Research Discussion Paper – RDP 8301 Financial Innovations and Monetary Policy: A Preliminary Survey


This paper provides a survey of ways in which financial innovations may affect the making of monetary policy. This subject has recently become more topical because of both the increased importance of monetary policy and the increasing pace of financial innovation.

The analysis makes use of the IS-LM framework. The discussion is by no means exhaustive or conclusive. However, it appears that in recent years there have been important factors which have altered the slope of the LM curve and others which have shifted it.

A steeper LM curve increases the effectiveness of monetary policy and vice versa. Two developments in recent years (the growth in the number and range of financial intermediaries and the increased volatility of interest rates) have reduced the slope of the LM curve and one (the payment of market-related interest rates to more forms of deposit) has increased the slope.

As regards the position of the LM curve, one could argue that the development of new transactions technologies would have reduced the demand for narrow money, shifting the relevant LM curve to the right. However, broader measures of money may not have been affected, or at least not to the same degree. Also, as innovation improves the efficiency of the whole financial system, the public might hold fewer financial assets for a given level of activity. This would also tend to shift the LM curve to the right.

Shifts in the slope and position of the LM curve complicate the task of using the money supply as an intermediate target. Redefinitions of the money supply might correct for shifts in the LM curve (if the magnitudes of the shifts could be predicted or estimated) but such redefinitions cannot allow for factors which have altered the slope of the LM curve. For this and other reasons, financial innovation strengthens the need to examine a range of financial variables in formulating monetary policy.