Money, Banking and the Foreign Exchange Market in Emerging Economies
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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.
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Chapter 1: Motivation and scope of study

Tarron Khemraj


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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