The macroeconomic implications of financial deregulation

This paper explores the possible macroeconomic consequences of financial deregulation in an institutional environment where deregulation raises risks in banking. The central bank is supposed to maximize an objective function in which the probability of bank failure is an argument. It is then shown that the usual tradeoffs between policy objectives imply that financial deregulation will lead to more interest rate smoothing than would otherwise take place, and further that, because of restricted entry into banking, deregulation will call for some inflation. The transition toward deregulation raises special problems, which are likely to require a more gradual approach toward the stationary equilibrium.