financial dualism in a cash-in-advance economy

BETTY C. DANIEL State University of New York at Albany

Albany, New York

HONG-BUM KIM Gyeongsang National University

Seoul, Korea

Financial Dualism in a Cash-in-Advance Economy*

This paper reexamines financial repression and financial dualism using an optimizing model in which demands for currency and deposits are motivated by cash-in-advance constraints. We contribute to the debate on whether financial liberalization will be expansionary, due to the interest rate stimulus to steady state capital, or contractionary, due to the effect of the higher interest rate on production costs. We find that in the presence of curb markets, neither effect is operative, and liberalization has little effect on output. Financial liberalization is likely to have significant welfare effects only" when curb markets are inoperative.

1. Introduction Developing country governments often place ceilings on bank deposit

and loan interest rates with the objective of subsidizing investment and thereby stimulating growth. McKinnon (1973) and Shaw (1973) argue along classical lines that low interest rates are a form of financial repression in that they retard savings and lead to a shortage of funds with which to finance investment. These arguments have led external advisers to advocate a return of bank interest rates to higher, market determined levels. Such a policy is referred to as financial liberalization.

Developing country governments typically resist such advice. One group of economists, known as the new structuralists, supports this resistance (Buffie 1984; Lira 1987; Taylor 1983; van Wijnbergen 1982, 1983). They argue that the McKinnon-Shaw advice neglects some important aspects of financing production in developing countries. They cite substantial lags in production, which make interest costs a significant component of total costs. A policy of financial liberalization would increase interest rates, raising the costs of production, and reducing output.

The new structuralists also point to the importance of curb markets in supplying firms with financing. Since bank interest rate ceilings result in

*The authors would like to thank Do-Chul Shin and an anonymous referee for helpful comments on an earlier draft.

Journal of Macroeconomics, Spring 1996, Vol. 18, No. 2, pp. 213-234 Copyright © 1996 by Louisiana State University Press 0164-0704 / 96 / $1.50

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Betty C. Daniel and Hong-Bum Kim

credit rationing, there is a significant demand for loans which banks cannot satisfy. To meet this need, black markets, referred to as curb or parallel markets, often develop. Government behavior implicitly allows these markets to operate, accepting deposits and making loans, relatively freely. It is thought, however, that the low bank interest rate keeps the curb market interest rate relatively low through the portfolio substitution effect. There- fore, even curb market loans provide a production subsidy. Furthermore, when savings are directed toward curb markets and away from banks with relatively high reserve requirements, total credit expands. ~ The financial structure in which curb markets operate alongside banks is called financial dualism. The operation of a large efficient competitive curb market together with a repressed banking system has been well documented for some of the newly industrialized countries, including Korea (Cole and Park 1983; Lee and Han 1990), Taiwan (Liang 1988), India (Timberg and Aiyar 1984), and Thailand (Fry 1988).

The conflict between economists over the effects of financial repression is a conflict over the appropriate choice of economic model. The purpose of this paper is to introduce yet another financial model to the argument. The intertemporal asset pricing model with cash-in-advance constraints, initially developed by Lucas (1982), has gained widespread usage in monetary and financial economics, but to our knowledge, it has not been used to analyze financial issues in development economics. 2 The model has the advantage of using specific transactions-based microfoundations for money demand to study financial issues.

In this paper, we apply this model to the issue of financial repression. At the same time, we incorporate into the model some of the financial structure which recent authors have thought important in modeling developing economies. In particular, to retain interest costs as a significant component of production costs, we follow the new strncturalists (for example, Taylor 1983 and van Wijnbergen 1983) and assume that workers must be paid prior to the receipt of sales revenue. In the literature, this is known as the financial constraint. Further, in many developing countries, bond and equity

1Owen and Solis-Fallas (1989) argue to the contrary that banks are relatively more efficient than the curb market in creating loans, such that a redirection of deposits toward banks would be expansionary. We do not pursue this argument here. There is evidence that curb markets are relatively efficient in newly-industrialized and semi-industrialized countries. See Cole and Park (1983), Timberg and Ayiar (1984) and Hang (1988) for arguments.

eOther models with explicit microfoundations are being introduced to deal with these issues. KiihkSnen (1987) analyzes the welfare effects of alternative sequencing of liberalization policies, one of which is financial deregulation. Molho (1986) formalizes arguments by McKinnon and Shaw in a life-cycle model. Kapur (1992) and Bencivenga and Smith (1992) use overlapping generations models with money to analyze financial repression.

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Financial Dualism in a Cash-in-Advance Economy

markets are poorly developed. Therefore, we assume that these methods of financing the wage bill are not available. Banks and curb markets serve as the sources of finance. To highlight the role of curb markets, results are compared in their presence and in their absence.

