What a difference a few years can make! The financial crisis that engulfed mature economies in the late 2000s has prompted much soul searching. Economists are now trying hard to incorporate financial factors into standard macroeconomic models. However, the prevailing, in fact almost exclusive, strategy is a conservative one. It is to graft additional so-called financial “frictions” on otherwise fully well behaved equilibrium macroeconomic models, built on real-business-cycle foundations and augmented with nominal rigidities. The approach is firmly anchored in the New Keynesian Dynamic Stochastic General Equilibrium (DSGE) paradigm. The purpose of this essay is to summarise what we think.
