Chapter 6: The investment demand constraint and the FX market
Previous chapters analysed commercial bank hoarding in a static framework. This chapter presents a dynamic macroeconomic model to explain the subtleties of commercial bank hoarding and its relationship to the dynamic adjustment of aggregate output and prices. Chapter 4 presented a dynamic model that is more suited to economies in which the central bank controls a benchmark policy interest rate; this chapter, on the other hand, outlines a model in which the central bank has to rely on reserve money management. The differences in the approach between the two chapters stem from the philosophical position of this work that insists that the models must reflect the institutional and structural characteristics of the economies under study. Therefore the policy of reserve management is analysed in a dynamic setting by assuming that the investment demand constraint is the binding constraint. In other words, this chapter demonstrates how bank liquidity generates an investment demand constraint, which is the opposite of the hypothetical bank liquidity trap regime presented in Chapter 4. The analysis is made richer by including commercial bank hoarding at the aggregate level. In the bank liquidity trap, which was examined in Chapter 3, liquidity preference of banks generates a credit supply constraint because the interest rate is very low relative to the risk-adjusted marginal cost of lending. Often in developing economies the foreign exchange market is fundamental for bringing about macroeconomic stability.
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