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

Author

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  • 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.

Suggested Citation

  • Rangan Gupta, 2005. "Rational Expectations and the Effects of Financial Liberalization on Price Level and Output," Working Papers 200507, University of Pretoria, Department of Economics.
    • Handle: RePEc:pre:wpaper:200507
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    More about this item

    Keywords

    Financial Liberalization; Price Level; Small open economy;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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