Original Research

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

Rangan Gupta
South African Journal of Economic and Management Sciences | Vol 10, No 1 | a540 | DOI: https://doi.org/10.4102/sajems.v10i1.540 | © 2013 Rangan Gupta | This work is licensed under CC Attribution 4.0
Submitted: 21 February 2013 | Published: 25 February 2013

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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.

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