An advantage of the cash-in-advance asset pricing model is that it provides the bank loan and curb markets with explicit microfoundations. The cost of providing explicit microfoundations is a more complicated model than the standard portfolio balance model. We maintain tractability by considering only one type of capital, working capital. This is the cash, held in advance by firms, to pay the wage bill. There is no source of growth in the model, so we sacrifice issues associated with capital accumulation and growth. Our results characterize the level of output, not its rate of growth.

The model is used to contribute to the debate on whether financial liberalization will be expansionary, due to the interest rate stimulus to the stock of working capital, or contractionary, due to the effect of the higher interest rate on production costs. The model requires intertemporal optimization on the part of households, permitting the first effect, and it contains the financial constraint, permitting the second. We find that in the presence of a curb market, financial liberalization does not affect the marginal interest rate. Therefore, its effects on output are likely to be negligible unless curb markets are absent. 3 If there are significant costs to such a policy, which are not explicitly incorporated into this model, it is easy to see why governments resist external pressures for liberalization.

The paper is organized as follows. In Section 2, we present the model. This includes a discussion of optimizing behavior by firms and households, together with a discussion of equilibrium in the absence of financial repression. Section 3 considers the effects of financially repressive policies, both in the presence and in the absence of a curb market. Section 4 contains conclusions.

2. The Model: Assumptions and Equations

General Description In this section, we present a non-stochastic version of the monetary

model in Englund and Svensson (1988), modified to analyze financial dualism. The model contains three representative agents, a household, a firm,

:~Our argument that financial liberalization would not be contractionary is quite different from that of Kapur (1992), who also incorporates the financial constraint. He argues that increased demand for high-powered money on the part of banks, which need reserves against additional deposits, provides government with a seigniorage opportunity.

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t -1 t ' ', ][ 1 ', ] - - > - - [ goods ~asset and produc- goods as se t and produc-

market 1 abor t ion market 1 abor t ion markets markets

Figure 1. Trading Sequence

and a bank, who interact in asset, labor, and goods markets. Households choose consumption, portfolio composition, and labor supply to maximize utility, subject to budget constraints and cash-in-advance constraints. In order to motivate separate demands for cash and for deposits, we follow Hartley (1988) and Englund and Svensson (1988) and assume that there are two types of goods, which are imperfect substitutes in consumption. Cash goods must be purchased with cash held in advance and check goods can be purchased with either cash or deposits held in advance. Firms hire labor and engage in production subject to the financial constraint that labor be paid in advance of the receipt of sales revenue. This assumption is motivated by the observation that there are significant lags in production in most developing countries, so that working capital requirements for the purchase of labor services are usually financed by credit. Banks serve as financial intermediaries accepting deposits from consumers and making loans to firms to finance working capital.

The trading sequence imposes the financial constraint on firms and the cash-in-advance constraint on households by prohibiting simultaneous re- ceipts and payments. It is given in Figure 1. Within each period, goods markets are assumed to open and close at the beginning, asset and labor markets clear simultaneously in the middle, and production occurs at the end of the period. Households use period t - 1 asset markets to acquire the means to purchase period t goods. Additionally, firms use period t - 1 asset markets to finance period t - i payments to labor for production which will be sold in period t.

In order to obtain demand and supply equations for each of the markets, we consider the behavior of each sector, including the government and the three representative agents, the bank, firm, and household. All markets are assumed to be competitive.

Sectors' The Government. The government sets the regulatory environment for

the banks and supplies fiat currency, also known as high-powered money. Regulations include the prohibition of an unregulated loan market (i.e., a curb market), an official reserve ratio for banks, assumed to be fixed at

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(0 < ct < 1), and the authority to impose ceilings on bank interest rates. Initially, we assume that this authority is not exercised so that ceilings are not imposed. High-powered money (H) is assumed to be fixed over time and is given by the sum of bank holdings as reserves and consumer holdings as cash, according to

H t = Hbt + H h t ,

where high-powered money held by banks (Hbt) is given by the bank's required r e s e r v e s (IXDht), and where Dht and nht , respectively, represent households" bank deposits and cash holdings, chosen in period t - 1 and held for period t goods market transactions.

Banks. When the asset market opens, banks receive deposits from households, cx of which is retained for currency reserves and 1 - cx of which is invested in loans to firms. Banks hold no excess reserves. The bank's reserves (Hht) and its supply of loans (L~t) are therefore given by

Hbt = (XDbt ,

Lbt = (1 -- (X)Dbt ,

where Dbt is determined by the deposits the bank receives (Dbt = Dht ).

Banks are assumed to be competitive so that bank profits are zero each period as in Englund and Svensson (1988). This links the bank deposit rate it a and the bank loan rate i~ according to

(1 - ~)Dbti~ = DbtiJt --~ i~ I = (1 - cx)i~.

