What are the quantitative effects of a government infusedbank recapitalization in response to loan defaults? We analyze two differentscenarios of government infused recapitalization using a dynamic stochasticgeneral equilibrium (DSGE) model, calibrated to an emerging market economy withstate owned banks. The first is an unconditional transfer and the second is an “equityin exchange for transfer” to banks. We show that a government infusedrecapitalization in response to a negative productivity shock may increaseoutput in the short run. However, there is welfare loss, which is higher in thecase of unconditional transfers. Our analysis suggests that bankrecapitalization facilitates credit creation, capital formation and growth,especially during a cyclical downturn. There is however a need for appropriatepolicy vigil to protect the quality of public expenditure in the social sectorthat matters for welfare in the long run.
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