When the economy of a nation has both organized and unorganized financial activities and structures, that nation is said to have a dual financial system. Dual financial systems are quite common in LDC economies, but heretofore have seldom been the subject of serious economic research. In this paper, the author establishes models incorporating the dual financial structure for both the long term and the short term. Exchange sequences and household portfolio choices are also taken into consideration, as are a variety of loan situations.
The two loan situations are the homogeneous condition, in which all firms are eligible to borrow funds from banks, and the heterogeneous condition, in which only a part of the firms wishing to take out loans meet the conditions of banks. Those firms that satisfy the bank conditions are referred to as the “first firms”; firms not satisfying these conditions are called the “second firms.” The heterogeneous situation is further classified into three categories (A, B, and C) according to whether the total amount borrowed by the “first firms” is larger than, equal to, or smaller than the total amount that banks are able to supply.
The author next builds a general equilibrium model for each of the three categories mentioned above. Each model comprises a firm sector, a household sector, the banking system, and a set of equilibrium conditions. Robustness in the models is guaranteed by means of the Walras’s Law test.
The models yield some interesting results. First, under the homogeneous firm situation, it is found that large central bank loans cause a general price increases in the short term, but a price decrease in the long term due to productivity increases. Increased bank interest rates have differential effects upon production – depending upon the change in total loanable funds after households adjust their portfolios to the higher bank rates. If deposits in the unorganized financial markets don’t decrease markedly, and if banks don’t retain a high level of reserves, then the total amount of loanable funds will increase, prompting in turn a fall in the interest rates charged by the unorganized markets, which assists investment and production. On the other hand, a decrease in the total amount of loanable funds causes interest rates on the unorganized markets to rise and is thus unfavorable to investment and production.
Concerning the heterogeneous situation, under case A, all firms obtain their marginal capital from the unorganized markets. The economic reactions are similar to those listed above for the homogeneous situation. Under Case B, the “first firms” and ” second firms” obtain money capital from different sources. Here, increasing central bank loans or bank interest rates directly favors only the “first firms.” Through the substitution of factors of production, price adjustments, and changes in the number of firms, the overall situation for all firms maybe deteriorates. In case C, banks hold excess reserves. An increase in central bank loans only affects the volume of excess reserves without disturbing the other economic variables. The effects of increased bank interest rates are related to the change in the total volume of funds in the unorganized markets. “Second firms”; are negatively affected when the total volume of these unorganized funds decreases.
