It is well-documented empirically and theoretically that the financial and real activities are interrelated. Earlier empirical evidence suggests that relaxation of credit rationing raises the deposit rate, encourages financial savings and promotes financial deepening [e.g., see Tsiang (1980) for the case of Taiwan and Diaz-Alejandro (1985) for the Latin American economies during the 1950s and 1960s]. However, recent cross-country econometric studies by Jappelli and Pagano (1994) and Liu and Woo (1994) indicate that there may exist a positive relationship between credit market imperfections and savings. This latter result may be combined with standard growth theory to conclude that credit rationing may spur an economy, in contrasting with the conventional view. One may therefore wonder whether credit constraints are beneficial or harmful for financial development and long-run macroeconomic performance.
Underlying this empirical puzzle, there are also divergent theoretical predictions on how credit rationing influences the equilibrium rates of interest: while Azariadis and Smith (1993) find a lower real interest rate in credit constrained equilibrium than in a unconstrained economy, Tsiddon (1992) and Bencivenga and Smith (1993) show the reverse. The present paper attempts to address these important but controversial issues by focusing on some plausible dynamic general-equilibrium channels through which credit constraints on firm borrowing influences long-run macroeconomic performance.
To facilitate a study of the long-run effects of credit market imperfections on financial returns and economic growth, we design a stylized dynamic general equilibrium model with two essential features. On the one hand, we fully specify the consumer behavior, the producer behavior and the financial sector so as to understand the determinants of the deposit and loan rates separately. On the other hand, for the purposes of studying the long-run interactions between the real and financial sectors, we differentiate technical progress originated in goods production from that in financial activity. In so doing, we allow for independent sources of financial and economic development through which the consequences of credit market imperfections can be examined.
More specifically, we delineate the environment of the economy with three types of optimizing agents: households, banks and firms. In the basic model, the rate of economic growth is exogenous and individual human capital is a fixed proportion of the society's stock of knowledge. The young households work to receive wages and save for consumption during their retirement period. Banks employ labor and undertake financial productivity improvement to convert deposits into loan services. Firms hire workers and obtain loan services from the banking sector to invest in goods-production projects. In the presence of the moral hazard problem in that firms may borrow and abscond without repaying bank loans, it is optimal for banks to ration the credit. We fully characterize the unconstrained and credit-constrained equilibrium, respectively, in Sections III and IV.
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Credit Market Imperfections and Long-Run Macroeconomic Consequences
