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The ongoing great recession is a stark reminder that financial frictions are a key driver of business-cycle fluctuations. Imbalances can build up during seemingly tranquil times until a trigger leads to large and persistent wealth destructions, potentially spilling over to the real economy. Whereas in normal times, the financial sector can mitigate financial frictions, in crisis times, the financial sector's fragility adds to instability. Adverse feedback loops and liquidity spirals lead to nonlinear effects with the potential of causing a credit crunch. Classic economic writers who experienced the Great Depression firsthand, including Fisher (1933), Keynes (1936), Gurley and Shaw (1955),Minsky (1957), and Kindleberger (1978), emphasized the importance of financing frictions and inherent instability of the financial system. Patinkin (1956) and Tobin (1969) also emphasized the important implications of financial stability for monetary economics.
This chapter surveys the growing literature that studies the macroeconomic implications of financial frictions straddling three branches of economics: macroeconomics, finance, and general equilibrium theory. All share common themes and similar insights, but they are disconnected in the profession partly because they differ in their modeling approaches and in their identification of the root of the instability. The objective of this survey is to lay bare important theoretical mechanisms and highlight the connections and differences across these approaches.