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 5: Compensation and endogenous money in an open economy

Tarron Khemraj


Estimating the sterilization coefficient for 76 economies, this chapter examines the idea of dual nominal anchors that was proposed by Khemraj and Pasha (2012a). This work sees sterilization as an endogenous process. The idea of the dual anchor contravenes the money neutrality hypothesis because many central banks in developing countries – given a de facto open capital account – could simultaneously intervene in the foreign exchange market and also manage commercial bank reserves or target its policy interest rate. This argument is positioned within the context of endogenous money theory. However, the idea of endogenous money is explained within the institutional context of emerging economies and developing countries in particular. Endogenous money has to be reconciled with the persistently high non-remunerated excess reserves that are found in developing economies. This chapter proposes the hypothesis that the excessive liquidities are the result of the compensation system, which the central bank uses to maintain ample foreign reserves. The central bank can maintain dual anchors in the event of endogenous changes in money holdings because the oligopolistic commercial banks require a minimum interest rate above zero to hold Treasury bills. Moreover, the oligopolistic private banks operate in a global financial architecture that requires the central bank to hold sufficient levels of international reserves. Imperfect competition models of microeconomics are used to illustrate the mechanism of dual anchors and the associated compensation hypothesis. As assumed in Chapter 3, the commercial banks maximize profit while the central bank does not.

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