The Theoretical Superiority of the Compensation view in Explaining Monetary Policy Autonomy

By Zico Dasgupta

PKES Working Paper 2315

November 2023

This paper compares three theoretical frameworks that attempt to explain the phenomenon of weak relationship between foreign and domestic interest rate under fixed or manage-float exchange rate regimes - the Mundell-Fleming (MF) model without sterilization and the Mundell-Fleming model with sterilization (MFS) and the Compensation view. It argues for the theoretical superiority of the Compensation view as it can explain monetary policy autonomy under less restrictive assumptions. The paper outlines the underlying models of these frameworks and highlights the centrality of commercial bank loans in the Compensation view. I discuss the trend in India’s interest rates which is consistent with the Compensation view.

Keywords: Monetary Policy, Endogenous money, Mundell-Fleming, Compensation view, Sterilization

JEL classification: E43 E51 E52 E58