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

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Celine Rochon
Andrew Feltenstein

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

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Length: 26 pages
Date of creation: 29 Nov 2006
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Handle: RePEc:imf:imfwpa:06/263

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Keywords: Banking failures fiscal policies Banking China Fiscal policy Tax rates Labor markets Foreign investment Economic models

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  1. 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. [Downloadable!] (restricted)
  2. 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. [Downloadable!] (restricted)
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  3. Celine Rochon, 2006. "Devaluation without common knowledge," OFRC Working Papers Series 2006fe03, Oxford Financial Research Centre. [Downloadable!]
  4. 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. [Downloadable!] (restricted)
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  5. 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. [Downloadable!] (restricted)
  6. Craig Burnside & Martin Eichenbaum & Sergio Rebelo, 2001. "Prospective Deficits and the Asian Currency Crisis," Journal of Political Economy, University of Chicago Press, vol. 109(6), pages 1155-1197, December. [Downloadable!] (restricted)
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  7. Chari, V V & Christiano, Lawrence J & Eichenbaum, Martin, 1995. "Inside Money, Outside Money, and Short-Term Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1354-86, November. [Downloadable!] (restricted)
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  8. David Altig & Charles T. Carlstrom & Kevin J. Lansing, 1995. "Computable general-equilibrium models and monetary policy advice," Working Paper 9503, Federal Reserve Bank of Cleveland. [Downloadable!]
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  9. Rochon, Celine, 2006. "Devaluation without common knowledge," Journal of International Economics, Elsevier, vol. 70(2), pages 470-489, December. [Downloadable!] (restricted)
  10. Maurice Obstfeld, 1986. "Rational and Self-Fulfilling Balance-of-Payments Crises," NBER Working Papers 1486, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  11. Krugman, Paul, 1979. "A Model of Balance-of-Payments Crises," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 11(3), pages 311-25, August. [Downloadable!] (restricted)
  12. 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 Journals, vol. 50(3), pages 6. [Downloadable!] (restricted)
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  13. Christophe Chamley, 1999. "Coordinating Regime Switches," The Quarterly Journal of Economics, MIT Press, vol. 114(3), pages 869-905, August. [Downloadable!] (restricted)
  14. Jeanne, Olivier & Masson, Paul, 2000. "Currency crises, sunspots and Markov-switching regimes," Journal of International Economics, Elsevier, vol. 50(2), pages 327-350, April. [Downloadable!] (restricted)
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  15. Jeanne, Olivier, 1997. "Are currency crises self-fulfilling?: A test," Journal of International Economics, Elsevier, vol. 43(3-4), pages 263-286, November. [Downloadable!] (restricted)
  16. Burnside, Craig & Eichenbaum, Martin & Rebelo, Sergio, 2004. "Government guarantees and self-fulfilling speculative attacks," Journal of Economic Theory, Elsevier, vol. 119(1), pages 31-63, November. [Downloadable!] (restricted)
  17. Pamela Labadie, 1994. "Financial intermediation and monetary policy in a general equilibrium banking model," Proceedings, Federal Reserve Bank of Cleveland, pages 1290-1320.
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