service ratio as leading indicators of household consumption (Juselius and Drehmann (2015) and Drehmann et al (2017)).<sup>55</sup> Some fundamental aspects associated with the demand side channels are still being debated. For example, questions surrounding the quantitative importance of financial market imperfections for small firms should be answered, as some argue that there is little difference between small and large firms. While many empirical studies find that the effects of financial conditions vary by type of economic agent, including households, firms, financial intermediaries and sovereign entities, many of those do not present rigorous tests for specific financial imperfections. To illustrate, the GFC has highlighted the role of house prices in affecting consumption and broader macroeconomic outcomes, but the exact channels by which this takes place are not yet well established. Consequently, the implications of empirical findings for regulation, institutional reform or other policy design issues require additional work.

Supply side channels. Since the GFC, few question the relevance of supply side factors for macroeconomic outcomes. That said, the theoretical literature still falls short of providing realistic models. While some models show how supply side dynamics can lead to macrofinancial linkages, they are still rudimentary in their treatment of the financial system. They tend to focus on banks rather than on the financial sector as a whole. And even when banks are included, their treatment is highly stylised. For example, many models simply assume the presence of banks, but do attempt to justify their existence, eg whether banks arise to overcome information asymmetries or because they are “special” in other ways.

Models often assume that banks are homogenous while in practice large banks operate very differently from small ones. There is often no distinction between liquidity and solvency risks, and the interaction between such risks is not always explicitly modelled. Moreover, the banks’ choice of assets, including which sectors they lend to, is often imposed a priori rather than being endogenously determined. Models typically ignore many parts of the financial system (other than banking) and are unable to account for gross positions or intra-financial system transactions (such as interbank claims or transactions between banks and capital markets).<sup>56</sup> A more realistic representation of the supply side of finance requires richer models that account for the heterogeneity of banks and capture the behaviour of other financial intermediaries. It also means modelling how banks, non-bank financial institutions and markets are linked to each other (such as through shadow banking activities) as well as how such institutions and markets are linked to the international financial system. Furthermore, more sophisticated approaches to modelling of the intricate linkages between financial imperfections, labour markets and real activity are sorely needed. Any advances in this area would require, among others, overcoming the general “linear” structure of DSGE models,

> 55 Several surveys discuss advances in the modelling of heterogeneous agents, news shocks, financial crises, bubbles and systemic risk (Heathcote et al (2009), Lorenzoni (2011, 2014), and Brunnermeier and Oehmke (2013)). Another strand of the literature uses ad hoc borrowing constraints to model financial imperfections in environments with a continuum of households (Huggett (1993), Aiyagari (1994), Krusell and Smith (1998)), which is particularly useful in studying distributional issues. Moll (2014) studies an environment in which financial frictions lead to misallocation of resources.

56 See Acemoglu et al (2015) and Boissay et al (2016) for analysis focusing on effects of networks and links among financial institutions, including through the interbank market. See Freixas et al (2011) for analysis on monetary and prudential policies in the interbank markets. See Dou et al (2017) for a review of the role of macro-financial interactions in dynamics models used at central banks.

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