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 3: Oligopolistic banking, compensation and financial stability

Tarron Khemraj


This chapter applies the industrial organization theory of banking to explain monetary stylized facts specific to developing economies and perhaps also many emerging ones. The basic industrial organization model is augmented to take into consideration capital flows and probability measures of risk. Central to the framework here is the application of models of imperfect competition instead of starting from the purely competitive model, which is used as a benchmark for comparing the imperfect outcomes. The following are objectives of the chapter. First, an oligopolistic model is used to demonstrate how commercial banks can engender an investment demand constraint in a period of financial liberalization. Second, a bifurcated model of the loan–deposit market is presented. This model is different in that there is no single rate that clears a market for loans. Third, commercial banks are also traders in the foreign exchange market; therefore, we will observe a model in which bank foreign exchange hoarding may occur. Fourth, commercial banks are a dominant participant in the primary and secondary Treasury bill market in which the central bank conducts open market operations. Therefore we will examine how oligopolistic bank traders interact with the monopolistic central bank in order to determine the interest rate on the government security. Fifth, lacking a true benchmark rate, the central bank relies on managing excess reserves.

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