RDP 8301: Financial Innovations and Monetary Policy, A Preliminary Survey Introduction

Neither financial innovation nor analysis of its impact on monetary policy is unique to recent years. From the late 1950s, names like Gurley, Shaw, Minsky, Tobin and Brainard have been associated with research in this area. The basic point was stated many years ago:

If financial institutions do not change significantly, then, once the efficacy of the various central bank operations is established, financial institutions can be ignored in discussions of monetary policy. However, if a period of rapid changes in the structure or in the mode of functioning of financial markets occurs, then the efficacy of central bank actions has to be re-examined. (Minsky, 1957, p.171)

In addition to the earlier work, much has been written recently by authors such as Donald Hester, Benjamin Friedman, Phillip Cagan, William Silber and economists from the Federal Reserve Board – e.g., Simpson and Porter.

There are several reasons to investigate this topic. The first reason is the apparently faster pace of financial innovation in the 1980s than previously. Second, monetary policy has been assigned a much more central role for economic stabilisation than in earlier decades; and third, we can hardly expect the rate of innovation to abate in the current climate.

Since the mid 1970s, the implications of financial innovation have been of mounting concern to the formulators of monetary policy in the U.S. Three related problems have appeared – greater short-run instability in the demand for money, a less reliable relation between M1 and economic activity, and slower growth in M1 than its historical relation with GDP would have suggested.^[1]

To some extent, Australia has avoided the American problems because most emphasis has been put on a relatively broad aggregate (M3) which is less affected by developments that shift balances between different types of bank deposits. In addition, the differences in institutional regulation mean that the Australian financial institutions are innovating around constraints different from their U.S. counterparts. For example, the U.S. legislation which imposed domestic taxation and Fed regulations on the international banking operations of American commercial banks induced banks to open offshore “brassplate” branches. In this fashion, some mobile transactions balances were kept out of required reports to the Fed (and IRS) and therefore out of M1 although they were available daily in domestic money markets. Finally, whereas the Reserve Bank of Australia releases volume of money figures monthly, the Fed's weekly announcements of the money supply have probably helped to increase public attention on the M1 figures, since policy was expected to react to each M1 outcome. As a result, further innovations were developed to exclude certain transactions balances from the M1 components reported to the Fed. These innovations, including repurchase agreements and sweep accounts, created elbow-room for financial institutions but exacerbated the slippage between M1 and the effective supply of transactions balances, so complicating the task of monetary control.

For these reasons, Australia should not be expected to experience the same innovations as America, nor such serious disruption to monetary relationships. However, with much more change still to come in our financial sector, we should not ignore the opportunity to learn from the American experience and research.

It is also important to note that financial innovation has not been the only factor of change in the Australian financial system. Stages of official deregulation have probably had at least an equal impact on the nature and range of bank and non-bank functions. For example, the lifting of interest rate ceilings on certificates of deposit in September 1973 and the total deregulation of interest rates on deposits at banks in December 1980 encouraged Australian banks to compete actively for a deposit base and to consider liability management as well as asset management where the emphasis had previously been. If foreign banks begin to operate domestically under full banking licences, the shape of our financial system is likely to alter even more dramatically.

No doubt it should also be said that, while the implications of financial innovation for the efficacy of monetary policy might seem important, much greater policy shifts result from changes in government or prevailing economic thought.

Bearing in mind that there are other factors which influence the direction and capacity of monetary policy, this paper is concerned with examining some effects of financial innovation. In the next section the causes of innovation are briefly examined. Sections II and III use an IS-LM framework to show several ways in which innovations influence the impact of monetary policies. After treating a few additional problems of money definition and controllability, some conclusions are ventured about what currently confronts Australian policymakers and how they might respond.

Footnote

Charles Goodhart, of the Bank of England, might have anticipated this since, according to his rule-of-thumb, “any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes” (Goodhart, 1975, p. 5). [1]