Macroeconomics with Financial Frictions: A Survey

Abstract

This article surveys the macroeconomic implications of financial frictions. Financial frictions lead to persistence and when combined with illiquidity to nonlinear 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.

Quantitative easing and the loan to collateral value ratio

“…The policy maker will maximize household utility (12) subject to constraints (13)(14)(15)(16)(17)(18)(19)(20). It is easy to see that constraints (13) and (18)(19)(20) are only used to define q t , M t , P t and T t .…”

“…π = 1. Applying the Benigno and Woodford (2012) method to the non-linear problem (12,(13)(14)(15)(16)(17)(18)(19)(20), we receive a pure quadratic approximation of the social objective. As we can see, it consists of the squares of output and inflation gaps similar to those of Benigno and Woodford (2005),…”

“…It is easy to see that constraints (13) and (18)(19)(20) are only used to define q t , M t , P t and T t . Therefore, we write a Lagrangian to reduced model (14)(15)(16)(17).…”

“…From constraints (13)(14)(15)(16)(17)(18)(19)(20) and first-order conditions (58-62), we compute the steady-state values for endogenous variables and Lagrange multipliers…”

“…The amount of borrowing is limited by a collateral constraint as in Kiyotaki and Moore (1997) or Iacoviello (2005). 1 For a comprehensive survey on macroeconomics with financial frictions, see Brunnermeier et al (2012). 2 We simply assume that competitive financial intermediaries can costlessly create as much credit as they want.…”