M.K.Y. Fung et al/ Journal of Development Economics 61(2000)111-13 he technology for producing the consumption good is characterized by the following production function Q=Q(k,1,H)=4kB”,i=p,,∈(0,1) where A'>0 is the time-invariant productivity parameter and H, is an indicator of the economy-wide technology level in period t. To capture the fact that the state-owned enterprises are less efficient in production than the private firms in China, it is assumed that AP=A and AS=aa, where a E(0, 1). moreover, to capture the fact that the private sector is more efficient in learning by doing(e.g adapting to a fast changing environment and adopting modern technologies and advanced management techniques) in China, we assume that the evolution of H is determined only by the capital stock accumulated in the private sector in period Formally H1=6k That is, the augmentation of the capital good in the private sector generates a positive external effect on the productivity of the whole economy 3. 2. The financial sector and gouernment fiscal arrangement In the economy, there are three types of financial assets: money and bonds. The government monopolizes the allocation of financial resources by etaining the rights for bond-issuing, and by controlling the banking system through a central bank. At the end of period t, the central bank issues B, units of government bonds, and the commercial banks accept deposits from individuals and make loans to the state-owned firms. Once bonds are purchased, they cannot be redeemed until the end of the next period. Similarly, once made, bank deposits cannot be withdrawn until the end of the next period. Since there is a cash-in-advance constraint on the purchases of the consumption good, and since savings in forms of bonds and bank deposits are illiquid for one period, only the young will purchase government bonds and deposit their income into the commercial banks at the end of period t Let Di and di denote respectively the amount of bank deposits held by the entative entrepreneur and non-entrepreneur in period t. Moreover, let D the total amount of bank deposits held by the young individuals and L the total amount of bank loans made by the banking system in period t Given that bank deposits are the only source of loanable funds of the state-banking system, the liquidity constraint faced by the system is D,=OD+(1-O)D2L Given the monopolization of the financial sector by the government, it is the ntral bank that sets the nominal interest rates on bonds (i ), bank deposits (id) and loans (i, ). The nominal interest rate on bonds is usually set at a higher level than that on bank deposits(see Qian, 1994). In this case, the young would like to old bonds instead of bank deposits. Given that B, is less than the desired gregate bond holdings of the young, each young individual is allowed to urchase b, units of the government bonds. In other words, the purchase ofM.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 119 The technology for producing the consumption good is characterized by the following production function: Qi sQ k i ,l i ,H sAi k i s l i 1ys H1ys t tt t tt t Ž . , isp,s, sgŽ . Ž. 0,1 , 2 where Ai )0 is the time-invariant productivity parameter and H is an indicator t of the economy-wide technology level in period t. To capture the fact that the state-owned enterprises are less efficient in production than the private firms in p s China, it is assumed that A sA and A sa A, where agŽ . 0,1 . Moreover, to capture the fact that the private sector is more efficient in learning by doing e.g., Ž adapting to a fast changing environment and adopting modern technologies and . t advanced management techniques in China, we assume that the evolution of H is determined only by the capital stock accumulated in the private sector in period t. Formally, H su k p . 3Ž . t t That is, the augmentation of the capital good in the private sector generates a positive external effect on the productivity of the whole economy. 3.2. The financial sector and goÕernment fiscal arrangement In the economy, there are three types of financial assets: money, bank deposits, and bonds. The government monopolizes the allocation of financial resources by retaining the rights for bond-issuing, and by controlling the banking system through a central bank. At the end of period t, the central bank issues B units of government bonds, t and the commercial banks accept deposits from individuals and make loans to the state-owned firms. Once bonds are purchased, they cannot be redeemed until the end of the next period. Similarly, once made, bank deposits cannot be withdrawn until the end of the next period. Since there is a cash-in-advance constraint on the purchases of the consumption good, and since savings in forms of bonds and bank deposits are illiquid for one period, only the young will purchase government bonds and deposit their income into the commercial banks at the end of period t. Let De and Dn denote respectively the amount of bank deposits held by the t t representative entrepreneur and non-entrepreneur in period t. Moreover, let Dt denote the total amount of bank deposits held by the young individuals and Lt denote the total amount of bank loans made by the banking system in period t. Given that bank deposits are the only source of loanable funds of the state-banking e Ž . n system, the liquidity constraint faced by the system is D suD q 1yu D GL . t t tt Given the monopolization of the financial sector by the government, it is the Ž b . Ž d central bank that sets the nominal interest rates on bonds i , bank deposits i ., t t Ž L and loans i .. The nominal interest rate on bonds is usually set at a higher level t than that on bank deposits see Qian, 1994 . In this case, the young would like to Ž . hold bonds instead of bank deposits. Given that Bt is less than the desired aggregate bond holdings of the young, each young individual is allowed to purchase b units of the government bonds. In other words, the purchase of t