Chapter 4 The Theory of Financial Liberalization and its Economic Impact: An Assessment ‘‘Nations control their own economic destiny’’. (Summers & Lawrence, 1992) 4.1 Financial Liberalization 4.1.1 A Brief Theoretical Assessment Led by the seminal papers of McKinnon (1973) and Shaw (1973), a significant number of studies have pointed out that financial liberalization can exert a positive effect on growth rates as interest rate levels rise towards their competitive market equilibrium, while resources are efficiently allocated. Accordingly, eliminating controls on interest rates and allowing them to increase could stimulate a higher level of savings. Moreover, with the assumption of a strong response of savings to the rate of interest, higher interest rates are expected to increase financial interme- diation (the level of financial asset channelled by the financial system). 1 Strictly under these strong assumptions, it is likely that financial liberalization produces higher savings which ultimately fosters economic development through changes in quality (by allowing efficient allocation of resources) and quantity of investment (Reinhart & Tokatlidis, 2003). From the past and recent theoretical work, we could briefly outline the route via which liberalization is expected to show its impact on important growth-related variables (refer to Table 4.1). Right from the early work of McKinnon (1973) and Shaw (1973), a primary premise behind the call for financial liberalization has been that an increase in real interest rates (particularly the real rate of deposit) will increase the level of savings which will in turn increase the supply of credit, hoping 1 We have also defined financial intermediation earlier. A.D. Ahmed and S.M.N. Islam, Financial Liberalization in Developing Countries, 91 Contributions to Economics, DOI: 10.1007/978‐3‐7908‐2168‐0_4, # Springer Physica‐Verlag Berlin Heidelberg 2010