Chapter 1: Motivation and scope of study
Banks play a powerful role in the process of financial intermediation, often establishing the interest rate and exchange rate, both of which borrowers and households take as given. Money does not enter the wallets of individuals, let alone their utility function, unless it passes through the banking sector first. Banks are also influential traders in the foreign exchange market of developing economies and some emerging ones. They also hoard foreign exchange for the purpose of helping their established client base or making proprietary trades. This means commercial banks intercede between central bank and firms or households in various financial markets, including the foreign exchange market. When commercial banks demand liquid assets in excessive amounts or purchase foreign assets, money may not enter the pockets of those transacting in the economy. Commercial banks often have a preference for non-remunerated excess liquidity; this liquidity preference is rooted in a system of centre-periphery financial arrangements and oligopolistic banking structures. Banks’ liquidity preference is also consistent with profit maximization. A few studies, but not many, have examined bank liquidity preference and its broader implications. For the purpose of this research, centre economies are those with an international currency and a benchmark policy interest rate that can influence other periphery economies. The latter economies often would not possess a true benchmark policy interest rate; therefore, they have to operate monetary management using a system of compensation given the existing foreign exchange constraints.
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