Fluctuations

T he financial crisis that developed starting in the summer of 2007 hasmade it clear that macroeconomic models need to allocate a moreprominent role to the financial sector for understanding the dynamics of the business cycle. Contrary to what has been often reported in popu-lar press, there is a long and well-established tradition in macroeconomics of adding financial market frictions in standard macroeconomic models and showing the importance of the financial sector for business cycle fluctuations. Bernanke and Gertler (1989) is one of the earliest studies. Kiyotaki and Moore (1997) provide another possible approach to incorporating financial frictions in a general equilibrium model. These two contributions are now the classic references for most of the work done in this area during the last 25 years. Although these studies had an impact in the academic field, formal macro-economic models used in policy circles have mostly developed while ignoring this branch of economic research. Until recently, the dominant structural model used for analyzing monetary policy was based on the New Keynesian paradigm. There are many versions of this model that incorporate several frictions such as sticky prices, sticky wages, adjustment costs in investment, capital utilization, and various types of shocks. However, the majority of these models are based on the assumption that markets are complete and, therefore, there are no financial market frictions. After the financial crisis hit, it became apparent that these models were missing something crucial about the behavior of the macroeconomy. Since then there have been many attempts I am indebted to Andreas Hornstein and Felipe Schwartzman for very detailed and insightful suggestions that resulted in a much improved version of this article. Of course, I am the only one responsible for possible remaining errors and imprecisions. The opinions expressed in this article do not necessarily reflect those of the Federal Reserve Bank of Richmond o