Rational expectations and the effects of financial liberalization on price level and output

Rational expectations and the effects of financial liberalization on price level and output

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This paper develops a generalized short-term model of a small open financially repressed economy, characterized by Dishwasher Door Panel 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 File Cabinets policy, however, requires the establishment of a flexible exchange rate regime.