Answer to Question #48535 in Microeconomics for Yoyo

Question

Consider the problem of a household that will earn $I during its working life – the present – and values consumption goods both in the present (Cp) and during its retirement years – the future – (Cf). Suppose the real after-tax interest rate between the two periods is “r”.
Q: One of the criticisms of monetary policy since the financial crisis of 2008 is that central banks around the world have been pursuing a policy of “financial repression”. This line of argument holds that that the policy-makers are reducing real after-tax interest rates (perhaps below zero) in an effort to reduce the burden on borrowers (including governments) and thereby punishing savers. Assuming that the household thinks of Cp as a normal good, show that such a policy might result in the household choosing to save more or less in response to the reduction in the interest rate. Make sure you illustrate and discuss the substitution and income effects.

Answer 1

Financial repression is any of the measures that governments employ to channel funds to themselves, that, in a deregulated market, would go elsewhere. Financial repression can be particularly effective at liquidating debt. The financial repression/liberalization model initiated by McKinnon (1973) and Shaw (1973) consists effectively a turning point in the theoretical ideas and policy recommendations concerning the financing of economic development. The basic idea was that adequate savings are necessary for the realization of investment projects desperately needed for the economic growth of Less Developed Economies (LDCs). However, government policies that seek to boost investment by keeping administered low loan rates – and hence deposit rates – prohibit the accumulation of enough savings – in the form of deposits with the banks. This, financial repression effect need to be alleviated by new financial liberalization policies that would free deposit rates to reach their market equilibrium levels. In this sense, both real economic growth would be promoted and inflation control would be achieved together. This is because, money supply increase would be the outcome of output expansion to sustain increased transaction needs and not the precondition for investment projects directed by government.