On the Neutrality of Financial Repression

24 Pages Posted: 22 Mar 2017 Last revised: 16 Jul 2020

See all articles by Mehran Ebrahimian

Mehran Ebrahimian

Stockholm School of Economics - Finance Department

Seyed Ali Madanizadeh

Sharif University of Technology

Date Written: February 10, 2020

Abstract

In this paper, we theoretically analyze the capital misallocation effect of financial repression---namely, a regulation to provide cheap loans to (public) firms, in less-developed economies. Limited contract enforcement and asymmetric information between lenders and borrowers are the features of the environment we study. We show raising the interest rate does not screen low-productive firms; due to adverse selection such firms borrow and strategically default. Hence, financial repression does not cause capital misallocation. Advanced enforceability of financial contracts and/or a rise in asset collateralizability of firms break the neutrality result, in which case the free market outcome achieves the optimal allocation of capital.

Keywords: Financial Repression, Capital Misallocation, Less-Developed Economies, Contract Enforcement, Asymmetric Information, Asset Collateralizability, Strategic Default.

JEL Classification: G1, O1, P4

Suggested Citation

Ebrahimian, Mehran and Madanizadeh, Seyed Ali, On the Neutrality of Financial Repression (February 10, 2020). Available at SSRN: https://ssrn.com/abstract=2937949 or http://dx.doi.org/10.2139/ssrn.2937949

Mehran Ebrahimian

Stockholm School of Economics - Finance Department ( email )

Sveavägen 65
Stockholm, 11383
Sweden

HOME PAGE: http://www.mehranebrahimian.com/

Seyed Ali Madanizadeh (Contact Author)

Sharif University of Technology ( email )

Tehran
Iran

HOME PAGE: http://gsme.sharif.edu/~madanizadeh/

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