# 1. Introduction

The Great Financial Crisis (GFC) of 2007–09 confirmed the vital importance of advancing our understanding of macro-financial linkages. The GFC was a bitter reminder of how sharp fluctuations in asset prices, credit and capital flows can have a dramatic impact on the financial position of households, corporations and sovereign nations.<sup>1</sup> These fluctuations were amplified by macro-financial linkages, bringing the global financial system to the brink of collapse and leading to the deepest contraction in world output in more than half a century. Moreover, these linkages have resulted in unprecedented challenges for fiscal, monetary and financial sector policies.

Macro-financial linkages centre on the two-way interactions between the real economy and the financial sector. Shocks arising in the real economy can be propagated through financial markets, thereby amplifying business cycles. Conversely, financial markets can be the source of shocks, which, in turn, can lead to more pronounced macroeconomic fluctuations. The global dimensions of these linkages can result in cross-border spillovers through both real and financial channels.

The crisis has led to a lively debate over the state of research on the role of financial market imperfections in explaining macroeconomic fluctuations. Some argue that the crisis showed that the profession did not pay sufficient attention to these linkages. Others, by contrast, claim that they have been recognised for a long time and that substantial progress has been made in understanding them. But most acknowledge that financial market imperfections can often intensify fluctuations in the financial and real sectors. Yet, the absence of a unifying framework to study the two-way interactions between the financial sector and the real economy has limited the practical applications of existing knowledge and impeded the formulation of policies.<sup>2</sup> This debate can be seen as a natural extension of the long-standing discussion about the importance of financial market developments for the real economy (as described in detail in Appendix I).<sup>3</sup> The diverging paths followed by the fields of macroeconomics and finance are 1 A large literature documents the various macro-financial linkages that have contributed to the devastating impact of the GFC. Some of the important books on the topic include Krugman (2009b), Sorkin (2009), Wessel (2009), Lewis (2010), Kose and Prasad (2010), Paulson (2010), Gorton (2012), Turner (2012), Bernanke (2013), Blinder (2013), Claessens et al (2014), Geithner (2014), Mian and Sufi (2014a), Wolf (2014), Farmer (2016), King (2016) and Taylor (2016). Lo (2012) reviews a set of 21 books on the GFC.

2 We presented some quotes reflecting the flavour of this debate at the beginning of the survey. Krugman (2009a) criticises the macroeconomics literature for its failure to recognise the strong relationship between the financial sector and the real economy, while Cochrane (2011, 2017) responds critically to Krugman’s views. Caballero (2010), Kocherlakota (2010), Taylor (2011), Romer (2016) and Reis (2017) provide varying assessments of research on macroeconomics. Blanchard (2017a) stresses the need for a broader class of macroeconomic models.

3 Early surveys of the literature on macro-financial linkages include Gertler (1988), Bernanke (1993), Lowe and Rohling (1993) and Bernanke et al (1996). Mankiw (2006) and Blanchard (2000, 2009) offer more general reviews of the state of macroeconomics before the crisis. Recent (but more selective) updates on macro-financial linkages include Gilchrist and Zakrajšek (2008), Matsuyama (2008), Solimano (2010), BCBS (2011, 2012), Caprio (2011), Gertler and Kiyotaki (2011), Quadrini (2011), Borio (2014) and Morley (2016), as well as papers in Friedman and Woodford (2011). Work related to macro-financial linkages includes: Cochrane (2006) on financial markets and the real economy; Brunnermeier (2001) and Cochrane (2005) on asset pricing; and Tirole (2006) on the role and impact 1