, the financial system is subject to risks with major macroeconomic implications.

In this chapter we briefly discuss the role of finance and financial markets, the nature and implications of financial frictions and finally introduce financial frictions in two alternative “new keynesian” models in order to analyze their macroeconomic implications.

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