Thursday, September 20, 2007

'Financial Repression Model'|Beneficial Effects of Elimination

Again a little bit of notes from class:
Raising interest rates is argued to have beneficial effects on economic growth eventually, through a chain of effects. We could summarise the steps in the argument as these:
* higher real interest rates raise real savings
* higher real interest rates raise financial forms of savings, specifically saving in the bank deposits, so that financial intermediation also increases
* higher real interest rates lead to greater domestic credit availability (because of increased financial saving) and hence an increased quantity of investments
* higher real interest rates lead to improved quality of investment also, because low-return projects will not receive funding if funds are rationed by price only; this is said to improve the 'efficiency' of investment
* increased financial intermediation leads to higher economic growth, so that higher interest rates bring about higher real growth eventually, also, through the effects on investment.

The "financial repression" theory states that while saviers may ignore small and transitory changes in real interest rates (from say, 4 to 6 per cent), savings behavior will change significantly when real interest rates undergo a large, sustained swing from negative to positive levels (e.g. from double-digit behative to double-digit positive levels) as a result of financial liberalization. Thus, according to this view savings do not simply depend on the level of interest rates, but also on the philosophy underlying the determination of interest rates. The theory also predicts a strong savings response to liberalization of interest rates under relatively high inflation, when such large jumps in the real interest rate can occur. (UNCTAD #40)



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