W.K.Y. Fung et al /Journal of Development Economics 61(2000)111-13 system actually subsidizes the government investment projects and the loss-incur ring state-owned enterprises (vi) Since the state banking system is employed as the main vehicle to transfer resources from the non-state sector to the state sector, the money supply process is endogenously determined by the governments budget requirement 3. The model In our analysis, we will incorporate into our model all of the six institutional features of the Chinese economy mentioned above. The model constructed in this paper has the following three sets of attributes. First, in order to examine the impact of government policy changes on the output growth, we construct an overlapping generations model featuring endogenous growth. Externalities or learning by doing are introduced to the production technologies, which makes sustained growth feasible through a combination of increasing social returns and diminishing private returns to capital. As such, economic growth is driven by the augmentation of the capital stock in the econom Second. to evaluate how allocation of financial resources affects the level of capital investment, production and thus the growth rate of output, our model pecifies an economic system with two sectors: a real sector consisting of the markets for a consumption good, a capital good, and labor services, and a financial ctor consisting of the markets for money, government bonds, and bank deposits and loans. Money is introduced into the model by assuming that there are cash-in-advance constraints on the purchases of the consumption and capital roods These bank loans are"hidden deficits"of the government(McKinnon, 1994). Using a two-dimen- onal moral hazard model, Zuo and Sun(1996) show that there are incentive-based reasons for the low interest rate policy in China. ccording to Feltenstein and Farhadian (1987), in China, changes in the money supply for the period of 1954-1983 can be explained by: (i the government deficit, (ii) procurement payments to the farmers, and(iii) the wage bill of govemment and state enterprises. As Brandt and Zhu(1995)argue when rapid economic growth is generated in the non-state sector, to equalize the benefits of growth, the govemment uses the financial system as the vehicle to transfer resources from the non-state sector to the state sector. As a result, the money supply process is endogenously determined by the government transfer requirement. nat the individuals of the economy are three-period lived overlapping generations, we can simplify their optimization problems and obtain a tractable framework for dynamic general equilibrium analysis. In addition, in contrast to a standard infinitely lived representative agent model an overlapping generations model incorporates the heterogeneity among individuals and allows the govemment's choice between and bond financing of its budget deficit and debt repayment to have real effects on the (1987), and Bencivenga and Smith ver externalities"considered by Romer(1986), Boyd and Prescott These are similar to the
116 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) system actually subsidizes the government investment projects and the loss-incurring state-owned enterprises. 12 Ž . vi Since the state banking system is employed as the main vehicle to transfer resources from the non-state sector to the state sector, the money supply process is endogenously determined by the government’s budget requirement. 13 3. The model In our analysis, we will incorporate into our model all of the six institutional features of the Chinese economy mentioned above. The model constructed in this paper has the following three sets of attributes. First, in order to examine the impact of government policy changes on the output growth, we construct an overlapping generations model featuring endogenous growth. 14 Externalities or learning by doing are introduced to the production technologies, which makes sustained growth feasible through a combination of increasing social returns and diminishing private returns to capital. 15 As such, economic growth is driven by the augmentation of the capital stock in the economy. Second, to evaluate how allocation of financial resources affects the level of capital investment, production and thus the growth rate of output, our model specifies an economic system with two sectors: a real sector consisting of the markets for a consumption good, a capital good, and labor services; and a financial sector consisting of the markets for money, government bonds, and bank deposits and loans. Money is introduced into the model by assuming that there are cash-in-advance constraints on the purchases of the consumption and capital goods. 12 These bank loans are ‘‘hidden deficits’’ of the government McKinnon, 1994 . Using a two-dimen- Ž . sional moral hazard model, Zuo and Sun 1996 show that there are incentive-based reasons for the low Ž . interest rate policy in China. 13 According to Feltenstein and Farhadian 1987 , in China, changes in the money supply for the Ž . period of 1954–1983 can be explained by: i the government deficit, ii procurement payments to the Ž. Ž . farmers, and iii the wage bill of government and state enterprises. As Brandt and Zhu 1995 argue, Ž. Ž . when rapid economic growth is generated in the non-state sector, to equalize the benefits of growth, the government uses the financial system as the vehicle to transfer resources from the non-state sector to the state sector. As a result, the money supply process is endogenously determined by the government’s transfer requirement. 14 By assuming that the individuals of the economy are three-period lived overlapping generations, we can simplify their optimization problems and obtain a tractable framework for dynamic general equilibrium analysis. In addition, in contrast to a standard infinitely lived representative agent model, an overlapping generations model incorporates the heterogeneity among individuals and allows the government’s choice between money and bond financing of its budget deficit and debt repayment to have real effects on the economy. 15 These are similar to the ‘‘spillover externalities’’ considered by Romer 1986 , Boyd and Prescott Ž . Ž. Ž. 1987 , and Bencivenga and Smith 1992
