Formal and informal financial markets, and the neo-structuralist critique of the financial liberalization strategy in less developed countries

Abstract

The neo-structuralist critique of the McKinnon-Shaw financial liberalization prescription rests fundamentally on the consideration that formal financial intermediaries have significantly higher reserve ratios than informal ones. However, the economic functions served by these reserves - in terms of 'liquidity enhancement' and 'seignorage creation' - are ignored. Incorporation of the latter function into the analysis leads to the complete neutralisation of the neo-structuralist critique, and incorporation of the former function produces the result that a financial liberalization is unambiguously welfare-increasing. Our optimizing framework also points up an important deficiency in neo-structuralist modelling of substitutions by asset-holders between formal-and informal-sector financial instruments. © 1992.