Can Good Events Lead to Bad Outcomes? Endogenous Banking Crises and Fiscal Policy Responses
In this paper, we study the impact of labor market restructuring and foreign direct investment on the banking sector, using a dynamic general equilibrium model with a financial sector. Numerical simulations are performed using stylized Chinese data, and banks failures are generated through increases in the growth rate of the labor force, a revaluation of the exchange rate or an increase in debt issue to finance the government deficit, as compared to a benchmark scenario in which banks remain solvent. Thus bank failures can result from what might seem to be either beneficial economic trends, or correct monetary and fiscal policies. We introduce fiscal policies that modify relative factor prices by lowering the capital tax rate and increasing the tax rate on labor. Such policies can prevent banking failures by raising the return to capital. It is shown that such fiscal policies are, in the short run, welfare reducing.
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Adaptive expectations assets in default assume bank assets FDI bank deposits bank failures bank’s banking system base simulation benchmark capital and labor Capital stocks Cobb-Douglas consumer’s cost of capital decline default at end deﬂated domestic and foreign domestic interest rates economy eﬀect end of period equilibrium exogenous exports Feltenstein ﬁnal ﬁnancial assets ﬁrms ﬁscal policies ﬁxed exchange rate foreign borrowing foreign direct investment growth historical period prior income increase in debt indices are normalized inﬂation Initial allocations initial level input-output matrix inputs of capital insolvencies investment lead loans macroeconomic monetization nomic Nominal GDP nominal interest rates normalized to levels parameters Percent bank assets percent diﬀerence percentage of GDP period and FDI Period Sector Price Level prior to period Real GDP real interest rate reﬂected return to capital rural labor rural-urban migration signiﬁcant speciﬁc stocks are normalized tax change tax rate Trade balance utility function wage tax workforce increase