Answer to Question #48536 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:Now imagine a household that will earn income of $Ip in the present an $If in the future. In a new diagram show that this household may switch from being a saver to becoming a borrower as a result of the “financial repression” as discussed above. Be sure to explain the substitution and income effects that explain this change in behaviour.

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.