M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 Last, in the model, there are both a state sector and a private sector, with the ng more efficient in production and markets are fully liberalized and thus perfectly competitive. However, the financial sector is monopolized by the government, which sets interest rates on the financial assets and determines the allocation of bank loans. The enterprises in the state ector face soft budget constraints, being subsidized by the government through bank loans with low interest rates, while the private sector faces hard budget constraints,thereby depending on its internal source of finance for capital invest ment. The government finances its budget by collecting tax revenue, issuing government bonds, and printing money. The money supply is endogenously determined in the sense that whenever the other two sources of funds are sufficient to finance the government's budget deficit, money creation is em- ployed to take up the residual 3.1. Agents, preferences, and production technology Consider the following partially reformed socialist economy. In the econom time is discrete and infinite, indexed by t=0, 1, 2,,.. The economy is inhabited by an infinite sequence of overlapping generations of individuals. At the beginning of each period, individuals of measure one are born. Each individual lives for three periods. When young, each individual is endowed with a single unit of labor and inelastically supplies it to a perfectly competitive labor market. Let Wi denote the nominal wage rate prevailing in the labor market in period t. Using the labor income earned, at the end of the first period of their lives, the individuals make their portfolio decisions. At the end of the second period of lives, the middle-aged individuals collect the return from their portfolios. When they are old, the individuals do nothing but consume their wealth The individuals of the same generation are heterogeneous in their ability to organize production processes (i.e, setting up and managing individual firms for commodity production ). There are two types of individuals in each generation:a measure of 8 individuals are endowed with the production-organizing ability, and the rest do not possess such ability. Hereafter, the first type will be referred to as Hereafter, we will refer to the non-state enterprises as the private firms. In our modeling, rivate enterprises and joint-ventures with urban collectives and TVEs will not cause any since both types of enterprises have large autonomy in decision making but receive few supports from the central govemment. sector have been iy d sector wage rates are determined administratively, they can be viewed as This is because since 1979, the growth rates of wages in the ne level as those in the non-state sector which are determined in the labor market. See Brandt (1995)for detailed discussion as to how and why
M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 117 Last, in the model, there are both a state sector and a private sector, 16 with the latter being more efficient in production and learning by doing. In the real sector, markets are fully liberalized and thus perfectly competitive. However, the financial sector is monopolized by the government, which sets interest rates on the financial assets and determines the allocation of bank loans. The enterprises in the state sector face soft budget constraints, being subsidized by the government through bank loans with low interest rates, while the private sector faces hard budget constraints, thereby depending on its internal source of finance for capital investment. The government finances its budget by collecting tax revenue, issuing government bonds, and printing money. The money supply is endogenously determined in the sense that whenever the other two sources of funds are insufficient to finance the government’s budget deficit, money creation is employed to take up the residual. 3.1. Agents, preferences, and production technology Consider the following partially reformed socialist economy. In the economy, time is discrete and infinite, indexed by ts0, 1, 2, 3, . . . . The economy is inhabited by an infinite sequence of overlapping generations of individuals. At the beginning of each period, individuals of measure one are born. Each individual lives for three periods. When young, each individual is endowed with a single unit of labor and inelastically supplies it to a perfectly competitive labor market. Let Wt denote the nominal wage rate prevailing in the labor market in period t. 17 Using the labor income earned, at the end of the first period of their lives, the young individuals make their portfolio decisions. At the end of the second period of their lives, the middle-aged individuals collect the return from their portfolios. When they are old, the individuals do nothing but consume their wealth. The individuals of the same generation are heterogeneous in their ability to organize production processes i.e., setting up and managing individual firms for Ž commodity production . There are two types of individuals in each generation: a . measure of u individuals are endowed with the production-organizing ability, and the rest do not possess such ability. Hereafter, the first type will be referred to as 16 Hereafter, we will refer to the non-state enterprises as the private firms. In our modeling, grouping the private enterprises and joint-ventures with urban collectives and TVEs will not cause any problem since both types of enterprises have large autonomy in decision making but receive few financial supports from the central government. 17 Even though in the state, sector wage rates are determined administratively, they can be viewed as if they are determined by the market. This is because since 1979, the growth rates of wages in the sector have been maintained at the same level as those in the non-state sector, which are determined in the labor market. See Brandt and Zhu 1995 for detailed discussion as to how and why. Ž
