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

  • Andrew Feltenstein
  • Céline Rochon

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 Oxford Financial Research Centre in its series OFRC Working Papers Series with number 2008fe03.

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Length: 27
Date of creation: 2008
Date of revision:
Handle: RePEc:sbs:wpsefe:2008fe03
Contact details of provider: Web page: http://www.finance.ox.ac.uk
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  1. Burnside, C. & Eichenbaum, M. & Rebelo, S., 1998. "Prospective Deficits and the Asian Currency Crisis," RCER Working Papers 458, University of Rochester - Center for Economic Research (RCER).
  2. Pamela Labadie, 1994. "Financial intermediation and monetary policy in a general equilibrium banking model," Proceedings, Federal Reserve Bank of Cleveland, pages 1290-1320.
  3. David E. Altig & Charles T. Carlstrom & Kevin J. Lansing, 1995. "Computable general-equilibrium models and monetary policy advice," Working Paper 9503, Federal Reserve Bank of Cleveland.
  4. 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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  7. Jeanne, Olivier, 1997. "Are currency crises self-fulfilling?: A test," Journal of International Economics, Elsevier, vol. 43(3-4), pages 263-286, November.
  8. Jeanne, Olivier & Masson, Paul R, 1998. "Currency Crises, Sunspots and Markov-Switching Regimes," CEPR Discussion Papers 1990, C.E.P.R. Discussion Papers.
  9. 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.
  10. Andrew Feltenstein, 2000. "Bank Failures and Fiscal Austerity; Policy Presecriptions for a Developing Country," IMF Working Papers 00/90, International Monetary Fund.
  11. Obstfeld, Maurice, 1996. "Models of currency crises with self-fulfilling features," European Economic Review, Elsevier, vol. 40(3-5), pages 1037-1047, April.
  12. Christophe Chamley, 2003. "Dynamic Speculative Attacks," American Economic Review, American Economic Association, vol. 93(3), pages 603-621, June.
  13. 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.
  14. 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.
  15. 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.
  16. Celine Rochon, 2006. "Devaluation without common knowledge," OFRC Working Papers Series 2006fe03, Oxford Financial Research Centre.
  17. Maurice Obstfeld, 1984. "Rational and Self-Fulfilling Balance-of-Payments Crises," NBER Working Papers 1486, National Bureau of Economic Research, Inc.
  18. Christophe Chamley, 1999. "Coordinating Regime Switches," The Quarterly Journal of Economics, Oxford University Press, vol. 114(3), pages 869-905.
  19. Rochon, Celine, 2006. "Devaluation without common knowledge," Journal of International Economics, Elsevier, vol. 70(2), pages 470-489, December.
  20. 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.
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