M.K.Y. Fung et al Journal of Development Economics 61(2000)111-135 Last, in the model, there are both a state sector and a private sector, with the ng more efficient in production and markets are fully liberalized and thus perfectly competitive. However, the financial sector is monopolized by the government, which sets interest rates on the financial assets and determines the allocation of bank loans. The enterprises in the state ector face soft budget constraints, being subsidized by the government through bank loans with low interest rates, while the private sector faces hard budget constraints,thereby depending on its internal source of finance for capital invest ment. The government finances its budget by collecting tax revenue, issuing government bonds, and printing money. The money supply is endogenously determined in the sense that whenever the other two sources of funds are sufficient to finance the government's budget deficit, money creation is em- ployed to take up the residual 3.1. Agents, preferences, and production technology Consider the following partially reformed socialist economy. In the econom time is discrete and infinite, indexed by t=0, 1, 2,,.. The economy is inhabited by an infinite sequence of overlapping generations of individuals. At the beginning of each period, individuals of measure one are born. Each individual lives for three periods. When young, each individual is endowed with a single unit of labor and inelastically supplies it to a perfectly competitive labor market. Let Wi denote the nominal wage rate prevailing in the labor market in period t. Using the labor income earned, at the end of the first period of their lives, the individuals make their portfolio decisions. At the end of the second period of lives, the middle-aged individuals collect the return from their portfolios. When they are old, the individuals do nothing but consume their wealth The individuals of the same generation are heterogeneous in their ability to organize production processes (i.e, setting up and managing individual firms for commodity production ). There are two types of individuals in each generation:a measure of 8 individuals are endowed with the production-organizing ability, and the rest do not possess such ability. Hereafter, the first type will be referred to as Hereafter, we will refer to the non-state enterprises as the private firms. In our modeling, rivate enterprises and joint-ventures with urban collectives and TVEs will not cause any since both types of enterprises have large autonomy in decision making but receive few supports from the central govemment. sector have been iy d sector wage rates are determined administratively, they can be viewed as This is because since 1979, the growth rates of wages in the ne level as those in the non-state sector which are determined in the labor market. See Brandt (1995)for detailed discussion as to how and whyM.K.Y. Fung et al.rJournal of DeÕelopment Economics 61 2000 111–135 ( ) 117 Last, in the model, there are both a state sector and a private sector, 16 with the latter being more efficient in production and learning by doing. In the real sector, markets are fully liberalized and thus perfectly competitive. However, the financial sector is monopolized by the government, which sets interest rates on the financial assets and determines the allocation of bank loans. The enterprises in the state sector face soft budget constraints, being subsidized by the government through bank loans with low interest rates, while the private sector faces hard budget constraints, thereby depending on its internal source of finance for capital invest￾ment. The government finances its budget by collecting tax revenue, issuing government bonds, and printing money. The money supply is endogenously determined in the sense that whenever the other two sources of funds are insufficient to finance the government’s budget deficit, money creation is em￾ployed to take up the residual. 3.1. Agents, preferences, and production technology Consider the following partially reformed socialist economy. In the economy, time is discrete and infinite, indexed by ts0, 1, 2, 3, . . . . The economy is inhabited by an infinite sequence of overlapping generations of individuals. At the beginning of each period, individuals of measure one are born. Each individual lives for three periods. When young, each individual is endowed with a single unit of labor and inelastically supplies it to a perfectly competitive labor market. Let Wt denote the nominal wage rate prevailing in the labor market in period t. 17 Using the labor income earned, at the end of the first period of their lives, the young individuals make their portfolio decisions. At the end of the second period of their lives, the middle-aged individuals collect the return from their portfolios. When they are old, the individuals do nothing but consume their wealth. The individuals of the same generation are heterogeneous in their ability to organize production processes i.e., setting up and managing individual firms for Ž commodity production . There are two types of individuals in each generation: a . measure of u individuals are endowed with the production-organizing ability, and the rest do not possess such ability. Hereafter, the first type will be referred to as 16 Hereafter, we will refer to the non-state enterprises as the private firms. In our modeling, grouping the private enterprises and joint-ventures with urban collectives and TVEs will not cause any problem since both types of enterprises have large autonomy in decision making but receive few financial supports from the central government. 17 Even though in the state, sector wage rates are determined administratively, they can be viewed as if they are determined by the market. This is because since 1979, the growth rates of wages in the sector have been maintained at the same level as those in the non-state sector, which are determined in the labor market. See Brandt and Zhu 1995 for detailed discussion as to how and why. Ž