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 and introducing them into tools for policy makers. The rapid growth of the literature on these issues is the motivation for our review of the presented approaches. 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 also 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. The role of financial frictions in DSGE models for macroprudential policy is also discussed, as these models can be used to generate stress-testing scenarios. It can be concluded that DSGE models with financial frictions could complement current stress-testing practice, but are not able to replace stress tests.