Optimal Financial and Foreign-Exchange Liberalization of Less Developed Economies

Abstract

This paper models a typical highly inflationary less developed economy, in which monetary forces are the result of three policy determinants: the rate of monetary expansion (µ), the interest rate on bank deposits (d), and the rate of depreciation of the real exchange rate (υ). The task confronting policy-makers is to reduce the equilibrium inflation rate without undue transitional sacrifice of the growth objective. We demonstrate that this optimally requires the precise coordination of all three instruments, with high but declining values of d and µ being adopted initially, and with υ being modulated so as to forestall excessive capital inflows and to influence favorably the evolution of relative input prices.