The process of endogenous liquidity in developing economies: the case of Mexico

The Post-Keynesian theory of endogenous money is typically used to explain the operations in advanced economies like the US. While the core ideas are relevant for all market economies, developing economies have additional features which complicate the process. These may include: the local currency is not accepted as a means of payment for international transactions, so the banking system (including the central bank) requires foreign currency reserves (balance-of-payments constraint); hard currency reserves are needed to provide 'credibility' for circulation of domestic currency; stock and bond markets are not well developed, so other financial instruments are necessary to complete the finance-funding process; and institutional differences regarding monetary control. We use the case of Mexico to show how these features of developing economies can complicate the endogenous-money process. For Mexico the process is constrained by the use of the US dollar as both a store of value and a reserve for the banking system. As a consequence, the interest rate is determined by the demand for the alternative sources of liquidity creation, and therefore a credit-financed expansion will necessitate an increase in the interest rate which can lead to a recession or other crisis scenarios.