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Many economists believe that a rise in bank rates in a developing country causes a decrease in inflation through its effects on reducing the funds available to expenditures on one hand; and, on the other hand, rises bank lending capability and eventually brings about economic growth through its effects on increasing national savings. However, with regard to the financial dualism of the economy, the private lending rates would be rising following the rise in bank rates leading to an increase in the cost of both existing and on coming borrowing. The latter would soon be reflected in the price level and cause inflation accompanied by a reduction in national income in the short run. It is in this respect that the effects of variations in interest rate on the price and output level is ambiguous and subject to controversy. The financial system in Taiwan, as predominated by interest rate regulation based upon her strategies toward economic development as well as the demand for stabilities both financially and politically, has long possessed characteristics such as credit rationing and financial dualism. However, as time pass by, financial deregulation is on its way. The purpose of this study is to simulate the effects of the interest rates deregulation on the economy of Taiwan. The focus is on the effects of variations in bank rates on income, investments, and price level. Moreover, empirical relations among bank rates, money market rates and the black market lending rates are also examined. Results of simulation obtained are as follows: (1) the increase in bank deposit rates causes a decrease in investments for the entire period simulated, with exception only in the second quarter both the price and income levels are falling for the entire period. Furthermore, both money market rates and black market lending rates are positively related to bank deposit rates. (2)In the case when bank lending rates are risen or both bank lending rates and deposit rates are risen, investments and income would be increased in the second and the third quarters. The price level rises. And, subsequently followed by a fall in all the variables. Similarly, both money market rates and black market lending rates would rise following the increase in bank rates. Finally, (3) it is a plausible strategy to decrease bank rates to promote investment and hence economic growth in the long run.
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