Financial Repression and Financial Sector Efficiency in a General Equilibrium Model

Being a source of budget revenues, financial repression discourages investment and overall economic activity. Apart from its direct impact on economy, financial repression can adversely influence financial sector efficiency. Such policy can discourage the financial sector's development by reducing its profits. This study proposes an approach to account for this fact in a DSGE model. In this model the role of the financial sector lies in overcoming the information asymmetry problem between lenders and borrowers. By investing in monitoring technology development, the financial sector can increase its efficiency and reduce the external finance premium. However, the financial sector's incentives to invest depend on market characteristics; thus, an indirect effect of financial repression emerges. The model is calibrated for the US economy. A permanent increase of financial repression revenues significantly reduces the long-run output. Almost a half of reduction in output comes from discouraging financial sector investments in monitoring. The reason is that financial repression makes investments in monitoring less beneficial by reducing the size of the corporate credit market. Temporary financial repression tightening does not have such a substantial impact on economic activity. Moreover, in this case the financial sector efficiency channel is negligible in a linearized DSGE model. A comparison of financial repression multipliers with those of distortionary taxes demonstrates that the former are the lowest during the first quarters after the shock If a longer time period is taken into account, financial repression can be a comparatively efficient source of a temporary budget revenues increase if the ratio of government debt to capital is not too high.