more on internal finance than large firms, potentially making the costs of external finance less relevant in the aggregate.

It has also been shown that large firms are affected by imperfections, especially during times of financial stress. Even relatively large firms, including publicly-listed corporations, have been shown to face external finance premia, as predicted by theories premised upon imperfections (see Levin and Natalucci (2005) and Levin et al (2004)). When large firms suffer from adverse shocks to their balance sheets, their investments are also negatively affected, especially during recessionary and stressed periods (Aguiar (2005) and Gilchrist and Sim (2007)). Almeida and Campello (2010) find that large firms can also face high external financial costs.

On balance, many studies confirm the role of imperfections for outcomes associated with the behaviour of firms and households. This is particularly true of studies based on microeconomic data. However, few studies cover the universe of firms or households and only a small number of studies analyse the aggregate quantitative importance of financial frictions in a rigorous fashion. Consequently, they are less clear about the aggregate impact of imperfections. The next section turns therefore to studies that focus on the aggregate impact of imperfections and how such imperfections give rise to the financial accelerator mechanism.

# 3. Financial imperfections in general equilibrium

This section describes how financial imperfections can lead to more pronounced macroeconomic fluctuations. It first introduces the financial accelerator mechanism through which financial imperfections amplify and propagate aggregate cyclical fluctuations. In general, equilibrium models featuring this mechanism display that real, monetary and financial shocks can have a magnified effect on the real economy because borrowers adjust their investment in response to changes in external financing. The section then presents a summary discussion of the empirical evidence on the quantitative importance of the various types of financial accelerator mechanism, mostly in the context of DSGE models.

## A. The financial accelerator

How does the financial accelerator work? The relationships described above, between the amount of external financing and its cost (premium), on one hand, and the strength of borrowers’ balance sheets and cash flow positions, on the other, lead to an amplification mechanism where small shocks can result in large economy-wide adjustments to investment and consumption. Since wealth is a state (or given) variable and economic agents cannot quickly (or optimally) adjust their investment/saving plans (as they face costs of doing so), this mechanism persists over time, causing short-lived shocks to real or financial variables to have longer-lasting effects on the real economy. This propagation mechanism can also have general equilibrium effects as individual agents’ actions affect other agents’ behaviour in a mutually reinforcing fashion (see Figures 4A and 4B).<sup>13</sup>

> 13 For surveys describing variants of the financial accelerator mechanism, see Antony and Broer (2010), BCBS (2011), Coric (2011) and Quadrini (2011).

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