Financial Liberalization and a Possible Growth-Inflation Trade-Off

The negative relationship between growth and inflation is well-documented in the literature. However, recent evidences tend to indicate of a possible growth-inflation trade-off. This paper provides a theoretical explanation to the above mentioned empirical contradiction. To validate our point, we develop a monetary endogenous growth model of a financially repressed small open economy in an overlapping generations framework, characterized by curb markets, productive public expenditures, capital mobility, transaction costs in domestic and foreign capital markets, and a flexible exchange rate system, and analyze the impact of financial liberalization on growth and inflation. We show that including financial repression in the model is only necessary, and not sufficient, to produce a trade-off between growth and inflation. Sufficiency, in turn, requires high transaction costs in the domestic financial market.