Credibility, real interest rates, and the optimal speed of trade liberalization

Abstract

This paper investigates the effects of imperfectly credible trade liberalization programs on welfare and the allocation of resources. We present a rational expectations model in which a government with limited access to international borrowing will abort a liberalization program if hard-currency reserves are depleted too quickly. The liberalization's lack of perfect credibility acts as a distortion which becomes (rationally) intensified under the typical first-best policy of immediate liberalization. A more gradual lowering of trade barriers leads to higher welfare and a greater probability that the program succeeds. We derive the optimal speed of liberalization, and the endogenous level of credibility.