The Domestic and International Effects of Financial Deregulation

This paper studies the domestic and international effects of financial deregulation in a dynamic, stochastic, general equilibrium model with endogenous producer entry. We model deregulation as a decrease in the monopoly power of financial intermediaries. We show that the economy that deregulates experiences producer entry, real exchange rate appreciation, and a current account deficit. The rest of the world experiences a long-run increase in consumption and an expansion in the number of domestic producers. Less monopoly power in financial intermediation results in less volatile business creation, reduced markup countercyclicality, and weaker substitution effects in labor supply in response to productivity shocks. Financial deregulation thus contributes to a moderation of firm-level and aggregate output volatility. In turn, trade and financial ties between the two countries allow the foreign economy to enjoy lower volatility as well. The results of the model are consistent with features of U.S. and international data following the U.S. banking deregulation started in 1977.