Firms. Firms hire labor as the only factor of production and produce output according to a constant-returns-to-scale (CRS) production function. Follow- ing Englund and Svensson (1988), we assume that a linear technology permits costless transformation of total output between the two types of goods after production has been completed. Therefore, their marginal rate of transformation is unity, so that with competitive firms their relative price is unity. Production lags are modeled by assuming that last period's production pro- cess yields output available for sale this period. Output available for consumption is therefore given by

Ylt + Y2t = Yt = L t - i , (1)

where Yt represents total output in time period t, Ylt of which is cash goods, and Y2t of which denotes check goods. Lt_ 1 is labor input used to produce

Yr.

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Bet ty C. Daniel and H o n g - B u m K i m

Profit maximization and competitive labor markets together imply that real wage costs, inclusive of interest, equal labor's marginal product of unity. The equilibrium real wage ( n t W t _ l ) * is therefore given by

(n tWt-1)* = 1/(1 + i~) = (1 - o0/(1 - (x + id), (2)

where i + i~ is the bank loan interest factor, determined in the period t - 1 asset market and paid in the period t asset market, and where n t is the period t price of money in terms of goods.

However, since the representative firm operates subject to the financial constraint, it might not be able to secure sufficient loans to enable it to pay labor equilibrium wages. The financial constraint implies that the actual real wage bill is bound by the total volume of real bank loans available. Since banks hold no excess reserves, this implies

~ W t - l " L t -1 = (1 - {2)lf, tDht <_ (R, t W t _ l ) * . L t * - i , (3)

where n t W t_ 1 is the actual real wage rate that the firm is able to pay, and Lt_ 1 ( L t _ l ) is employment at ~ W t _ 1 ([ntWt_l]*) , such that the labor market clears.

In the period t asset market, the firm uses sales revenue earned in the period t goods market to repay bank loans with interest ([1 - {2]ntDht • [1 + i~]) and to distribute dividends (ntF t • Zt) to households owning firm shares (Zt = number of firm shares held, ntFt = profits per firm share). 4 Total dividends (or total profits) can be expressed as

lftF t , Z t = Clt + c2t - L t_ 1 • n t W t _ l ( 1 + i~) . (4)

The Household. The household supplies labor, demands financial assets (cash, bank deposits, and firm shares), and consumes goods (cash goods and check goods). Its choices are assumed to maximize utility subject to budget constraints and to cash-in-advance constraints. Letting 1] - 1/(1 + ~), where

represents the rate of time preference, clt and c2t be the consumption of cash and check goods, respectively, and 1 - L t the consumption of leisure, utility is given by

U(Clx, c2~, 1 - Lx) ,

4Most authors note that equity is not an important source of financing in developing countries. Equity is necessary here to deal with the distribution of firm profits. We do assume that the stock of equity is fixed so this cannot be a source for financing working capital.

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Financial Dua l i sm in a Cash- in -Advance E c o n o m y

where the time endowment is normalized at unity and 0 < [3 < 1. The cash-in-advance constraints (liquidity constraints) for cash goods

and check goods respectively are ~

CIt <-- g t H h t (5)

czt < ntDm . (6)

Household wealth at time t, w t, is given by the real value of assets carried into the period, including cash, bank deposits, and firm shares, together with current income, including interest on deposits, dividends on firm shares and the value of today's labor endowment. These assets and income can be used to purchase cash goods, check goods, and leisure for current consumption, and assets, including cash, bank deposits, and firm shares, to carry into the next period. Wealth in period t, and the household's budget constraint during period t can be expressed as

W t = n t H h t + K t D h t + Q t Z t + 7 t t D h t . i~ ! + n t F t • Z t + gt'~Vt

= Clt + c2t + g t H h t + l + ~, tDht+l + Q t Z t + l + r c t W t • (1 - Lt) , (7)

where Qt denotes the period t price of equity in terms of goods. The household's optimization problem is a dynamic programming

problem as follows

1)(Wt, H h t , O h t , Z t ) = m a x {tt(Clt , c2t , 1 - L t ) + ~I)(Wt+l, Hht+l , Dht+l , Zt+l) } ,

subject to (5), (6), and (7). The control variables are clt, czt, L t , H h t + l , Oh t+ l ,

and Zt+l. Real wages, prices, interest rates and profits are exogenous to the consumer.

Let ~., gl, and Ix2, be Lagrange multipliers on real wealth and the two liquidity constraints, respectively. Dropping subscripts and denoting time t + 1 variables with a prime ('), the first-order conditions can be expressed as a

cl <- n H h , (~tl ___ 0) ; (8)

c2 <- rtDh , (~t 2 >_ 0) ; (9)

5Following Englund and Svensson (1988), we define the cash-in-advance constraint as c2t <_ gtDht rather than as c~ <_ IItDht + gHht. Using non-interest bearing currency', rather than interest bearing deposits, to satisfy the check goods cash-in-advance constraint, would be suboptimal.

e'rhis section is in many respects a non-stochastic version of the results in Englund and Svensson (1988), and the reader is referred to their article for interpretation of the first-order conditions. However, the absence of bonds from our model implies that we cannot obtain a solution for the deposit interest rate which is linked to the bond rate. In one version of our model, the curb asset serves the same role as Englund and Svensson's bond. See Section 3.

