Financial liberalization: the case of Sri Lanka

According to the advocates of financial liberalization in LDCs, a rise in real interest rates is essential to stimulate savings, investment and the output growth rates. 'Structuralists', however, argue that such a rise could lead to higher inflation, lower investment and lower output when such rates account for a major proportion of the total production costs and loanable funds can be diverted from the unorganized (UMM) to the organized money market (OMM). It is argued that it is difficult to decide in favor of any one of these conflicting views on a purely theoretical ground. A simple econometric model is set up to examine the validity of the conflicting theories in the light of the experience of financial liberalization in Sri Lanka. The authors test different aspects of invariance of structural parameters and the robustness of the model in the light of the 'Lucas critique' that the model structure is likely to be affected by agents' expectations. No evidence of such Lucas type critique of the model is found. Results seem to confirm a positive and significant effect of financial liberalization on economic growth of Sri Lanka between 1950 and 1987.