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

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  • Andrew Feltenstein
  • Celine Rochon

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 captial 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.

Suggested Citation

  • Andrew Feltenstein & Celine Rochon, 2008. "Can Good Events Lead to Bad Outcomes? Endogenous Banking Crises and Fiscal Policy Responses," Economics Series Working Papers 2008fe03, University of Oxford, Department of Economics.
    • Handle: RePEc:oxf:wpaper:2008fe03
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    More about this item

    Keywords

    Banking failures; Fiscal policies;

    JEL classification:

    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • F37 - International Economics - - International Finance - - - International Finance Forecasting and Simulation: Models and Applications
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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