Why Is Finance Important? Some Thoughts on Post-Crisis Economics

The global financial crisis around 2008 and the subsequent great recession have forced attention on the relevance of economics. In particular, the core of economic theory suggests that money is neutral (affecting only the price level but not real economic variables) and hence finance and financial crises are not very important. This papers shows that this neutrality is based on the unrealistic institutional assumption of perfect competition. Relaxing this alone (without time lags, price rigidities, menu costs, and other frictions) makes money no longer necessarily neutral and hence makes finance and financial crisis much more important. The presence of increasing returns to scale at the firm level and to specialization at the economy level due to the division of labour also makes finance much more important than suggested by traditional economics. It also makes pecuniary external effects possibly of efficiency relevancy. The reasons for these are explained using simple analyses.