ABSTRACT
This chapter analyses the implementation of monetary policy in economies with an exchange rate anchor and imperfectly competitive foreign exchange and money markets. It explains how the monetary authority's tool used for compensating commercial banks also contributes to financial stability by diminishing the volatility of the portfolio of assets. The chapter discusses a small open economy is defined as a country that a price taker in international trade and has a high percentage of trade to gross domestic product. It explores the central bank's demand for foreign exchange reserves. The chapter examines and reinterprets the emerging literature on excess bank liquidity. It outlines the notion of compensation and looks at its cost. The chapter shows how compensation contributes to financial stability. It argues that bank liquidity–excess or otherwise–is an important aspect of the workings of exchange rate policy and concomitant monetary policy in small open developing economies.
