Currency Substitution and Financial Repression

Abstract

In this paper, we use a general equilibrium overlapping generations monetary endogenous growth model of a small open economy, to analyze whether financial repression, measured via the ‘high’ mandatory reserve-deposit requirements of financial intermediaries, is an optimal response of a consolidated government following an increase in the degree of currency substitution. We find that higher currency substitution can yield higher reserve requirements, but the result depends crucially on how the consumer weighs money in the utility function relative to domestic and foreign consumptions, and also the size of the government.

Keywords:

• Currency substitution
• endogenous growth models
• financial repression
• small open economy
• public finance

JEL CLASSIFICATIONS :

• E31
• E44
• E63
• F43

Acknowledgements

The auhor would like to thank an anonymous referee for many helpful comments.

Notes

¹See Caprio et al. (2001) for further details.

²See Roubini and Sala-i-Martin (1992), and the references cited there in.

³This assumption has no bearing on the results of our model. It makes computations easier and also seems to be a good approximation of the reality. For details see Hall (1988).

⁴Note θ is independent of λ as the savings decision of the consumers, d _t , is free of the currency substitution parameter.

⁸Note this value of φ ensures a government-size of 20%, a figure widely encountered in the literature. See Bhattacharya and Haslag (2001) for further details.

⁵All the calculations were carried out using the NMaximize routine in Mathematica 5.0.

⁶The World Development Indicators (published by the World Bank), suggests that the per-capita world growth rate, in recent times, has tended to vary between 1.5% to 2.5%. We choose 2% simply as an average of this range.

⁷It must be pointed out that, for the sake of simplicity and without any loss of generality, we have converted the parameter values obtained from the five studies, mentioned above, to their nearest multiple of 5. As long as the framework is retained, the qualitative results of our analysis continues to hold irrespective of the values chosen for these parameters.

⁹See Espinosa and Yip (1999) for further details.

¹⁰For example these were also obtained by Freeman (1987) and Gupta (2005, 2006, 2008) and Gupta and Ziramba (2008a, 2009, 2010b). Also refer to Bhattacharya and Haslag (2001) and Gupta and Ziramba (2008b) for a nice exposition as to how this issue can be handled.

¹¹Gupta (2008) and Gupta and Ziramba (2009) raise similar concerns about studies treating tax evasion as exogenous and analyzing optimal responses of government policies following changes in the exogenous degree of tax evasion.