TAX EVASION, FINANCIAL DEVELOPMENT AND INFLATION

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CHAPTER 3    SOCIAL STATUS, INFLATION AND ENDOGENOUS GROWTH IN A CASH-IN ADVANCE ECONOMY: A RECONSIDERATION USING THE CREDIT CHANNEL

INTRODUCTION

“In order to hold the esteem of men, it is not sufficient merely to possess wealth or power. The wealth and power must be put in evidence, for esteem is awarded only on evidence.” – Thorstein Veblen²
The effect of monetary growth – and hence, the efficiency or optimality of monetary policy – on capital accumulation and economic growth remains a central theme in macroeconomic literature. In the aftermath of the 2007–2009 financial crises, renewed theoretical focus has characterised the global monetary policy environment.³ Complementary to this broader debate, there is also a deepening in the literature studying the effects of wealth-induced preferences for social status (or ”the spirit of capitalism” of Weber (1905)) on capital accumulation and economic growth using dynamic general equilibrium (DGE) models. Chang, Hsieh and Lai (2000) amend the framework of Stockman (1981) and establish a one-sector monetary growth model where the production function takes the general AK form as the engine of growth and a cash-in-advance (CIA) constraint applies to consumption only. The results from the Chang et al. (2000) model seem to confirm the well-known Mundell (1963) and Tobin (1965) effect,⁴ namely that an increase in the money growth rate leads to an increase in the long-run growth rate of the economy, if a capital stock due to a wealth motive is included directly in the production function. This would imply that consumers derive utility not only from consumption, but also from holding capital stock based on a direct wealth motive as some ”evidence of esteem” (Veblen, 1899).⁵ Further proof that individuals care about their social status in a market economy and pursue capital accumulation to advertise their wealth to achieve social status and power is provided by Zou (1994), Bakshi and Chen (1996), Corneo and Jeanne (1997) and Futagami and Shibata (1998).
Using Chang et al. (2000) as a benchmark, subsequent studies on Kurz’s (1968) wealth effects, or linking an individual’s preference for capital holding with wealth and social status, produced mixed and ambiguous results. Zou (1998) included money directly in the utility function (MIU) in a one-sector model and found that higher inflation leads to higher capital stock in the long run, thus increasing the endogenous growth rate of the economy. Gong and Zou (2001) find the same result with a similar model, but using a CIA constraint on consumption only, instead of a MIU specification. When the liquidity constraint is applied to both consumption and investment, the results are ambiguous and depend on the weight ascribed to social status in the utility function and investment in the CIA constraint. Chang and Tsai (2003), using the exact framework of Gong and Zou (2001), find the exact opposite result. More recently, Chen and Guo (2009) with a similar framework but with the CIA constraint applying to both consumption and investment, present results that inflation is detrimental to economic growth.⁶
To gain an understanding of the Chang et al. (2000) results, consider intuitively the presence of an individual’s preferences for social status under a binding CIA constraint: an increase in the money growth rate leads to an increase in inflation, which in turn increases the opportunity cost of consuming as consumption purchases requires the individual to keep cash to effect such purchases. The individual will thus substitute consumption goods for capital goods, and given the social status motive this substitution will lead to higher capital accumulation. In the endogenous growth framework, the mechanism is slightly different: an increase in the money growth rate causes inflation, which in turn leads to a decrease in the holding of real money balances and thus to a decrease in consumption (as consumption require cash in advance). The individual will thus substitute towards physical capital, as the real rate of return on physical capital is constant. As capital accumulation promotes higher social status and the individual’s social status matters, he has a further incentive to accumulate capital. As long as there are constant returns to scale (CRS) with respect to capital, the growth rate of the economy will increase due to increasing capital accumulation.
This intuitive explanation and the results presented by Chang et al. (2000), present an impasse in that a positive growth-inflation relationship is inconsistent with the empirical evidence on the growth-inflation phenomenon and is even inconsistent with the literature on threshold inflation as more clearly detailed in Vaona and Schiavo (2007), Jha and Dang (2012) as well as Neanidis and Savva (2013).⁷
