This paper describes the origins of the global financial crisis and how the prevailing New Keynesian macroeconomic orthodoxy failed to anticipate its severity. This failure, we argue, stemmed from an incomplete understanding of the pivotal role of financial institutions in the amplification of the crisis and its transmission to the wider economy. Low global interest rates and a consequent 'search for yield' in the pre-crisis period encouraged financial institutions to build highly leveraged balance sheets which, in turn, generated extremely large asset-price movements when a 'small event'-the downturn in the US sub-prime mortgage market-triggered the worldwide crisis. The paper then briefly describes the element of the broadly successful and coordinated macroeconomic policy response to the crisis before turning to the medium-term challenges facing policy-makers in sustaining global recovery. At the national level, we focus on the resolution of fiscal imbalances which contributed, in part, to the crisis, and which then worsened because of the policy actions which have been taken to deal with it. At the international level, we emphasize the need to rectify the imbalances between savings and investment in many significant countries. This will require greater coordination of macroeconomic policy across the world's major economies. It will also involve strengthening the role, and the governance, of the International Monetary Fund.Copyright 2009 The Authors. Published by Oxford University Press. This is a pre-copyedited, author-produced PDF of an article accepted for publication in the Oxford Review of Economic Policy following peer review. The definitive publisher-authenticated version Oxf Rev Econ Policy (2009) 25 (4): 507-552 is available online at: http://oxrep.oxfordjournals.org
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