Business cycles and monetary regimes in emerging economies: a role for a monopolistic banking sector

Starting from a variant of the New Keynesian model for a small open economy, I extend the standard credit channel framework to show that the presence of imperfect competition in the banking system propagates external shocks and amplifies the business cycle. This novel modeling of the banking system captures various well-documented facts in developing economies. I show that strategic limit pricing, aimed at protecting retail niches from potential competitors, generates countercyclical bank markups. Markup increments, as a consequence of sudden capital outflows, end up increasing borrowing costs for firms as well as damaging the financial position of firms? balance sheets. The recognition of monopoly power in banking allows the model to account for the relatively high investment volatility registered in emerging countries, even in the presence of debt that is fully denominated in local currency and flexible exchange rates.