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Can Good Events Lead to Bad Outcomes? Endogenous Banking Crises and Fiscal Policy Responses

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  • Céline Rochon
  • Andrew Feltenstein

Abstract

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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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 06/263.

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Length: 26
Date of creation: 01 Nov 2006
Date of revision:
Handle: RePEc:imf:imfwpa:06/263

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Keywords: Tax rates; Labor markets; Foreign investment; Economic models; banking; bank failures; budget deficit; banking system; fiscal policies; bank assets; tax change; bank deposits; foreign borrowing; fiscal policy; banking crises; taxation; present value; government budget; banking sector; government budget deficit; debt obligations; foreign debt; balanced budget; tax changes; tax credit; capital expenditures; government deficit; foreign interest obligations; bank loans; budget surplus; nominal government expenditure; fiscal policy responses; macroeconomic stability; bank soundness; banking model; tax revenues; fiscal austerity; decentralization; public debt; budget deficits; savings rate; tax on wages; aggregate demand; bank solvency; fiscal decentralization; debt service; budget constraints;

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References

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  1. Diaz-Gimenez, Javier & Prescott, Edward C. & Fitzgerald, Terry & Alvarez, Fernando, 1992. "Banking in computable general equilibrium economies," Journal of Economic Dynamics and Control, Elsevier, vol. 16(3-4), pages 533-559.
  2. Rochon, Celine, 2006. "Devaluation without common knowledge," Journal of International Economics, Elsevier, vol. 70(2), pages 470-489, December.
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  4. Andrew Feltenstein & Saleh M. Nsouli, 2003. ""Big Bang" Versus Gradualism in Economic Reforms: An Intertemporal Analysis with an Application to China," IMF Staff Papers, Palgrave Macmillan, vol. 50(3), pages 6.
  5. David E. Altig & Charles T. Carlstrom & Kevin J. Lansing, 1994. "Computable general equilibrium models and monetary policy advice," Proceedings, Federal Reserve Bank of Cleveland, pages 1472-1505.
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  7. Blejer, Mario I. & Feldman, Ernesto V. & Feltenstein, Andrew, 2002. "Exogenous shocks, contagion, and bank soundness: a macroeconomic framework," Journal of International Money and Finance, Elsevier, vol. 21(1), pages 33-52, February.
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  12. Obstfeld, Maurice, 1986. "Rational and Self-fulfilling Balance-of-Payments Crises," American Economic Review, American Economic Association, vol. 76(1), pages 72-81, March.
  13. Feltenstein, Andrew, 1992. "Oil prices and rural migration: the Dutch disease goes south," Journal of International Money and Finance, Elsevier, vol. 11(3), pages 273-291, June.
  14. Labadie, Pamela, 1995. "Financial Intermediation and Monetary Policy in a General Equilibrium Banking Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1290-1315, November.
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  16. Flood, Robert P. & Garber, Peter M., 1984. "Collapsing exchange-rate regimes : Some linear examples," Journal of International Economics, Elsevier, vol. 17(1-2), pages 1-13, August.
  17. Celine Rochon, 2006. "Devaluation without common knowledge," OFRC Working Papers Series 2006fe03, Oxford Financial Research Centre.
  18. Jeanne, Olivier, 1997. "Are currency crises self-fulfilling?: A test," Journal of International Economics, Elsevier, vol. 43(3-4), pages 263-286, November.
  19. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
  20. Ball, Sheryl & Feltenstein, Andrew, 2001. "Bank failures and fiscal austerity: policy prescriptions for a developing country," Journal of Public Economics, Elsevier, vol. 82(2), pages 247-270, November.
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