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Bet ty C. Daniel and H o n g - B u m K i m

ul = ;~ + Ix1 ; (10)

u ,2=~+p2 ; (11)

u.3 = )~nW ; (12)

13{(~.' + ~t~)n'} = ~n ; (13)

13{()t,' + ~ ) n ' + i d" )~'n'} = ~,n ; (14)

13{~,'(Q' + n'F')} = ~.Q ; (15)

where we use the fact that v~ = ~,, VHh = p.lX, VDh = ~t2r:, and Vz = O. Equations (8)-(15) can be used to characterize an equilibrium in which

real variables are constant over time, given the consumer's preferences, government regulations, and the supply of high-powered money. Under the assumption of constant high-powered money, prices are constant, implying n -- n'. Consider the following equilibrium relationships from Equations (13)-(15):

~tl/)~ = 8 ; (16)

i d + ~t2/)~ = 8 ; (17)

p = n~/8. (18) Equation (8) implies that if the liquidity constraint for cash goods is not binding, then the liquidity component of the marginal utility of real cash (~q) is zero. Therefore, given a positive rate of time preference, 8, and assuming

> 0, Equation (16) shows that the liquidity constraint for cash goods is always binding. Equations (9) and (17) show that the liquidity constraint for check goods can be either binding or nonbinding in equilibrium, depending on whether 8 - i d is positive or zero. Further, the requirement that ~t 2 be non-negative places an upper bound on i ~, implying that the household's demand for deposits becomes infinitely elastic at i a = 8. Implicitly, wealth must be given by the value which permits this equality. Therefore, in equilibrium,

l~Hh = Cl for 0 < i d < 8 ; (19)

rtDh = c2 for 0 < i a < 8 ; (20)

nDh -- c2 = K4h > 0 for i d = 8 , (21) where KA h represents real deposits above those needed for purchases of check goods. These deposits are held as assets, not for their liquidity services. Using Equations (19)-(21), and (7), the consumer's budget constraint can be expressed as

c 1 + c2(1 - i d) + n W . (1 - L) = nF + n W + K4h id , (22)

2 2 0


w h e r e KA h = 0 when i '~ < 8, and nA h > 0 when i J = 8. In Equation (22) and in what follows below, Z is normalized to unity. Equation (22) states that the consumption of cash goods, check goods net of interest costs, and of leisure, must equal the real value of profits, time endowment, and of interest on bank deposits held as assets. Note that, when i d = 8, ~A h must be whatever is necessary to clear the market for loans and deposits.

To obtain additional results, utility is assumed to be logarithmic according to

u = r h l n c 1 + H e l n c 2+ ( l - q 1 - r l 2 ) l n ( 1 - L ) ,

where ql > 0, ~2 > 0, and r h + q2 < 1. Using Equations (16) and (17), and the logarithmic utility function, Equations (10), (11), and (12) can be expressed as

c I = I~1/~,(1 + 8) ; (23)

c2 = r l jZ , (1 + 5 - i 'l) ; (24 t

L = 1 - (1 - rll - rl2)/~,nW. (2,51

Market Clearing The model is solved by requiring that all markets clear. Graphical

solutions are presented below, and an appendix containing algebraic solutions is available from the authors upon request.

Goods Market. Goods are assumed to be non-storable so that goods market equilibrium requires that all output be consumed according to

c 1 +c~ 2 = y = L , (26)

where the second equality is from Equation (1) for the production function.

Labor nuzrket. Labor demand differs depending on whether the loan market clears. When it does, the demand for labor is infinitely elastic at the real wage which equals labor's marginal product divided by the interest rate factor on loans (Equation [2]). In Figure 2, labor demand is labeled La(free) where free market equilibrium prevails in the bank loan market. When firms are constrained in the amount of financing which they can obtain, labor demand is different. The assumption of competitive labor markets implies that the firm views the wage as exogenous. Therefore, when firms fail to obtain financing at the wage given by labor's marginal productivity, they hire fewer workers. Excess labor supply causes the wage rate to fall until the labor market clears. Labor demand is no longer given by the marginal product, but becomes

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n4N L

$ '

to' Lo

Figure 2. Financial Repression in the Labor Market

L s

Ld(free)

Ld(reg)

infinitely elastic at the wage which yields a total wage bill equal to total available financing. In Figure 2, it is labeled Ld(reg), where regulation characterizes the bank loan rate.

