Optimal Policy for Financial Market Liberalizations: Decentralization and Capital Flow Reversals

Financial market liberalizations are an integral part of economic development. While initial booms in investment and output are commonly seen as signs of successful deregulation, they often reverse at a later stage as international capital flows turn negative and economic growth slows markedly. Such reversals of fortunes have commonly been attributed to incorrect policies that supposedly followed the initial, appropriate measures. It is unclear, however, if capital flow reversals are actually the result of policy reversals, or if they occur as part of the normal transition when financial liberalization is accompanied by a single suboptimal policy. The later hypothesis has not been explored in the theoretical literature Copyright Verein fü Socialpolitik and Blackwell Publishers Ltd 2000.