Chapter 3 The McKinnon-Shaw School

Outlines Kapur’s model and its dynamic adjustment Mathieson’s model and its dynamic adjustment Open-Economy Extensions

In this chapter, we mainly study the first generation financial repression model. In all the first generation financial repression models, money demand is a function of the real deposit rate of interestｄ-πe Financial repression could be exerted through reserve requirements Inflation intensifies financial repression cause by reserve requirements

Among the first generation financial repression models, the most elaborate are those of Kapur and Mathieson The Kapur-Mathieson model applies to a labor-surplus developing economy characterized by the following Harrod-Domar aggregate production function: Y=σK The proportion of utilized fixed capital in total utilized capital is α and fixed capital is fully utilized.

Kapur Banks provide credit to finance a fixed fraction θ of the cost of replacing depleted working capital (in real terms). Bank credit is used to finance all the additions (again in real terms) to working capital. In the next period, entrepreneurs repay only the fraction θ of bank loans used to finance the now-depleted net additions to working capital before taking out new loans.

The net increase in total utilized capital in real terms in Kapur’s model is where is the nominal increase in bank loans.

The ratio of bank credit to money L/M is q. The centre bank controls the rate of growth of nominal high-powered money and through this the rate of growth of bank loans and deposit money: The equation can be rewritten

Since Y/K equals σ and equals the rate of economic growth or , equation can be expressed in terms of by dividing both sides by K: It shows that the rate of economic growth is affected by , , q, , PY/M, , π.

Kapur chooses a variant of Phillip Cagan’s money demand function frequently used in the inflation tax literature: Combine the two equations:

Money is nonneutral in its effect on the rate of economic growth in Kapur’s model for three reasons: (a) the fixed nominal deposit rate of interest d. (b) the required reserve ratio imposes an effective tax on financial intermediation which increases as inflation increases. (c) all net working capital investment is financed by bank credit, while only a fraction of replacement working capital is financed by banks.

The third source of nonneutrality highlights the main defect of Kapur’s model — the absence of a behavioral saving function or supply constrains. Investment can be increased indefinitely, even exceeding the total value of output.

Dynamic adjustment Kapur includes two sources of dynamic adjustment: adaptive expectations of the inflation rate money market disequilibrium

Adaptive expectations can be expressed : Kapur uses an expectations-augmented Philips curve to introduce money market disequilibrium:

Defining W as the logarithm of velocity of circulation V, Kapur’s model can be reduce to two equations of motion:

Kapur’s growth equation can be expressed in terms of the logarithm of velocity W:

Kapur simulates two alternative stabilization policies: The first policy is reducing the rate of monetary growth μ. The second policy raises the deposit rate of interest d towards its equilibrium level.

Mathieson A fixed proportion θ of all investment—fixed capital, net working capital, and replacement working capital—is financed by bank loans. Total real loan demand is

Mathieson explains the rate of capital accumulation by firms’ saving behavior. Mathieson’s growth rate function is:

Equilibrium deposit rate is determined by It yields

Money neutrality Money is not neutral in Mathieson’s model if d or l is fixed below its competitive market equilibrium level, or if q<1.

Dynamic adjustment Mathieson incorporates adaptive expectations of the inflation rate and decaying stock of fixed-interest bank loans as two sources of dynamic adjustment in his model.

Optimal strategy It necessitates initial discrete increases in both d and l. A discrete decrease in μ to a rate below its long-run value will also be required. During the transition d and l are gradually reduced and μ is gradually raised to its steady state value consistent with

Open-Economy Extensions Kapur Mathieson

Kapur adds to his closed economy model a production function for working capital Kw: The price of Kw at the cost-minimizing combination of Kwd and Kwf is Pw: Pw is substituted for P in equation….

With rational expectations, the growth rate for this open economy is

The main additional economic insight gleaned from Kapur’s model is that the real exchange rate may well have to depreciate during the transition from repressed to liberalized states. Kapur shows that it is not necessarily optimal to devalue the nominal exchange rate initially by the full extent required for trade balance in the new steady state.

Mathieson’s open economy model is an extension of his closed economy model. In addition to balance-of-payments considerations, the open economy model contains a Phillips curve: And

The general price level Pg is defined as The rate of capital accumulation is The demand for deposits is

The most serious problem with Mathieson’s model is the lack of any equilibrating mechanism in the money market. Mathieson actually assumes that the monetary authority adjusts the deposit rate to prevent money market disequilibrium at all times.

Assuming that the economy starts from a position of “rapid inflation, low or zero growth, and a balance-of-payment deficit.” Mathieson shows that price stability can be approached through an initial discrete increase in d and l, an overdepreciation of en, and a decline in the growth rate of C. (This conclusion is opposite to Kapur’s)

Summary In the first generation financial repression models, money demand is a function of the real deposit rate of interestｄ-πe. Even if deposit and loan rates of interests were allowed to be freely determined in a competitive environment, however, financial repression could be exerted through reserve requirement.

The policy implications of these models are that economic growth can be increased by abolishing institutional interest rate ceiling abandoning selective or directed credit program eliminating the reserve requirement tax ensuring that the financial system operates competitively under conditions of free entry.