Labor supply is given by Equation (25). Equations (23)-(25), and (26) can be used to express labor supply as a function of real wages and the deposit interest rate. Differentiation with respect to the real wage, holding interest (i 't) constant, implies that labor supply is an upward-sloping function of the real wage. 7 In Figure 2, labor supply is labeled L s. A decrease in i d shifts the curve left.

Assets Markets. Assets include bank deposits, firm shares, and bank loans. The deposit market clears by the assumption that the bank accepts all deposits generated. In the firm shares market, agents willingly hold the fixed supply of unity at the price given by Equation (18).

Turn, now, to the market for bank loans. The demand by firms for loans is given by the equilibrium wage bill. s Equation (2) for the equilibrium real

7With the Cobb-Douglas utility function, the income and substitution effects of a change in the real wage are exactly offsetting when the only" source of income is wages. However, when income has other sources, the percentage change in income from a wage change is smaller, implying a dominant substitution effect.

SThe only reason for the wage bill to fall short of its equilibrium level is if the firm cannot secure sufficient loans, that is, if there is excess loan demand.

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i d

G q'

q

Y' y

A' A B

Z

C bank Ioens

Figure 3. Financial Repression in the Bank Loan Market

wage, together with Equations (23)-(25) and (26), can be used to show that an increase in the deposit interest rate reduces loan demand, due to the interest rate effect on production cost. In Figure 3, loan demand is drawn as downward sloping and is labeled 1 d.

Loan supply is de te rmined by the household's demand for bank deposits, given effective government prohibition of a free loan market. 9 Recall that deposits are held to purchase check goods (c z) and as assets (nAb). Equations (23)-(25) and (26) can be used to show that, for a given real wage, the consumer 's demand for check goods (or, equivalently, the bank's supply of loans) is an upward-sloping function of interest. Once i d reaches 8, the supply of loans must become infinitely elastic to assure i d does not exceed 8. In Figure 3, loan supply is the kinked line labeled XYZ A decrease in real wages shifts the XY portion of the curve left.

Equil ibrium occurs along the upward-sloping portion of the XYZ curve, when the bank interest rate which equates nA to zero is less than or equal to 8. Otherwise, equilibrium occurs along the horizontal portion as drawn in

9If a free loan market were "allowed, it is shown later, and in Englund and Svensson (1988), that the equilibrium interest rate would be 8, the rate of time preference. Therefore, if 8 < id*/(1

- ct), where i d* is the market clearing deposit interest rate in the absence of a free loan market, then there is an incentive for the development of the free loan market (i.e., a curb market) in which loans are not subject to reserve requirements and whose deposits do not serve as a medium of exchange.

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Figure 3. Since i a cannot exceed 8, 7rA h plays the equilibrating role. House- holds hold the level of ~ h necessary for market equilibrium, consuming the interest. In this case, the equilibrium level of 7r, A h is given by BC/(1 - ~) in Figure 3.

To determine whether equilibrium occurs on the upward sloping portion of the curve or not, solve for the interest rate which would clear the market for m~ h = 0.1° hnposing the equilibrium conditions in the goods, loan, and labor markets from Equations (26), (27), and (2), respectively, requiring ma~h = 0, and substituting for consumer demands from Equations (23)-(25) and (26), yields

i d* = (1 + 8) (111 + rh~) [111 + q2(1 + 8 ) ] - 1 .

If 8 - i d* > 0, or equivalently, if ql < 112(1 + 8)(8 - a), then equilibrium occurs on the upward-sloping portion and/~,A h = 0 , whereas, if 8 - i '/* < 0, then equilibrium occurs on the horizontal portion, and 7rA h > 0. Note that since reserve requirements (a) are substantially higher than time preference (8) over a meaningful time period (something like a week), then the empirically relevant case is equilibrium along the horizontal portion of the curve. Also, note that since i d* is calculated by setting/r,A h = 0, the equilibrium deposit interest rate equals rain (i a*, 8), when curb assets are not permitted in the economy.

Algebraically, equilibrium in the loan market requires that the equilibrium wage bill equal loan supply, derived from household bank deposits, according to

(~W)* . L* = (1 - ~)(ce +/r~h) , (27)

where L* and c 2 are explicitly functions of (nW)*. Consider, finally, the market for high-powered money (H). Its stock is

exogenous. It is held by households to purchase c 1 and by banks as reserves against deposits. The price level (~) adjusts instantaneously to maintain an equilibrium in which real demand equals real supply, according to

c 1 + ~ I ~ D h = ~ H .

3. Financial Repression

Curb Markets Prohibited Consider, now, the economic effects of financial repression, that is, of

a governmentally imposed reduction in the bank deposit interest rate to a

l(~I'his requires that the constraint that 11 z > 0 not be imposed.

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level q, below ~ for the empirically relevant case of i (l* > 5.11 Assume that freely operating loan markets remain effectively banned. It is possible to demonstrate the policy effects using Figures 2 and 3.

