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DEFICITS, INFLATION, AND THE BANKING SYSTEM IN DEVELOPING COUNTRIES: THE OPTIMAL DEGREE OF FINANCIAL REPRESSION

It is often argued that a well-functioning system of financial markets has beneficial effects for countries in the early stages of industrialization (Gerschenkron (1962), Cameron (1967), McKinnon (1973), Shaw (1973), Fry (1988)). Specifically, the development of a banking system has been viewed as playing a central role in determining both short-term real growth rates and long-run levels of output in such economies. It is also often suggested that the primary impediment to the development of an intermediary sector is legislative. In particular, government policies associated with 'financial repression' hinder the development of banks, and promote self-financed investment and investment financed through 'informal' (and presumably inefficient) money markets. These arguments raise the possibility that the 'liberalization' of financial markets in developing countries can yield substantial benefits in the form of increased output. Nevertheless, while some moves in the direction of financial liberalization have taken place (for example, in Chile and Argentina), financial repression associated with high reserve requirements and/or deposit interest rate ceilings is still widespread in developing countries. It has been recognized that such 'repressive' policies have some justification in economies where the government is forced to monetize a sustained deficit. In particular, the kinds of arguments offered by Nichols (1974), Bryant and Wallace (1984), Villamil (1988), and Cooley and Smith (1990) can be applied to developing countries to suggest that efficient use of the inflation tax will typically involve some legal restrictions to 'augment' the demand for money. This reasoning implies that developing countries face a trade-off in the use of reserve requirements and interest rate ceilings: output losses from the use of such instruments must be weighed against benefits derived from more efficient use of the inflation tax. And indeed, analyses like that of McKinnon and Mathieson (1981), Courakis (1987), and