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

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Author Info

  • Rangan Gupta

    ()
    (Department of Economics, University of Pretoria)

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.

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Bibliographic Info

Paper provided by University of Pretoria, Department of Economics in its series Working Papers with number 200507.

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Length: 18 pages
Date of creation: Nov 2005
Date of revision:
Handle: RePEc:pre:wpaper:200507

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Keywords: Financial Liberalization; Price Level; Small open economy;

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