Financial frictions in macroeconomics

I review two examples that show how the nature of the financial system can play a central role in shaping the behavior of the aggregate economy. In the first example, variations over time in the cross-sectional dispersion of a productivity shock, which would have no aggre-gate effect in a frictionless model, produce effects that look like business cycles because of the nature of financial (and nominal) frictions. The second example suggests how a shock originating outside the financial system, which ordinarily might not be expected to have a large aggregate effect, can lead to a systemic banking collapse. The relevance of the exam-ples to the US economy is discussed.(c) 2021 Elsevier Ltd. All rights reserved.

Automated summary

This article reviews two examples that illustrate how the nature of the financial system can significantly shape the behavior of the aggregate economy. The first example demonstrates how variations in the cross-sectional dispersion of a productivity shock, due to financial and nominal frictions, can create effects that resemble business cycles. The second example highlights how an external shock, which may not be expected to have a large aggregate effect, can lead to a systemic banking collapse.