Money, Banking and the Foreign Exchange Market in Emerging Economies

Money, Banking and the Foreign Exchange Market in Emerging Economies

Tarron Khemraj

Despite the financial liberalization agenda of the mid-1980s, a system of bank oligopolies has developed in both large and small, open developing economies. Mainstream monetary theory tends to assume a capital markets structure and is therefore not well suited to an analysis of these economies. This book outlines a unique theoretical framework that can be used to examine monetary and exchange rate policies in developing economies or other economies in which banks dominate external finance.

Chapter 4: The bank liquidity trap

Tarron Khemraj

Subjects: economics and finance, development economics, financial economics and regulation, post-keynesian economics


The previous chapter proposed an oligopolistic theory of bank liquidity preference. The theory implies that at the lower bound lending interest rate excess reserves do not affect bank lending. Although this mechanism is similar to Keynes’ exposition of liquidity preference and its relationship to the liquidity trap, there are some important differences. First, the non-zero lower bound rate is determined by the mark-up interest rate of commercial banks. Second, the thesis is institutionalized in the sense that it presents a role for commercial banks in macroeconomic fluctuations – namely aggregate output and prices. Explicitly introducing banks into the macro model allows for interpreting bank liquidity preference as a form of financial friction. Furthermore, it allows for examining the fluctuations in inflation and output taking into consideration oligopolistic banking frictions. In particular, the model permits an examination of how quantitative easing – an extreme form of reserve management – affects aggregate prices and output in a dynamic setting. Liquidity management is analysed in two financial regimes: (1) the bank liquidity trap; and (2) the investment demand constrained regime. The latter is presented in Chapter 6 and the former is the focus of this chapter. Here we will examine the scenario in which the liquidity preference of banks swivel or shift to the point where it engenders the regime which we label the bank liquidity trap (BLT).

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