When is financial repression—namely, policies that force banks to hold government debt—optimal? With commitment, such policies are never optimal because they crowd out banks’ productive investments. Without commitment, they are optimal when governments need to issue unusually large amounts of debt, such as during wartime. In such times, repression allows governments to credibly issue more debt. Repression increases credibility because when banks hold government debt, defaults dilute net worth, reduce investment, and are thus costly ex post. Forcing banks to hold debt endogenously increases these ex post costs but has ex ante costs because doing so crowds out investments.
Bibliographical noteFunding Information:
Teles, Ivan Werning, Mark Wright, and Pierre Yared for helpful comments; Joan Gieseke for editorial assistance; and the National Science Foundation for supporting this research. The views expressed herein are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System.
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