By Markus Brunnermeier, Thomas Eisenbach and Yuliy Sannikov
http://d.repec.org/n?u=RePEc:cla:levarc:786969000000000384&r=dge
This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to non-linear amplification effects. Risk is endogenous and liquidity spirals cause financial instability. Increasing margins further restrict leverage and exacerbate downturns. A demand for liquid assets and a role for money emerges. The market outcome is generically not even constrained efficient and the issuance of government debt can lead to a Pareto improvement. While financial institutions can mitigate frictions, they introduce additional fragility and through their erratic money creation harm price stability.
This a paper is a long read, 100 pages. Yet, it should be a required reading for anybody arguing that macroeconomics has been ignoring financial frictions or the financial sector in general. I have highlighted a few recent papers here, but this survey also looks at older ones and puts them all into context.
