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Credit rationing is a common feature of most developing economies. In response to it, the governments of these countries often operate a number of programs intended to expand the supply of credit to the private sector. Expansionary monetary policy is often seen as a way of reducing the extent of credit rationing. We examine the consequences of a common policy tool in these economies: the use of expansionary monetary policy combined with direct central bank lending to inject credit. In the context of a small open economy we show that such a policy increases long-run production if and only if the economy is in a development trap. Moreover government credit programs often lead to endogenously arising aggregate volatility. Thus the case for government intervention in credit markets relies largely on the notion that output is artificially low because the economy is in a development trap. However, it is the case that the kind of policy we consider can be used to eliminate certain indeterminacies of equilibrium created by endogenous credit market frictions. Journal of Economic Literature Classification Numbers: E44, O16, O42.

It is often asserted that the presence of credit rationing gives monetary policy considerable scope to affect real economic activity.1 In particular, the claim is thatwhen credit is rationed, an “easier” monetary policy can expand the availability of credit. As a result, there can be a corresponding expansion of lending, investment, and production. It is also the case that the rationing of credit seems to be especially prevalent in developing countries. Moreover, in developing country contexts, central banks are often actively involved in the allocation of credit. Indeed, the central bank often lends directly to banks engaged in making loans to “strategic” sectors of the economy or rediscounts a variety of private sector loans. Here, then, the connection between monetary expansion and the supply of credit is particularly tight: money growth is used to finance direct or indirect lending by the central bank.2 If the claim about the link between monetary policy and credit availability in the presence of credit rationing is correct, this link should be particularly strong in developing countries. However, expansionary monetary policy has other consequences in addition to its impact on the availability of credit. Most specifically, increases in the rate of money creation also increase the rate of inflation. And, it is empirically wellestablished that increases in the rate of inflation can have strong adverse consequences for credit market conditions3 and consequently output growth. These observations suggest an obvious question: which of these effects is likely to dominate? Or, alternatively, when (if at all) should a central bank use expansionary monetary policy as a means of injecting credit into an economy? Clearly, expansionary monetary policies can lead to an expansion of credit only if the consequences of credit injection are strong enough to offset the contractionary effects of higher rates of inflation on bank lending. All of the issues mentioned thus far can be posed with reference to long-run equilibria. In addition, there is the question of how the use of monetary policy to inject credit affects equilibrium dynamics in a small open economy—a category which presumably includes most developing countries. In this regard, two facts are well established but not theoretically explained: (a) high average rates of inflation are strongly associated with high inflation variability, and (b) when the rate of inflation exceeds some critical level, further increases in inflation can lead to socalled inflation crises with dramatic consequences for output.4 One of our goals is to provide theoretical explanations for these observations. We would also like to understand whether the use of monetary policy to fund credit extension can affect the determinacy of equilibrium. In order to investigate these issues, we construct a conventional monetary growth model (Diamond, 1965), which has been reformulated so that capital investment requires access to external finance. In our model, credit rationing arises endogenouslybecause of a costly state verification (CSV) problem5 in credit markets. Motivated by the presence of this rationing, the government (central bank) utilizes seigniorage income to rediscount bank lending or to subsidize private credit extension. Also, in keeping with the circumstances relevant to most developing countries, we focus on a small open economy. Furthermore, in our model, lenders are subjected to a reserve requirement, just as intermediaries have been for long periods of time in most developing economies. In this framework, we are able to obtain the following results. First, if there is any steady state equilibrium where credit is rationed domestically, then there are typically at least two such equilibria. One has relatively high capital stock and output level; we refer to this as the high activity steady state. The other has a relatively low capital stock and output level. Moreover, for a wide range of parameter values both steady states can be approached. Hence development traps are possible; here these are the consequence of a CSV problem in credit markets. The long-run aggregate consequences of using expansionary monetary policy to finance the direct extension of credit by the government turn out to depend very heavily on which of the steady state equilibria prevails. Under certain methods for financing central bank lending, we show that at the high activity steady state, an increase in the volume of government lending (rediscounting) necessarily reduces the long-run capital stock and output level, as well as the volume of private credit extended to domestic residents. Thus, government credit market interventions are counterproductive—at least with respect to long-run output—in the high activity state. This effect is reversed, however, whenever the economy is caught in a development trap. Only there can the expansion of credit associated with monetized government lending outweigh the negative implications of higher rates of inflation. In essence, then, the case for subsidized government lending as a means of stimulating production may make sense only if the economy is stranded in a low activity equilibrium to begin with. With respect to shorter-run phenomena, we also show that the magnitude of government lending substantially affects the properties of dynamical equilibria, the scope for indeterminacy of equilibrium, and the potential for endogenously arising volatility. More specifically, when government credit programs are not too large, we showthat the lowactivity steady state is a saddle, and the dynamical equilibrium paths approaching it do so monotonically. Matters are much different near the high activity steady state, however. In particular, we state conditions where extremely small government lending leads the high activity steady state to be a sink. Since our economy has only a single initial condition, the result is an indeterminacy; there are multiple equilibrium paths that approach the high activity steady state. Moreover, as the size of the government credit program increases, we state conditions under which dynamical