W.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 the entrepreneurs(indexed by a superscript e), and the second type will be referred to as the non-entrepreneurs (indexed by a superscript n) The individuals of all generations have identical preferences on consumption or simplicity, it is assumed that individuals value consumption only when they are old. The preferences of an individual of generation t are characterized by the utility function U(C14,Cr+1C计+2)=CH2,i=e,n,Vt≥1 (1) Note that the first superscript indicates which generation the individual belongs to, the second superscript indicates his type, and the subscript indicates which riod the individual lives in. Since the individuals value consumption only when old, they save their labor income made when young by holding money, bank deposits, government bonds, and/or the capital good in the second period of their ives. Further, because consumption must be paid in cash, old individuals finance their consumption by the cash balance carried over from the second period of their ves There are two types of commodities being produced in the economy: a non-storable consumption good and a capital good. The markets for trading the two types of commodities are perfectly competitive. The nominal price of the tal good and consumption good in period t are denoted by Pk and P espectively. The capital good is produced by an investment technology, which converts one unit of the consumption good into one unit of the capital good without using the inputs of labor effort. Thus, the nominal prices of the two goods are always equal, PI=P For simplicity, it is assumed that the capital good depreciates completely after the production processes have been completed By the nature of ownership, there are two types of producers in the consump- tion good industry: the private firms (indexed by a superscript p) owned by the entrepreneurs and the state-owned enterprises(indexed by a superscript s)owned by the government. In the state sector, the number of firms is a measure of one and the number of firms in the private sector is a measure of A Production of the consumption good requires the inputs of capital and labor effort. In order to produce the consumption good in period t+ l, the firms must install the capital good at the end of period t. It is assumed that the capital good must be paid when purchases are made but workers are paid only after the production processes are completed. That is, there exists a cash-in-advance (liquidity) constraint on hiring capital but not on hiring labor 18T1 equired to simplify the problem so that analytical solutions can be obtained. ption, we do not have to worry about how individuals allocate their income or current and savings. a more detailed discussion on how changi affect our results will be presented in Section 5.2
118 M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) the entrepreneurs indexed by a superscript e , and the second type will be referred Ž . to as the non-entrepreneurs indexed by a superscript n . Ž . The individuals of all generations have identical preferences on consumption. For simplicity, it is assumed that individuals value consumption only when they are old. 18 The preferences of an individual of generation t are characterized by the utility function: U t,i Ct,i ,Ct,i ,Ct,i sCt,i Ž . , ise,n, ;tG1. 1Ž . t tq1 tq2 tq2 Note that the first superscript indicates which generation the individual belongs to, the second superscript indicates his type, and the subscript indicates which period the individual lives in. Since the individuals value consumption only when old, they save their labor income made when young by holding money, bank deposits, government bonds, andror the capital good in the second period of their lives. Further, because consumption must be paid in cash, old individuals finance their consumption by the cash balance carried over from the second period of their lives. There are two types of commodities being produced in the economy: a non-storable consumption good and a capital good. The markets for trading the two types of commodities are perfectly competitive. The nominal price of the capital good and consumption good in period t are denoted by P k and P , t t respectively. The capital good is produced by an investment technology, which converts one unit of the consumption good into one unit of the capital good without using the inputs of labor effort. Thus, the nominal prices of the two goods are always equal, Pt t ksP . For simplicity, it is assumed that the capital good depreciates completely after the production processes have been completed. By the nature of ownership, there are two types of producers in the consumption good industry: the private firms indexed by a superscript p owned by the Ž . entrepreneurs and the state-owned enterprises indexed by a superscript s owned Ž . by the government. In the state sector, the number of firms is a measure of one, and the number of firms in the private sector is a measure of u. Production of the consumption good requires the inputs of capital and labor effort. In order to produce the consumption good in period tq1, the firms must install the capital good at the end of period t. It is assumed that the capital good must be paid when purchases are made but workers are paid only after the production processes are completed. That is, there exists a cash-in-advance Ž . liquidity constraint on hiring capital but not on hiring labor. 18 This assumption is required to simplify the problem so that analytical solutions can be obtained. With this simplifying assumption, we do not have to worry about how individuals allocate their income for current consumption and savings. A more detailed discussion on how changing this assumption will affect our results will be presented in Section 5.2
