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

November 1, 2006

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Celine Rochon, and Andrew Feltenstein. Can Good Events Lead to Bad Outcomes? Endogenous Banking Crises and Fiscal Policy Responses, (USA: International Monetary Fund, 2006) accessed November 23, 2024

Disclaimer: This Working Paper should not be reported as representing the views of the IMF.The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate

Summary

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.

Subject: Banking, Budget planning and preparation, Distressed institutions, Foreign direct investment, Government debt management

Keywords: Cost of capital, Rate of return, WP

Publication Details

Pages:

26
Volume:

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DOI:

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Issue:

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Series:

Working Paper No. 2006/263
Stock No:

WPIEA2006263
ISBN:

9781451865233
ISSN:

1018-5941

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