• Financial liberalisation

Financial liberalisation

Developing countries typically rely on exports of primary commodities and goods that are low in the production chain, to generate foreign currency. As a consequence, they are highly vulnerable to the frequent and persistent shocks that afflict these industries. A natural and often-proposed remedy is to diversify the economy. But while some countries have made progress in this direction, diversification remains a difficult challenge for many others. This paper examines the relationship between economic integration, sectoral diversification, and macroeconomic stability in developing economies.

The paper shows that:

• lower trade barriers and diversification can have ambiguous effects on macroeconomic stability
• lower trade barriers on primary goods increases volatility in the economy stemming from primary shocks, whereas lower trade barriers on domestic nonprimary goods have the opposite effects
• lower trade barriers on foreign nonprimary goods enhances exchange rate stability while it increases the volatility of the aggregate variables
• diversification in the form of a relatively smaller primary sector reduces volatility in the economy stemming from primary shocks
• diversification in the form of equal distribution of resources between the nonprimary sectors may be counterproductive
• investment in the nonprimary sector with lower trade barriers is shown to unambiguously promote macroeconomic stability.

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