M.K.Y. Fung et al/ Journal of Development Economics 61(2000)111-13 he technology for producing the consumption good is characterized by the following production function Q=Q(k,1,H)=4kB”,i=p,,∈(0,1) where A'>0 is the time-invariant productivity parameter and H, is an indicator of the economy-wide technology level in period t. To capture the fact that the state-owned enterprises are less efficient in production than the private firms in China, it is assumed that AP=A and AS=aa, where a E(0, 1). moreover, to capture the fact that the private sector is more efficient in learning by doing(e.g adapting to a fast changing environment and adopting modern technologies and advanced management techniques) in China, we assume that the evolution of H is determined only by the capital stock accumulated in the private sector in period Formally H1=6k That is, the augmentation of the capital good in the private sector generates a positive external effect on the productivity of the whole economy 3. 2. The financial sector and gouernment fiscal arrangement In the economy, there are three types of financial assets: money and bonds. The government monopolizes the allocation of financial resources by etaining the rights for bond-issuing, and by controlling the banking system through a central bank. At the end of period t, the central bank issues B, units of government bonds, and the commercial banks accept deposits from individuals and make loans to the state-owned firms. Once bonds are purchased, they cannot be redeemed until the end of the next period. Similarly, once made, bank deposits cannot be withdrawn until the end of the next period. Since there is a cash-in-advance constraint on the purchases of the consumption good, and since savings in forms of bonds and bank deposits are illiquid for one period, only the young will purchase government bonds and deposit their income into the commercial banks at the end of period t Let Di and di denote respectively the amount of bank deposits held by the entative entrepreneur and non-entrepreneur in period t. Moreover, let D the total amount of bank deposits held by the young individuals and L the total amount of bank loans made by the banking system in period t Given that bank deposits are the only source of loanable funds of the state-banking system, the liquidity constraint faced by the system is D,=OD+(1-O)D2L Given the monopolization of the financial sector by the government, it is the ntral bank that sets the nominal interest rates on bonds (i ), bank deposits (id) and loans (i, ). The nominal interest rate on bonds is usually set at a higher level than that on bank deposits(see Qian, 1994). In this case, the young would like to old bonds instead of bank deposits. Given that B, is less than the desired gregate bond holdings of the young, each young individual is allowed to urchase b, units of the government bonds. In other words, the purchase of
M.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 119 The technology for producing the consumption good is characterized by the following production function: Qi sQ k i ,l i ,H sAi k i s l i 1ys H1ys t tt t tt t Ž . , isp,s, sgŽ . Ž. 0,1 , 2 where Ai )0 is the time-invariant productivity parameter and H is an indicator t of the economy-wide technology level in period t. To capture the fact that the state-owned enterprises are less efficient in production than the private firms in p s China, it is assumed that A sA and A sa A, where agŽ . 0,1 . Moreover, to capture the fact that the private sector is more efficient in learning by doing e.g., Ž adapting to a fast changing environment and adopting modern technologies and . t advanced management techniques in China, we assume that the evolution of H is determined only by the capital stock accumulated in the private sector in period t. Formally, H su k p . 3Ž . t t That is, the augmentation of the capital good in the private sector generates a positive external effect on the productivity of the whole economy. 3.2. The financial sector and goÕernment fiscal arrangement In the economy, there are three types of financial assets: money, bank deposits, and bonds. The government monopolizes the allocation of financial resources by retaining the rights for bond-issuing, and by controlling the banking system through a central bank. At the end of period t, the central bank issues B units of government bonds, t and the commercial banks accept deposits from individuals and make loans to the state-owned firms. Once bonds are purchased, they cannot be redeemed until the end of the next period. Similarly, once made, bank deposits cannot be withdrawn until the end of the next period. Since there is a cash-in-advance constraint on the purchases of the consumption good, and since savings in forms of bonds and bank deposits are illiquid for one period, only the young will purchase government bonds and deposit their income into the commercial banks at the end of period t. Let De and Dn denote respectively the amount of bank deposits held by the t t representative entrepreneur and non-entrepreneur in period t. Moreover, let Dt denote the total amount of bank deposits held by the young individuals and Lt denote the total amount of bank loans made by the banking system in period t. Given that bank deposits are the only source of loanable funds of the state-banking e Ž . n system, the liquidity constraint faced by the system is D suD q 1yu D GL . t t tt Given the monopolization of the financial sector by the government, it is the Ž b . Ž d central bank that sets the nominal interest rates on bonds i , bank deposits i ., t t Ž L and loans i .. The nominal interest rate on bonds is usually set at a higher level t than that on bank deposits see Qian, 1994 . In this case, the young would like to Ž . hold bonds instead of bank deposits. Given that Bt is less than the desired aggregate bond holdings of the young, each young individual is allowed to purchase b units of the government bonds. In other words, the purchase of t