Working Papers

2017-15 | July 2017

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Interest-Rate Liberalization and Capital Misallocations

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We study the consequences of interest-rate liberalization in a two-sector general equilibrium model of China. The model captures a key feature of China's distorted financial system: state-owned enterprises (SOEs) have greater incentive to expand production and easier access to credit than private firms. In this second-best environment, liberalizing interest rate controls improves capital allocations within each sector, but exacerbates misallocations across sectors. Under calibrated parameters, interest-rate liberalization may reduce aggregate productivity and welfare, unless other policy reforms are also implemented to alleviate SOEs' distorted incentives or improve private firms' credit access.

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Article Citation

Liu, Zheng, Pengfei Wang, and Zhiwei Xu. 2017. "Interest-Rate Liberalization and Capital Misallocations," Federal Reserve Bank of San Francisco Working Paper 2017-15. Available at https://doi.org/10.24148/wp2017-15