Abstract
This paper develops a generalized short-term model of a small open financially repressed economy, characterized by unorganized money markets, intermediate goods imports, capital mobility, flexible exchange rates and rational expectations, to analyze the price- and output-effects of financial liberalization. The analysis shows that financial deregulation, in the form of increased rate of interest on deposits and higher cash reserve requirements, unambiguously and unconditionally reduces domestic price level, but fails to affect output. Moreover, the result does not depend on the degree of capital mobility. The paper recommends that a small open developing economy should deregulate interest rates and tighten monetary policy if reducing inflation is a priority. Such a policy, however, requires the establishment of a flexible exchange rate regime.
Highlights
This paper develops a model of a financially repressed small open economy and analyzes the inflationary dynamics following financial liberalization
Financial restriction consists of three elements: first, the banking system is favoured and protected because the government can finance the budget deficit at a low or zero cost by forcing banks to hold government bonds and money through the imposition of “high” multiple reserve requirements; second, since government revenue cannot be extracted from private securities very the development of private bond and equity markets is discouraged; and, interest rate ceilings are imposed on the banking system to encourage low-cost investment and curtail competition with public sector fundraising from the private sector
The influential analysis of financial liberalization initiated by the liberal school has been strongly criticized by a group of economists adhering to the new structuralist school
Summary
This paper develops a model of a financially repressed small open economy and analyzes the inflationary dynamics following financial liberalization. Gupta (2006) extends the analysis of Nag and Mukhopadhyay (1998), by incorporating capital account mobility, relaxing the assumption of perfect wage indexation (which is typically not the case in a small open financially repressed country) and endogenizing money supply, to bring in the role of reserve requirements. The paper recommends financial liberalization in the form of lower reserve requirements for economies with restricted transactions in the capital account Even though both these studies are insightful, neither of them endogenizes expectations. This paper is structured in the following fashion: Besides the introduction and conclusion, section 2 lays out the economic environment and section 3 solves the model and discusses the effects of financial liberalization on the rate of inflation
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