RDP 8301: Financial Innovations and Monetary Policy, A Preliminary Survey II The Slope of the LM Curve

Analysis of the consequences of financial innovation for the efficacy of monetary policy requires some framework, and in this study the familiar curves of macroeconomic equilibrium, is and LM, will be employed. The limitations of these analytical tools are familiar and acknowledged. Their use means that dynamics of adjustment cannot easily be discussed. There is also the question of which definition of money to employ. Furthermore, one of the more obvious features of new financial instruments is their combination of transactions and investment qualities in a single asset. Such developments blur the traditional distinction between “money” and “bonds” on which the IS-LM framework rests. Nevertheless, by representing the repercussions of financial innovation in this way, some understanding of how monetary policy withstands financial change can be gained. The analysis looks first at factors which alter the slope of the LM curve, then at factors which cause the LM curve to shift.

The Slope of the LM Curve

Three aspects of financial innovation can be isolated which tend to alter the slope of either the money-demand or the money-supply function, and hence the slope of the LM curve. Refore discussing these aspects it should be noted that a steeper LM curve will indicate more effective monetary policy in the sense of Davis and Lewis (1982, pp. 16–17).

Much of the early work in this area focussed on the growth in number and range of financial intermediaries and instruments, which was argued to have increased the interest elasticity of the demand for money^[3] and thereby reduced the slope of the LM schedule. Monetary policy had become less effective, according to this reasoning, since balances were more readily transferred to near-money assets but central bank control over burgeoning non-bank deposit-taking institutions was weak.^[4] Supporting the case for greater substitutability between money and other financial assets are the current high opportunity cost of holding excess balances in deposit forms which earn low or no interest and the technological advances made in banking. Improvements in processing associated with the microcomputer and electronic funds transfer have drastically reduced the costs in time and money incurred when transferring balances between assets.^[5] Both M1 and M3 money-demand functions would be open to this effect.

The slope of the LM function would, on the other hand, tend to increase as innovations eventually bring the payment of market-related interest rates to more and more forms of deposit. In this case, money demand functions become more interest inelastic since yield differentials between assets will appear to remain constant with the whole structure of yields moving in response to market forces (a point made by Davis and Lewis (1982) in their consideration of the effectiveness of monetary policy in a deregulated world where banks could determine the interest rates to be paid on deposits in line with market yields). Again, M1 and M3 demand curves could exhibit this impact, although this effect will probably be more important for M3.

The LM curve also depends on the money supply function. In the present climate of high levels and volatility of interest rates, the supply of money might become more sensitive to interest rates. With increased interest elasticity, the money-supply function becomes less steep; the slope of the LM schedule also declines, thus indicating diminished effectiveness of monetary policy. For example, a given expansion of the money supply produces, in the case of a flatter LM curve, a smaller drop in interest rates and a smaller increase in aggregate income than could have been achieved with a steeper LM schedule.

Thus, three disturbances to the slope of the LM function have been identified: two working to reduce the slope of the curve, the other to increase it. These effects appear to be applicable to functions based on both a narrow (M1) and a wider (M3) definition of money, although at present it is not possible to say what the combined impact of the three effects might be.

Footnotes

Or, as Ibba Lerner phrased it, the elasticity of supply and of Substitution for money of near-money had increased, but had not become infinite. [3]

See, for example, Gurley and Shaw (1960), Cagan (1979) and Cagan and Schwartz (1975) on this topic. Marty (1961, pp.59–60) outlines a contrary case. Even earlier writers – Simons (1936) and Minsky (1957) – had discussed the structural instability produced by innovation. [4]

Two examples are the availability of 24-hour automatic telling machines and cable-TV banking from home, both of which reduce the time costs of transacting. Working in the opposite direction to some extent are the recently introduced transactions taxes. For much more on new payments technologies see Mart! and Zeilinger (1982). [5]