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Rational Expectations and the Effects of Financial Liberalization on Price Level and Output

Rangan Gupta ()

No 200507, Working Papers from University of Pretoria, Department of Economics

Abstract: The paper develops a more generalized short-run model of a small open financially repressed economy, characterized by unorganized money markets, intermediate good 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. The pre-requisite for such a policy, however, requires the establishment of a flexible exchange rate regime.

Keywords: Financial Liberalization; Price Level; Small open economy (search for similar items in EconPapers)
JEL-codes: E31 E44 E52 F41 (search for similar items in EconPapers)
Pages: 18 pages
Date: 2005-11
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Persistent link: https://EconPapers.repec.org/RePEc:pre:wpaper:200507

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