Introduction

This chapter surveys the literature on the role of financial factors in explaining economic fluctuations. We place special emphasis upon the recent literature on the implications for economic fluctuations of asymmetric information in the market for investment finance. The basic argument of this literature is that, in the presence of informational asymmetries and agency costs, financial factors may affect real variables like investment and output. In dynamic models these real variables may also affect financial factors and may generate persistent effects of shocks even in models which would not display persistence in the absence of the informational asymmetry.

The plan of the chapter is as follows. The second section provides a brief discussion of the views of some earlier writers on the importance of financial factors in the determination of economic activity. The third section reviews the microeconomic arguments concerning informational asymmetries and their implications for investment finance. The fourth section shows one way in which these microfoundations have been used to provide a real business cycle model based on informational asymmetries and agency costs. We show that this model may yield multiple equilibria with the possibility that the economy tends to oscillate around either a high output or a low output equilibrium. The fifth section reviews the literature and the sixth section concludes.