Financial structure and aggregate economic activity: an overview Mark Gertler Working Paper No. 2559 National Bureau of Economic Research 1050 Massachusetts Avenue Cambridge, MA 02138 April 1988 * University of Wisconsin and NBER. Prepared for the Federal Reserve Bank of Cleveland's Conference on Recent Developments in Macroeconomics. I thank Jonathon McCarthy for research assistance. The research reported here is part of the NBER's research program in Financial Markets and Monetary Economics. Any opinions expressed are those of the author and not those of the National Bureau of Economic Research. Financial Structure and Aggregate Economic Activity: An Overview ## Abstract This paper surveys literature which explores the possible links between the financial system and aggregate economic behavior. The survey is in two parts: The first reviews the traditional work and the second discusses new research. Mark Gertler Department of Economics University of Wisconsin Madison, WI 53706 ## Introduction Most of macroeconomic theory presumes that the financial system functions smoothly - and smoothly enough to justify abstracting from financial considerations. This dictum applies to modern theory. The currently popular real business cycle paradigm proceeds under the working hypothesis that financial structure is irrelevant. To a first approximation, it also applies to the traditional literature. The main real/financial interaction in conventional Keynesian, Monetarist and Classical models stems from activity in the market for the medium of exchange, and not from the performance of markets for borrowing and lending. Recently, interest has grown in exploring the possible links between the financial system and aggregate economic behavior. This interest partly reflects the on-going beliefs of applied economists and policy-makers that financial markets and institutions deserve serious attention - that they play important roles in the growth and fluctuation of output. (See Kaufman [1987] and Eckstein and Sinai [1986], for example.) It also arises for two reasons connected to developments in academic work: First, new empirical research, examining both historical and post-war data, provides support for further pursuit of this topic; second, progress in theory over the last decade has made it possible to address these kinds of questions using the same degree of rigor that is currently being applied elsewhere in macroeconomics. In this paper, I survey recent developments in the study of the real/financial interaction and try to place a perspective on where it currently stands. Many of the ideas in this new literature have appeared earlier, though in less formal statements. My discussion thus includes earlier work as well, beginning with the period of the Great Depression. The survey is in two parts: The first reviews the traditional literature and the second discusses new work. Part I, I argue that Depression-era economists believed that the behavior of the financial system was largely responsible for the extraordinary events of the time. However, the Keynesian revolution supplanted further immediate research in this direction. WhileFinancial structure and aggregate economic activity: an overview Mark Gertler Working Paper No. 2559 National Bureau of Economic Research 1050 Massachusetts Avenue Cambridge, MA 02138 April 1988 * University of Wisconsin and NBER. Prepared for the Federal Reserve Bank of Cleveland's Conference on Recent Developments in Macroeconomics. I thank Jonathon McCarthy for research assistance. The research reported here is part of the NBER's research program in Financial Markets and Monetary Economics. Any opinions expressed are those of the author and not those of the National Bureau of Economic Research. Financial Structure and Aggregate Economic Activity: An Overview ## Abstract This paper surveys literature which explores the possible links between the financial system and aggregate economic behavior. The survey is in two parts: The first reviews the traditional work and the second discusses new research. Mark Gertler Department of Economics University of Wisconsin Madison, WI 53706 ## Introduction Most of macroeconomic theory presumes that the financial system functions smoothly - and smoothly enough to justify abstracting from financial considerations. This dictum applies to modern theory. The currently popular real business cycle paradigm proceeds under the working hypothesis that financial structure is irrelevant. To a first approximation, it also applies to the traditional literature. The main real/financial interaction in conventional Keynesian, Monetarist and Classical models stems from activity in the market for the medium of exchange, and not from the performance of markets for borrowing and lending. Recently, interest has grown in exploring the possible links between the financial system and aggregate economic behavior. This interest partly reflects the on-going beliefs of applied economists and policy-makers that financial markets and institutions deserve serious attention - that they play important roles in the growth and fluctuation of output. (See Kaufman [1987] and Eckstein and Sinai [1986], for example.) It also arises for two reasons connected to developments in academic work: First, new empirical research, examining both historical and post-war data, provides support for further pursuit of this topic; second, progress in theory over the last decade has made it possible to address these kinds of questions using the same degree of rigor that is currently being applied elsewhere in macroeconomics. In this paper, I survey recent developments in the study of the real/financial interaction and try to place a perspective on where it currently stands. Many of the ideas in this new literature have appeared earlier, though in less formal statements. My discussion thus includes earlier work as well, beginning with the period of the Great Depression. The survey is in two parts: The first reviews the traditional literature and the second discusses new work. Part I, I argue that Depression-era economists believed that the behavior of the financial system was largely responsible for the extraordinary events of the time. However, the Keynesian revolution supplanted further immediate research in this direction. While