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

27 Pages Posted: 12 Jan 2007

See all articles by Andrew Feltenstein

Andrew Feltenstein

Georgia State University - Department of Economics

Celine Rochon

University of Oxford; IMF

Date Written: November 2006

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 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.

Keywords: Banking, China, Fiscal policy, Tax rates, Labor markets, Foreign investment, Economic models

JEL Classification: D58, E44, F37, G21

Suggested Citation

Feltenstein, Andrew and Rochon, Celine, Can Good Events Lead to Bad Outcomes? Endogenous Banking Crises and Fiscal Policy Responses (November 2006). IMF Working Paper No. 06/263, Available at SSRN: https://ssrn.com/abstract=956726

Andrew Feltenstein (Contact Author)

Georgia State University - Department of Economics ( email )

P.O. Box 3992
Atlanta, GA 30302-3992
United States
404-4130093 (Phone)

Celine Rochon

University of Oxford ( email )

Park End Street
Oxford, Oxfordshire OX11HP
United Kingdom

IMF ( email )

700 19th Street, N.W.
Washington, DC 20431
United States

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