We provide a novel and simple explanation of the effects of monetary growth on economic growth that is empirically consistent. Benchmarking the Chang et al. (2000) framework, we reconsider the monetary growth impact by introducing a competitive banking sector subject to mandatory reserve requirements along the lines of Chari et al. (1995). Note that, Chari et al. (1995) attempted to match the size of the effect of inflation on growth as reported in empirical studies, with those obtained from endogenous growth models with and without banking intermediation. However, they are unable to match the size of the impact reported in econometric model, to the extent that the growth rate of the money supply is found to have a quantitatively trivial effect on the growth rate of output. The incorporation of the banking sector into a monetary model of social status with endogenous growth allows the banking system to play a fundamental role in facilitating both production and capital accumulation and hence, long run economic growth.
To our knowledge, the model presented here is the first attempt at explaining how the money growth rate together with cash reserve requirements – in a similar vein as the reserve requirement coordinating arrangement proposed by Barnett (2005) – affect the outcome of an endogenous monetary model in the presence of the spirit of capitalism or wealth-induced social status. More specifically, the paper brings the importance of the banking literature, especially cash reserve requirements, to bear upon the inflation-growth relationship, which in the presence of social status in an endogenous growth model was found to be positive and hence, inconsistent with the empirical literature. In other words, through the explicit modelling of the banking sector in an otherwise standard endogenous growth model with spirit of capitalism, we are able to obtain the empirically consistent negative relationship between growth and inflation under certain very plausible conditions on the cash reserve requirements.
Cash reserve requirements have long been perceived as a measure of financial repression, since higher cash reserve requirements result in fewer loans available to a bank to lend out for investment/production purposes. For a detailed discussion along these lines, refer to Gupta (2008), Gupta and Ziramba (2009, 2010) and Bittencourt, Gupta and Stander (2014). Essentially, the cash reserve requirement induces a wedge between the deposit rate and the loan rate and hence, creates friction in financial intermediation (Haslag and Young, 1998). Although the mandatory reserve requirement ratios have been reduced consistently across developed and developing countries (Di Giorgio, 1999), it is still considered a monetary policy instrument that broadens the inflation tax base (as it increases real money balances for a given level of deposits in the banking system) and it is still widely used as a liquidity management tool making it easier for central banks to influence the level of market interest rates, as clearly explained in Primus (2017).
Moreover, Chari et al. (1995) report a reserve requirement ratio for the United States (US) over the period 1986-1991 of 4.2 percent. Di Giorgio (1999) summarises data on the reserve requirement for a host of industrial countries over the period 1990-1996 and reports a range of values between 0.5 percent to 22.5 percent, and recently Gupta (2011) reported the average reserve requirement value for a large number of countries to be 22.0 percent. Lastly, Carrera (2013) reports that only 9 of the central banks recently surveyed had a 0 percent reserve ratio; 51 had a reserve ratio between 6 percent to 15 percent, and 15 had a reserve ratio of more than 16 percent. Clearly, reserve requirements are widely prevalent and at times quite significant in size, and hence, cannot be ignored as a monetary policy instrument.
There are two opposing effects on long-run growth in the presence of social status when banks face cash reserve requirements, given an increase in the growth rate of money. One is the well-known Tobin (1965) portfolio substitution effect, where the resultant increase in inflation due to an increase in the money growth rate leads to substituting real balances for capital, as the marginal product of capital is constant and not affected by cash reserve requirements. The resultant increase in capital holdings has a positive effect on long-run growth. This portfolio substitution effect to capital is further reinforced by the preference for social status. The second effect is observed through a deposit rate channel, since the real deposit rate is negatively affected by inflation, even though the real loan rate is still tied to the constant marginal product of capital (given that we consider an endogenous growth framework).
The disconnect between the real deposit rate and the real loan rate arises because of the cash reserve requirements, which, in equilibrium, create a wedge between the deposit and the loan rates. Hence, a lower real rate of deposits results in agents substituting away from capital goods to holding real balances to finance current consumption. The resultant decrease in capital holdings has a negative effect on long-run growth. But these two effects do not simply cancel each other out and lead to money being super-neutral, as in Sidrauski (1967). Our theoretical results show that as long as the cash reserve requirement exceeds a (small) critical value, the effect of inflation or monetary growth on economic growth, is negative. This is in contrast to those findings presented by Chang et al. (2000).
The rest of this paper is organised as follows: Section 3.2-3.4, respectively, defines and solves the specific model, characterises equilibrium along a balanced growth path (BGP) and examines the money growth effects within the characterised economy.

