Interest rate and endogenous money under capital mobility and fixed exchange rate: alternative closures and implications

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The central banks of many emerging countries registered a weak relationship between domestic and foreign interest rates during the globalization period, despite registering significant changes in their foreign assets. Such a phenomenon stands in contrast with the propositions of the conventional Mundell–Fleming (MF) model and has been explained within various open-economy models by accommodating the role of the central bank’s sterilization operations. However, the analytical differences among these contesting models of sterilization have received less attention. The central contribution of this paper is to highlight these differences by providing a general theoretical framework of interest rate determination, where contesting open-economy models emerge as particular closures. This paper compares four distinct models – the MF model, the MF model with sterilization and quantity targets of money (MFS-1), the MF model with sterilization and interest rate targets (MFS-2) and the Compensation view. This paper argues that the way the domestic interest rate responds to the policy rate, foreign interest rate and the autonomous components of demand would be different across these models because they endogenize money supply in different ways. This paper highlights the implication of a loan-induced money supply in contrast to the central bank-induced and the capital flow-induced money supply processes.