We address three related questions concerning financial liberalization in a small open economy. Does financial liberalization and the resulting capital inflow improve production efficiency in the domestic economy? Who benefits from financial liberalization in the long run and in the short run? Should financial liberalization be implemented gradually or hastily?
Our main results are as follows. First, whether financial deregulation in one sector can improve production efficiency may depend on financial regulation in other sectors. Second, financial liberalization may have opposite welfare implications to domestic agents with different productivity in the long run. Third, although some domestic agents lose in the long run, they actually benefit from financial liberalization during the transitional process of deregulation. Finally, a gradual implementation helps achieve a smooth transition.
Keywordsfinancial liberalization macroeconomic fluctuations overshooting
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