Financial Repression and Financial Liberalization in a Small Open Economy: A Cash-in-Advance Approach

It is widely believed that fragile domestic banks. together with their huge intermediation of foreign capital, contributed to outbreak and propagation of the 1997 Asian economic crisis. Notably, the crisis countries were those that had recently replaced their old regime of financial repression with a new regime of financial liberalization. This paper reexamines financial repression and liberalization using a cash-In-advance model, which explicitly considers capital accumulation in a small open economy. We derive and discuss the steady state in each regime. Further. we demonstrate that an economy is structurally more vulnerable to a negative real shock when it is financially liberalized than when repressed. Policy implication of this finding is also discussed.