Financial Liberalization and Inflationary Dynamics in the Context of a Small Open Economy

The paper develops a short-run model of a small open financially repressed economy characterized by unorganized money markets, capital good imports, capital mobility, wage indexation, and flexible exchange rates. The analysis shows that financial liberalization, in the form of an increased rate of interest on deposits and tight monetary policy, unambiguously and unconditionally causes deflation. Moreover, the results do not depend on the degree of capital mobility and structure of wage setting. 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.

Monetary Policy, Exchange Rate Overshooting, and Endogenous Physical Capital

We develop an open economy macroeconomic model with real capital accumulation and microeconomic foundations. We show that expansionary monetary policy causes exchange rate overshooting, not once, but potentially twice; the secondary repercussion comes through the reaction of firms to changed asset prices and the firms' decisions to invest in real capital. The model sheds further light on the volatility of real and nominal exchange rates, and it suggests that changes in corporate sector profitability may affect exchange rates through international portfolio diversification in corporate securities.

A Generic Model of Financial Repression

The paper develops a growth model in an overlapping generations framework of a financially repressed small open economy, and analyzes the effects of financial liberalization. The following observations are made: An increase (decrease) of interest rate (reserve requirements) reduces (increases) the steady-state stock of capital and the trade balance, but improves (deteriorates) the level of foreign exchange reserves. However, financial liberalization, in any form, is always welfare-improving. The paper, thus, advocates financial liberalization policies to be oriented towards reduction of reserve requirements rather than interest rate deregulation, if foreign reserve holding is not in a critical position.

Automatic Stabilizer Feature of Fixed Exchange Rate Regimes in Emerging Markets

This paper shows that countries characterized by a financial accelerator mechanism may reverse the usual finding of the literature -- flexible exchange rate regimes do a worse job of insulating open economies from external shocks. I obtain this result with a calibrated small open economy model that endogenizes foreign interest rates by linking them to the banking sector's foreign currency leverage. This relationship renders exchange rate policy more important compared to the usual exogeneity assumption. I find empirical support for this prediction using the Local Projections method. Finally, 2nd order approximation to the model finds larger welfare losses under flexible regimes.

Measuring Potential Output and Output Gap and Macroeconomic Policy: The Case of Kenya

Measuring the level of an economy.s potential output and output gap are essential in identifying a sustainable non-inflationary growth and assessing appropriate macroeconomic policies. The estimation of potential output helps to determine the pace of sustainable growth while output gap estimates provide a key benchmark against which to assess inflationary or disinflationary pressures suggesting when to tighten or ease monetary policies. These measures also help to provide a gauge in the determining the structural fiscal position of the government. This paper attempts to measure Kenya.s potential output and output gap using alternative statistical techniques and structural methods. Estimation of potential output and output gap using these techniques shows varied results. The estimated potential output growth using different methods gave a range of .2.9 to 2.4 percent for 2000 and a range of .0.8 to 4.6 for 2001. Although various methods produce varied results, they however provided a broad consensus on the over-all trend and performance of the Kenyan economy. This study found that firstly, potential output growth is declining over the recent time and secondly, the Kenyan economy is contracting in the recent years.