Survey of Research on Financial Sector Modeling within DSGE Models: What Central Banks Can Learn from It

This survey gives insight into the ongoing research in financial frictions modeling. The recent financial turmoil has fueled interest in operationalizing financial frictions concepts. The rapid growth of the literature on financial frictions motivates this review. The empirical facts that motivate the inclusion of financial frictions are surveyed. This survey provides a description of the basic approaches for introducing financial frictions into dynamic stochastic general equilibrium models. The significance and empirical identification of the financial accelerator effect is then discussed. The role of financial frictions models in CNB monetary and macroprudential policy is described. It is concluded that given the heterogeneity of the approaches to financial frictions it is beneficial for the conduct of monetary policy to focus on the development of satellite approaches. DSGE models with financial frictions used to generate stress-testing scenarios could complement current stress-testing practice, but are not able to replace it.