Financial repression, directed credit subsidies, and low-income traps: The problem of optimal monetary control

The dissertation examines how extreme repression of financial markets can undermine monetary stability while reducing real output. Careful financial liberalization then becomes necessary for restoring monetary control and revitalizing production. These theoretical ideas are illustrated by Nicaragua's hyperinflation in the 1980s, which peaked at 33,600% in 1988.; A microeconomic model of a profit-maximizing firm (or farm) analyzes how directed credit subsidies affect the complementarity between money and capital under conditions of financial repression. Given bank deposit and lending rates, credit policy, and inflation, the firm's demand for fixed and working capital is examined. Paradoxically, real output can actually decline as credit subsidies increase if the macroeconomic cost of the subsidies require a fall in the real deposit rate or an increase in inflation. The resulting microeconomic distortions undermine the productivity of capital, and compliance with credit eligibility criteria further hinders production. These considerations underscore the importance of explicitly modeling the macroeconomic problem.; The macroeconomic models explore the feasible set of policy combinations consistent with overall financial balance and asset-market equilibrium, demonstrating how an economy in these circumstances may find itself at the worst of multiple equilibria--extremely high inflation, negative real interest rates, and low real income. High lending and deposit interest rates, on the other hand, are associated with a low inflation equilibrium characterized by higher output. A judicious choice of financial policies, however, might not be sufficient to propel an economy to the desired equilibrium. The Nicaraguan hyperinflation exemplifies an inefficient combination of high inflation and low interest rates--characterized by high credit subsidies yet rapidly falling output in the face of steeply negative returns to monetary assets. Based on Nicaragua's partial liberalization in 1989, the macroeconomic model shows how raising deposit and lending rates is associated with substantial reductions in inflation and higher real income.