Financial liberalization and a possible growth-inflation trade-off

Abstract

The negative relationship between growth and inflation is well-documented in the literature. However, recent evidence tends to indicate the possibility of a growth-inflation trade-off. This paper attempts to provide a theoretical explanation for this apparent empirical contradiction. To validate our point, we develop a monetary endogenous growth model of a financially repressed small open economy in an overlapping generations framework, characterized by curb markets, productive public expenditures, capital mobility, transaction costs in domestic and foreign capital markets, and a flexible exchange rate system, and analyze the impact of financial liberalization on growth and inflation. We show that including financial repression in the model is necessary but not sufficient to produce a trade-off between growth and inflation. Sufficiency requires high transaction cost in the domestic financial market.