Organized and unorganized financial activities always exist coterminously in less developed countries. The mutual existence of two types of financial activities is called financial dualism. Governments in LDCs have also often employed a low interest rate policy to stimulate investment. In this paper, the author presents the results of theoretical research on the economic effects of interest rate management in LDCs.
A general equilibrium model containing 28 endogenous variables and satisfying Walras’ Law is built in the study. The model has the following four parts:
(1) Production Behavior – the production sector is subdivided into two industries. The first industry, whose products are capital and consumer goods, is financed only by banks. The second industry, whose products are consumer goods only, is financed by both banks and the black market.
(2) Banking System – the banking sector creates money and quasi-money. The government uses bank interest rates as its policy tool.
(3) Household Sector – households consume goods and hold real assets.
Money, quasi-money, a black market fund, and value-preserving storage comprise the four types of real assets.
(4) Equilibrium Condition – demand and supply in the labor market, the loanable funds market, and the goods market should be equal.
Various economic reactions can be obtained through comparative statics under some assumptions. The major results of raising the interest rate are as follows:
(a) Income increases;
(b) Price decreases;
(c) Capital and labor move from the first to the second industry;
(d) The relative price of the first industry to the second industry decreases;
(e) The black market interest rate decreases;
(f) The per capita product of the first industry decreases, while that of the second industry increases.
