The survey focuses on two main channels through which financial market imperfections can lead to macro-financial linkages. The first channel, largely operating through the demand side of finance, describes how changes in borrowers’ balance sheets can amplify macroeconomic fluctuations. The central idea underlying this channel is best captured by the financial accelerator – an extensively studied propagation mechanism in a wide range of models. The second channel, associated with the supply side of finance, emphasises the importance of balance sheets of banks and other financial institutions in lending and liquidity provision for the real economy.

Given the large number of studies on the macroeconomic implications of financial imperfections, a survey on the topic comes with a number of caveats. First, for presentational purposes, we use the rough distinction between the demand and supply sides of finance, reviewing each separately and analysing how they can lead to macro-financial linkages. The demand and supply sides are of course interrelated as transactions are endogenous outcomes, especially when they are considered in a general equilibrium framework. Nevertheless, this rough demarcation allows us to classify many studies in a simple manner. Second, our objective is to provide intuitive explanations of how financial frictions can lead to macrofinancial linkages. Hence, rather than delving into the details of certain models, we explain the general ideas describing the workings of models and then summarise the relevant empirical evidence for specific channels. In order to present a coherent review of this large body of work, each section provides a self-contained summary of the specific literature.

Third, macro-financial linkages ultimately originate at the microeconomic level. Hence, whenever possible, we draw lessons from the theoretical and empirical work on the microeconomic factors that are relevant for the behaviour of macroeconomic and financial aggregates. Fourth, while many of the papers we review have policy relevance, we largely stay away from directly addressing policy issues, including those related to monetary, macroprudential, regulatory and crisis management policies. Finally, while we did our best to include all the major studies on the topic, it is probably unavoidable that a survey of such a rich literature would miss some contributions.

Section 2 presents a brief review of the basic microeconomic mechanisms that could lead to financial market imperfections on the demand side. It starts with a conceptual discussion of how imperfections (financial frictions) stemming from information asymmetries and enforcement difficulties affect the amount and costs of external financing available to firms and households.<sup>5</sup> Financial frictions can lead to deviations from the predictions of the standard complete market models in terms of how (real and financial) resources are allocated.<sup>6</sup> Models incorporating financial frictions typically predict that access to external finance becomes easier and the premium charged for such financial transactions decreases with the strength of borrowers' balance sheets and net worth. This can lead to the amplification of (monetary, financial and real) shocks as changes in net worth affect access to finance – and the use of that finance – and subsequently influence consumption and investment.

The section also reviews the empirical evidence on the importance of financial market imperfections on the demand side. Studies have employed microeconomic (firm, household, and sector-level) data to examine the role of imperfections in explaining the behaviour of

> 5 Some of the pioneering papers on financial frictions include Akerlof (1970), Jensen and Meckling (1976), Townsend (1979), Stiglitz and Weiss (1981), Bulow and Rogoff (1989) and Hart and Moore (1994).

> 6 Throughout this paper, the terms “financial market imperfections” and “financial frictions” are used interchangeably. Financial frictions – in conjunction with a country’s legal, regulatory and tax system – influence the design and evolution of financial contracts, markets and intermediaries.

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