Abstract
This paper investigates the effect of liberalization of capital account transactions on the viability of a fixed exchange regime. Using a finite time horizon model à la Blanchard, the paper demonstrates a case where removal of restrictions on capital outflows alone can cause a balance-of-payments crisis in the absence of any other external shocks. The increased burden of debt service as well as the dynamics of the economy after liberalization are identified as potential sources of reserve outflow. The paper also discusses the dynamics of the economy when liberalization is expected to force the central bank to give up exchange rate pegging.
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