THE MODEL

The principal economic activities are: (i) consumers receive income from their deposits held by banks, and do not accumulate capital directly. They also receive lump-sum transfers from the government. Consumers must decide on their consumption, which is financed by cash as well as the deposits they accumulate with due regard to their social status preferences; (ii) firms derive income using a simple AK-type production technology, and accumulate capital by financing capital purchases with loans obtained from banks. Firms choose the amount of capital they purchase as well as the amount of loans they take from the bank; (iii) the banks operate in a competitive environment and perform a rudimentary pooling function by collecting the deposits from the consumers and lending it out to the firms after meeting an obligatory cash reserve requirement. Banks collect the interest rate on these loans and meet their obligation to the depositors; and (iv) there is an infinitely-lived government which supplies money and distributes the seigniorage income in the form of lump-sum transfers to the consumers. There is a continuum of each type of economic agent with unit mass.

 Consumers

The consumer is an infinitely-lived, representative agent with unit mass who supplies labour inelastic-ally, and hence labour is normalised to unity and there is no labour-leisure decision affecting consumers. The perfect foresight consumer derives utility from both consumption and wealth-induced social status, where social status is represented by his deposits. The idea of direct utility accruing to the consumer from holding capital stock in general, and in this model specifically, deposits, was mathematically formulated by Kurz (1968). The consumer wishes to maximize his intertemporal discounted lifetime utility, where the chosen logarithmic utility function is separable and defined over both consumption and deposits. Formally,

Banks

As in Chari et al. (1995), there exist a finite number of banks in this economy, which we assume to behave competitively and who are all subject to an obligatory cash reserve requirement g, set by the government. Two simplifying assumptions, that no resources are used to operate the banking system and bank deposits are essentially one period contracts, guarantee that all competitive banks levy the same cost on their loans, the nominal loan rate i_l and guarantee the depositor a nominal deposit rate, i_d . Banks accept and pool deposits, choose their allocation portfolio of loans and required cash reserves and then extend loans to firms, subject to g, with the goal of maximising their profits. Subsequently, banks receive interest income from loans to firms and meet their interest obligations to depositors. The bank’s balance sheet is constrained by the reserve requirement, and is represented by (1 −g)d = l. Hence,
The presentation of the constraint as an inequality is to keep the problem structure general, and to indicate that the equality holds only under equilibrium. This helps us avoid imposing the equilibrium condition before solving the optimization problem.
Once we know that the cash reserve requirement is binding, i.e. the banks will only hold reserves up to the point that the requirement is satisfied, it also implies that we could have presented the feasibility condition as equality. The bank’s portfolio choice must include both cash reserves and loans, but since reserves do not earn a nominal interest, the real rate of return on deposits is negatively affected by inflation. The size of this effect, or the size of the inflation tax on cash reserves, is −gp. Hence, in equilibrium

CHAPTER 1 INTRODUCTION
1.1 PROBLEM STATEMENT .
1.2 RESEARCH OBJECTIVE AND QUESTIONS
1.2.1 Research Objective One
1.2.2 Research Objective Two
1.2.3 Research Objective Three
1.2.4 Research Objective Four
1.3 RESEARCH CONTRIBUTION
1.3.2 Research Contribution Two
1.3.3 Research Contribution Three
1.3.4 Research Contribution Four
1.4 OVERVIEW OF STUDY
CHAPTER 2 TAX EVASION, FINANCIAL DEVELOPMENT AND INFLATION
2.1 INTRODUCTION
2.2.1 Entrepreneurs
2.2.2 Depositors
2.2.3 Financial intermediaries
2.3 EQUILIBRIUM
2.4 SOLVING THE MODEL FOR THE STEADY STATE DEGREE OF SHADOW ECONOMY
2.5 THE EMPIRICAL SETTING
2.5.1 Data
2.5.2 The empirical methodology employed
2.5.3 Dynamic panel GMM estimation
2.5.4 Empirical results .
CHAPTER 3 SOCIAL STATUS, INFLATION AND ENDOGENOUS GROWTH
3.1 INTRODUCTION
3.2 THE MODEL
3.3 EQUILIBRIUM ALONG A BALANCED GROWTH PATH
3.4 EQUILIBRIUM ANALYSIS OF MONEY GROWTH EFFECTS
CHAPTER 4 OPENNESS AND GROWTH 
4.1 INTRODUCTION
4.2 THE ECONOMIC SETTING
4.3 EQUILIBRIUM ALONG A BALANCED GROWTH PATH (BGP)
4.4 SOLVING THE MODEL FOR THE STEADY–STATE GROWTH RATE
4.5 THE EMPIRICAL SETTING
CHAPTER 5 FLUCTUATIONS, GROWTH AND INFLATION TARGETING .
5.1 INTRODUCTION .
5.2 THE ECONOMIC SETTING
5.3 EQUILIBRIUM
5.4 GROWTH DYNAMICS
5.5 POLICY IMPLICATIONS
CHAPTER 6 CONCLUDING REMARKS
6.1 INTRODUCTION
6.2 RESEARCH OBJECTIVE ONE
6.3 RESEARCH OBJECTIVE TWO
6.4 RESEARCH OBJECTIVE THREE
6.5 RESEARCH OBJECTIVE FOUR
REFERENCES 
APPENDIX
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