In Figure 3, financial repression reduces the interest rate on bank deposits from 8 to q. There are two effects on loan supply. The first effect is a reduction in the supply of bank loans along XYZ. This happens because 7Lfli h falls to zero and because c z falls along XY. The second effect is a further reduction in deposits due to a leftward shift of XYZ to X'Y'Z. This occurs since the real wage (~W) falls. Therefore, loan supply falls from 0C to OA', reducing the stock of working capital. The new equilibrium is attained instantaneously as agents swap deposits for currency and the price level adjusts to equilibrate the market for currency (H).

To understand the change in nW, consider the following. The fall in loan supply creates a credit crunch in which firms cannot secure sufficient bank loans to pay labor its marginal product. In Figure 3, loan demand is not satisfied such that actual labor demand is given by the real wage which clears the labor market at a total wage bill of 0q x OA'. In Figure 2, labor demand and real wages fall from La(free) to Ld(reg). Labor supply shifts left due to the fall in the deposit interest rate. Employment falls from L o to L~. From Equation (4), profits increase.

The effects of financial repression are to raise profits, but to reduce employment and output. The higher profits are windfalls, absent at the margin, and they do not serve as incentives to expand. Therefore, the fall in production costs, stressed by the new structuralists is present, but it is in inframarginal costs, not in marginal costs. The reduction in the interest rate reduces the equilibrium stock of working capital such that firms cannot hire more workers at current wages.

Curb Markets Permitted Now, consider the constrained equilibrium in which a financially re-

pressed bank market and a free curb market coexist. This coexistence is referred to as financial dualism. A curb asset is not subject to reserve requirements and entails no transaction costs. It cannot be used as a means of payment, but it can yield higher returns than bank deposits.

A curb asset develops when the government removes its ban on the operation of a free loan market, if the wage bill at the curb market interest rate, i c, exceeds the supply of bank loans at the repressed bank loan rate, i t = q/(1 - o~). When a curb market develops, we assume i c > i t. If equality held instead, firms would be indifferent between bank loans and curb loans, whereas if the inequality were reversed, firms would prefer curb loans.

11The results for the other case are similar (Kim 1990).

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Empirically, the inequality seems to hold (Cole and Park 1983; Edwards 1988; Liang 1988; Timberg and Aiyar 1984). Under this assumption, firms exhaust their access to the bank loan market before turning to the curb market.

Modifications Permitting a Curb Asset. Firms can use both bank loans and curb loans to finance the wage bill. Thus, the financial constraint (Equation [3]) is modified to yield

n t W t _ l Z t _ 1 = (1 - - ~ ) • ~ t D h t + n t C h t . ( 3c )

Modified versions of original equations retain their original numbers together with a "c'" for the curb market.

As before, labor demand is infinitely elastic at the real wage equal to labor's marginal productivity of unity divided by the interest factor due to the assumption that i c > i t. Therefore, the relevant interest rate in determining the marginal productivity of another unit of labor is the curb interest rate. Equilibrium wages are given by

(rctW,_l)* = 1/(1 - i~). (2c)

As long as the bank loan rate is lower than the curb interest rate, the firm is subsidized for its use of bank loans by the difference in the two loan interest rates. This feature implies that positive profits (dividends) will be generated even though firms can pay equilibrium wages. Again, profits are windfalls, absent at the margin, and they do not serve as an incentive to expand production. Assuming goods market equilibrium, and using Equation (3c), real profits (dividends) are defined as

~ t F t = L t _ 1 - [~ tD h t • (1 -- a + q ) + n t C h t . (1 + i~)] . (4c)

The consumer's wealth and budget constraint in period t (Equation [7]) must be modified such that sources of wealth include interest and principal on the curb asse t (~tfht [1 + i~]) and uses of wealth include purchases of the curb asse t (~tfht+l). The additional asset yields an additional first-order condition which can be used to show that the level of curb assets must be determined such that i C = 8 in equilibrium. 12 This result has policy implications, and is in contrast to the usual prediction that a financially repressed bank interest rate can keep the curb interest rate low through the portfolio substitution effect. In this model, bank deposits and curb assets are not gross

lZThat additional first-order condition is: 13[~,'x'(1 + i")] = )~rc. It can be used to show that if the ban on freely-operating loan markets were lifted while the bank loan market remains unrepressed, and if i 't* > 8(1 - oQ, so that a free loan market developed, then the equil ibrium level for the bank deposit rate would be given by i 't = 8(1 - co). This is an Englund and Svensson (1988) result.

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L $'

i

Lo Figure 4.

Financial Dualism in the Labor Market

L s

L=r

Ld(free)

substitutes. The level of the curb rate is independent of the bank interest rate ceiling.

Financial Dualism Compared with Alternatives At this point it is possible to compare a regime of financial dualism with

alternatives. Consider, first, a policy of financial repression in which curb markets are initially banned, but after bank interest rates are repressed, they are allowed to develop. 13 Again assume that i d* > 8 such that the initial deposit rate is 8. The initial equilibrium, prior to financial repression, can be described with the aid of Figures 4 and 5.

