The Welfare Effects of Liquidity Constraints

We analyse the welfare implications of liquidity constraints for households in an overlapping generations model with growth. In a closed economy with exogenous technical progress, liquidity constraints reduce welfare if the economy is dynamically inefficient. But if it is dynamically efficient, some degree of financial repression is optimal in the steady state, even though it hurts some generations in the transition. In an open economy with capital mobility, financial repression of domestic households is never optimal at the national level; but generalized capital mobility leads to an inefficiently low steady-state supply of saving at the world level. With endogenous technical progress, financial repression may increase welfare even along the transition path, thus leading to a Pareto improvement. In this case the optimal degree of financial repression increases as the economy grows.