equilibria approaching the high activity steady state must exhibit fluctuations. In effect, then, government lending programs become responsible forendogenously arising volatility. This volatility will be reflected in all endogenous variables, including the rate of inflation. Thus high average rates of inflation are associated with inflation variability, as we observe. Moreover, the potential of government credit extension financed by high enough rates of money creation to produce volatility, coupled with some of the findings described above, supports the view that these programs may interfere with macroeconomic performance. However, our most important result is that the case for using monetary expansion to fund government lending depends on the economy being “trapped” in or near a low activity steady state. At or near the high activity steady state, monetary expansions—even if they are used to directly inject credit into the economy— adversely affect long-run capital formation and production. This finding is of interest in view of the fact that government credit interventions have widely been viewed as counterproductive.6 Interestingly, as government credit programs become very large, the properties of the dynamical equilibria near each steady state become very different. For large government interventions the lowactivity steady state can become a sink, while the high activity steady state becomes a saddle. When this is the case, the high activity steady state is no longer indeterminate. But, as we show, it is also the case that paths approaching the high activity steady state necessarily display endogenously arising fluctuations as they do so. This last point deserves some emphasis. As a whole, our results imply that small government credit programs will be most conducive to large output levels, near the high activity steady state. But they can also easily lead to the indeterminacy of equilibrium. Large government programs have adverse consequences for long-run output (again, near the high activity steady state), and they can lead to endogenously generated volatility. But they are consistent with a determinate equilibrium. Thus here as elsewhere,7 a tension between the determinacy and the “efficiency” of equilibrium can easily arise. Intuitively speaking, what accounts for the steady state results we have described above? The answer has to do with the interaction between the CSV problem, the domestic reserve requirement, the operation of international capital markets, and the way the government lending program is financed. In a small open economy, agents lending domestically must receive the prevailing world real return on their investments. In addition, the domestic reserve requirement forces such agents to hold a portfolio consisting of domestic loans and domestic real balances. It is the return on this portfolio that must match the world rate of interest. For a given domestic rate of inflation, this return is clearly determined by the rate of return on loans. In the presence of the CSV problem, the return on domestic loans depends on two factors: the domestic marginal product of capital, and theamount of internal finance provided by domestic investors.8 A higher domestic capital stock reduces the marginal product of capital, but it also increases the income level—and the quantity of internal finance—of domestic investors. As a result, there are two ways in which domestic borrowers can offer the necessary expected return on loans. They can either have a high capital stock and income level, a large volume of internal finance, and a low marginal product of capital, or have a low capital stock, a low volume of internal finance, and a large marginal product of capital. Hence there will typically be two steady state equilibria: one with a high, and one with a low capital stock. The use of monetary expansions to fund government lending affects these equilibria in two ways. When the government increases the magnitude of its lending— or the implied subsidy on a given volume of lending—it must finance this by printing money. Thus the steady state rate of inflation rises. At the same time, the cost of funds to agents lending domestically—net of implied government subsidies—falls. Under weak conditions the interaction of these two effects implies that the real return that borrowers must offer lenders declines as the magnitude of government lending increases. In the high (low) activity steady state this is accomplished via a decline in the level of internal finance (the marginal product of capital), and a corresponding reduction (increase) in the steady state capital stock. This change in the capital stock also partially accounts for the results we obtain regarding dynamical equilibria. Surprisingly, the consequences of expansionary monetary policy in an economy with credit rationing have received little attention in the literature. Azariadis and Smith (1996), Boyd and Smith (1998), and Huybens and Smith (1999) examine the consequences of changes in the rate of money creation in a closed economy context when credit is rationed. Thakor (1996) also considers how changes in monetary policy can affect the extent of credit rationing in a closed economy. Of those papers, only Azariadis and Smith (1996) allow for the possibility that monetary expansions are used to directly inject additional credit into the economy. Moreover, to our knowledge, the only paper that explicitly considers monetary policy in an open economy context with credit rationing is Huybens and Smith (1998). There monetary expansions do not fund direct lending. A comparison of the Huybens–Smith results with the results stated above will indicate that this makes a considerable difference. The remainder of the paper proceeds as follows. Section 2 lays out the model environment, while Section 3 describes trade in credit and factor markets. As a point of reference, Section 4 analyzes the general equilibrium of a closed economy, and Section 5 then examines the steady state equilibria of a small open economy. Section 6 takes up dynamics, and Section 7 offers some concluding remarks.

We have analyzed the effects of central bank rediscounting, and expansionary monetary policy, in a small open economy with a domestic credit market friction. Under certain methods of financing government lending, we have seen that such a policy can potentially have a positive effect on long-run output levels only when the economy is in a development trap; otherwise it is counterproductive.We have also seen that such policies can give rise to endogenous volatility. On the other hand,central bank rediscounting on a large scale can render the high activity steady state determinate. In this sense, there is a tension in central bank rediscounting between the determinacy of equilibria—on the one hand—and the level of output and the volatility of output and inflation, on the other. Of course these results have been obtained only for one particular—albeit important—kind of program: the central bank conducts monetary policy by rediscounting private loans. An important issue for future research concerns whether similar results can be obtained for other types of government programs—such as loans guarantees or direct lending—intended to inject credit or for other methods of conducting monetary policy.