In Figure 4, labor demand (L d) is infinitely elastic at the equilibrium real wage rate of [1 + 8/(1 - cz)] -1, Labor supply (L ~) is an upward-sloping function of the real wage rate. Its~osition is determined by the bank deposit rate. In Figure 5, loan demand (l), prior to government intervention in the loan market, is drawn as a decreasing function of i d. Loan supply (XYZ) is a kinked curve. The upward-sloping portion is determined by consumption of check goods at the prevailing wage rate. Once i d reaches 8, the quantity of excess bank deposits is infinitely elastic at b.

131t is possible to show that the incentives for the development of curb markets are greater under financial repression than under a free bank market.

227


i d

8 q'

q

Y y,

x i

i

A A' B C

Z

bank loans

Figure 5. Financial Dualism in the Bank Loan Market

Now, assume that the bank deposit rate is reduced from ~ to q, and that curb markets are simultaneously introduced. The introduction of curb markets has two effects. First, equilibrium wages rise because banks operate subject to reserve requirements and the curb market does not. x4 Second, the operation of curb markets permits firms to pay equilibrium wages even when the banking sector is financially repressed. Therefore, in Figure 4, when financial repression and curb markets are simultaneously implemented, labor demand shifts up due to the increase in equilibrium wages. Labor supply shifts left due to the reduction in the deposit interest rate. The change in employment is ambiguous.

In Figure 5, the supply of bank loans under financial dualism could rise or fall, compared with that in the initial free market equilibrium. The reduction in the deposit rate reduces ~]t h to zero and reduces the consumption of check goods along XY. However, the higher wage shifts the XY portion of the curve right to X'Y'. Total loan demand increases due to the increase in equilibrium real wages (not shown). 1~ Any shortfall in bank loans is offset by curb loans, since agents are indifferent as to the quantity of curb assets they

14Equilibrium wages become (1 + 5) -1. 15Note that under financial dualism, the equilibrium wage is determined by the interest rate

in the curb market, making equilibrium wages independent of the interest rate on deposits. Therefore, the total demand for loans, given the curb market rate, is an upward-sloping function of the interest rate on deposits, reflecting the effect of this interest rate on labor supply.

228


hold when the interest rate on curb assets equals the rate of time preference. Therefore, firms are not constrained in the amount of credit which they can obtain. Real wages and the stock of working capital do not fall due to credit restrictions.

Once again, although financial repression raises firm profits, it provides no incentives to expand output. When curb markets are permitted, the reduction in output created by financial repression is substantially mitigated and possibly reversed. 16 Both wages and employment are higher when curb markets are permitted.

We can also consider a move toward financial liberalization. The bank rate is increased from q to q', but it remains below 8, and therefore remains repressed. The increase in the bank rate increases the bank loan supply available as agents move up along X'Y' in Figures 3 and 5. When a curb market is operating, equilibrium wages are unchanged since curb loans are used to finance the wage bill at the margin and the curb rate is unchanged. The increase in the deposit rate shifts labor supply right, increasing employment, the total wage bill, and loan demand and supply. In contrast, when there is no curb market, an increase in the deposit rate and the corresponding increase in available loans permits an increase in real wages. This shifts the X'Y' portion of the curve right further increasing the availability of bank loans. In Figure 4, the increased interest rate shifts the labor supply curve right as before (not shown), and the increased availability of bank loans increases real wages, thereby shifting labor demand upward. Employment rises both due to higher wages and higher interest rates, whereas in the presence of a curb market, only the effect of higher deposit interest rates is operative. Therefore, the effect of financial liberalization on employment and wage rates is greater in the absence of a curb market.

Welfare Welfare comparisons in the model are always ambiguous. This is be-

cause the free market equilibrium has Pareto distortions due to its cash-in- advance constraints on households, reserve requirements on banks, and financial constraint on firms. In such an economy, repressive financial policy introduces another distortion which can magnify or reduce existing ones, making welfare comparisons difficult. In an attempt to assess the magnitudes of the effects of financial repression on welfare with and without curb markets, we calculated maximized utility, assuming parameter values for the repressed bank rate (q), for the curb interest rate (5 = ic), and for reserve requirements ((x), as actually observed in Korea over different periods with

loCI'he tendency for emplo~anent to rise is due to the effect that the introduction of curb markets has on the equilibrium real wage.

229


varying degrees of financial repression. The relevant time horizon is assumed to be one week. Rates are calculated for the period 1976-1980 (financial repression), 1986-1990 (modest financial liberalization) and for 1976-1990. The shares for cash goods and check goods are set arbitrarily at (ql, r12) = (0.1, 0.8), (0.4, 0.4), (0.8, 0.1). Details of the calibration are available from the authors upon request.

