Linkages between the Financial and the Real Sector of the Economy: A Literature Survey

This document reviews the literature on the relationship between financial markets and the real economy. In the light of the recent financial crises, we focus on channels that are likely to be important in times of financial stress. Some channels are governed by balance sheet effects like the Financial Accelerator and the Bank Lending Channel. We discuss the significance of these channels in the light of empirical evidence and try to extract their quantitative importance from the literature. Both channels seem to have played an important role in the aftermath of the crisis. Further, we discuss the role of trade finance in the collapse in world trade following the financial crisis 2007-2009. While finance is important for trade, the literature is not conclusive on whether finance was also the reason for the observed collapse. Naturally, risk is important during a financial crisis. Taking a look at risk channels, we find risk also to play an important role in feedback loops between finance and the real economy. The theoretical and empirical evidence found in the literature appears to be useful in explaining the severe and long-lasting effects of the recent financial crisis.