Financial liberalisation and inflationary dynamics in the context of a small open economy

Abstract

This paper develops a short-term model of a small open financially repressed economy characterised by unorganised money markets, intermediate goods imports, capital mobility and flexible exchange rates. The analysis shows that financial liberalisation, in the form of increased rate of interest on deposits and tight monetary policy, causes deflation for an economy with a high degree of capital mobility. However, for economies with a low degree of capital mobility, the possibility of stagflation cannot be ruled out. These results suggest that financial liberalisation in the form of lower reserve requirements should be recommended for economies with restricted transactions in the capital account.