Theoretical models for the analysis of the banking system and financial repression in less-developed nations

A common feature of financial sectors in the third world is the presence of financial repression: the gamut of policies, regulations and restrictions that inhibit financial intermediaries from operating to their full potential. It has been argued that a common feature of financially repressed economies is a very low real interest rate. However, many financial sector studies have not yielded conclusive evidence that levels of real interest rates have systematically affected growth and savings rates. This paper examines reserve requirements, in lieu of real interest rates, as a policy variable indicative of financial repression. Two neoclassical growth models highlight the importance of efficient bank intermediation and predict that levels of and changes in reserve requirements have significant impacts on the time paths of inflation, consumption, real money balances, capital and growth. Key results indicate that raising reserve requirements leads to adverse supply- and demand-side effects that raise inflation, lower growth (both considered reserve effects ) and reduce the monetary base, the base for the inflation tax. Hence, financially repressive policies are short-sighted and self-defeating. Moreover, raising reserve requirements raises real lending rates, lowering the demand for capital goods and depressing aggregate demand. In effect, the inflation tax and the reserve requirement tax conspire to form a system of double taxation. Empirical tests reveal that reserve effects tend to be generated in nations where banks and other financial institutions intermediate a large portion of GDP and/or reserve requirements are very high. For the most part, these reserve effects are generated in the long-run