Financial liberalization: a theoretical perspective

This paper makes three points: In economies with the fundamentals described by McKinnon and Shaw - asymmetric information, heterogeneity and incomplete market - the Arrow-Debreu (AD) competitive equilibrium(CE) is not the appropriate equilibrium concept; recognizing that the processes assumed by neoclassical monetary theory models did not apply to lagging economies, McKinnon and Shaw argued that the monetary system and financial intermediation in these economies played an irreplaceable role in transmitting information and competing markets.The original Mckinnon-Shaw (MS) policy recommendations were therefore incomplete and so is most current advice on financial reform. This paper explains this assertion by describing the general theory which rationalizes MS's views and the results of models which explicitly incorporate the features they described. It summarizes the MS hypotheses from a microeconomic viewpoint, highlighting the environment and behavioural background of their arguments, rather than the macroeconomic interpretation usually stressed. It considers the informational role of financial asset prices. In the McKinnon-Shaw theories it is the ability of interest rates to signal information about relative scarcities which permits an improved allocation of resources following liberalisation. It discusses the literature on equilibrium when markets are incomplete, information is asymmetric and there is money, as in the McKinnon-Shaw economies. It also surveys some of the recent literature which explains the function and existence of financial intermediaries. The last section illustrates how specific models of markets of the type described by MS contradict three propositions from McKinnon-Shaw's financial liberalization hypotheses. (To be presented at the XXIX Meeting of Technicians of Central Banks of the American Continent (CEMLA) November 16, 1992.)