The most interesting results can be summarized as follows. Utility is lowest under a regime of financial repression with curb markets banned. This is consistently observed for different pairs of (111, ~z) and for all sets of (~, ix, q). Utility under financial dualism is similar in magnitude to utility under the regime of free bank markets. Finally, the introduction of financial liberalization improves utility dramatically for the regime in which curb markets are banned and negligibly for the regime which permits curb markets. These results leave open the possibility that policymakers, who choose financial repression and who are permissive toward curb markets, are making good choices in the real world of second best. The gains from financial liberalization, when curb markets are present, are likely to be negligible.

4. Conclusions This paper provides a study of financial repression and financial dualism

in the context of an asset pricing cash-in-advance model in which asset demands have explicit microfoundations. This provides an alternative frame- work for the study of financial repression, distinct from those used to date. Although the model does not deal with capital accumulation and growth for tractability reasons, it does provide new insights into the controversy in development economics over financial liberalization. The model generates implications of repressive financial policies on wealth, market interest rates, firm profits, production costs, and output. These results can be compared with equilibrium results generated in more traditional economic models.

Consider, first, the controversy over whether low bank interest rates are a disincentive to holding wealth. If the highest interest rate offered to savers is below the representative agent's rate of time preference, the household will choose to hold no financial assets above those necessary for meeting cash- in-advance constraints. Agents move to a corner solution. Therefore, financial repression, coupled with a ban on curb markets, provides a severe disincentive toward the holding of wealth. If curb markets are present, the equilibrium curb rate is given by the rate of time preference, and repressive bank interest rates do not prevent firms from obtaining the quantity of loans they need to pay equilibrium wages. Financial repression is not a constraint on the acquisition of working capital.

230


We also find that the bank interest rate has no effect on the curb market rate. The latter is determined by the rate of time preference. The gross substitutes assumption, made in portfolio balance models of asset demand, requires that an increase in the bank rate reduce demands for all other assets, thereby raising other interest rates. This result is absent here. Bank deposits and curb assets are not gross substitutes. Agents hold the minimum amount of bank deposits required to purchase check goods, and additional wealth is held in the form of curb assets. Money is rate of return dominated and is held only to meet cash-in-advance requirements. Therefore, governments need not be concerned that an increase in the bank rate, following a policy of financial liberalization, would raise the curb rate.

Profits are positively affected by financial repression either with or without curb markets. However, these profits are windfalls and they do not serve as incentives to expand production. When the interest rate is forced below its market-determined level, households eliminate all deposits above those needed for liquidity services. In addition, the lower the interest rate on deposits, the fewer check goods they consume, thereby reducing deposits further. Therefore, financial repression reduces the pool of deposits available for financing wage payments. In the absence of a curb market, wages fall below labor's marginal product, generating profits. Even with a curb market, profits are positive, due to the implicit subsidy to costs resulting from the low interest rate on bank loans. Therefore, production costs are lower, as argued by the new structuralists, but since costs are not lower at the margin and profits are windfalls, the lower costs do not serve as an incentive to expand production.

Consider employment. Since financial repression, in the absence of curb markets, lowers wages, households reduce labor supply, thereby reducing employment. The fall in interest rates provides an additional incentive to curtail labor supply. With curb markets operating, financial repression does not lower wages, mitigating the reduction in employment.

The analysis shows that the welfare benefits of financial liberalization in the presence of curb markets are likely to be small. However, in the absence of a curb market, financial liberalization significantly increases the availability of working capital thereby stimulating output and employment.

Received: October 1994 Final version: July 1995

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Appendix

Notation H

D~

i a

Lb

Z F

q C 1

C2

Y

L

W

-- total high powered money; H b = H held by banks; H h = H held by households;

= inverse of the goods price level; = bank deposits received by banks; D h = bank deposits held by

households; = deposit interest rate; i a* = market-clearing deposit rate for ~h

= 0 ;

= bank loan supply; I a = loan demand; i 1 = loan interest rate; = number of shares of equity; Q = price of equity in terms of goods; = firm profits per share of equity; = required reserve ratio on bank deposits; = effective interest rate ceiling on bank deposits; = consumption of cash goods; Yl = production of cash goods; = consumption of credit goods; Y2 = production of credit goods; --- total production; w real wealth; = 1/(1 + 5) and ~ = the rate of time preference; = labor; L s = labor supply; L a = labor demand; L* = equilibrium

labor; = nominal wage rate; (roW)* = equilibrium real wage rate;

~', P-l, ~te = Lagrange multipliers on real wealth and liquidity constraints, respectively;

2 3 3


TII~ ~2

Ah

Ch

= share of cash goods and credit goods, respectively, in consumption;

= household holdings of deposits above those needed for check goods;

= curb assets; i c = curb rate of interest.

234

financial dualism in a cash-in-advance economy

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