RDP 8605: On Some Recent Developments in Monetary Economics[*] 1. Overview

Most economists would accept a common general description of the economic system. In this view there are many markets – for various classes of labour, types of commodities, and financial instruments – which are in a series of temporary equilibria. The movement of these temporary equilibria depends on the behaviour of stocks of real and financial instruments, since it is these stocks which allow the shifting of consumption and production between one time period and another. Money, as one of these stocks, is one instrument which links present and future decisions; indeed, its role as a transactions asset may allow agents to achieve these linkages with economy of information.

Much debate in economics concerns the role of various frictions and imperfections in these myriad markets. Generally speaking, financial markets are seen as suffering fewer imperfections – at least in “normal” cases in which the risk of default by the relevant parties is small. Innovation and deregulation in recent years have reduced frictions in these markets still further. (Although the possibility of default qualifies this conclusion, it is worth noting that innovation and deregulation have enabled development of markets in which a wide range of financial risks can be traded.)

To some extent, the presence of risks in financial markets has given money a special role in the spectrum of financial instruments; it is risk arising from price uncertainty that underlies the concept of liquidity preference. However, this special role has not been fully explained and, in much of monetary economics, it is treated as axiomatic. It is therefore not clear to what extent the process of deregulation and innovation will change the role of money; this remains a crucial issue on the agenda of economic research.

In monetary economics, debate has centred on the roles in the adjustment process of financial prices, direct “money supply” effects (for example, because of the role of money as a buffer stock) and various forms of credit rationing. The exact relationships will depend on the set of regulations and imperfections in financial and other markets. The reduction of frictions in financial markets as a result of innovation and deregulation means that the “transmission mechanism” is likely to rely more on movements in relative prices and less on credit rationing. Real balance effects may also be changed (for example, by the tendency to pay interest on all bank deposits).

Monetary economics has also been concerned with relationships within the financial sector. Particular importance has been placed on defining appropriate classes of financial assets. One traditional dichotomy is between “money” and “bonds”, with the latter but not the former bearing a competitive rate of interest. Financial innovation and deregulation has blurred the distinction between “money” and “bonds” and between various other sub-classes of financial assets and liabilities. This too has necessitated a rethinking of conventional wisdom.

This survey is motivated by the major changes that have been occurring both within the financial sector and in the relationships between financial and other markets. These changes have greatly complicated monetary analysis. In practical terms, various rules of thumb derived from earlier experience have been cast into doubt. As a result, the making of monetary policy has been forced to rely more on informed judgement and less on the rules suggested by the models of a decade ago. One obvious example of this is the demise, or at least downgrading, of monetary “targets” in many western economies. However, as shall be argued, the differences in approach are more apparent than real. The main change is increased uncertainty about economic inter-relationships.

Whether or not this situation will settle down quickly is unknown. History suggests that economic theory does not rapidly catch up with economic reality: models which satisfactorily account for the present structure may be some time in coming. Moreover, the structure will continue to change as rapid financial evolution is likely to remain important for some time to come.

This paper, like most of the relevant literature, covers macroeconomic issues, and therefore tends to ignore microeconomic issues.[1] Increasing interest is being taken (in official circles especially) in the implications of rapid financial change for the behaviour of individual savers, investors and intermediaries. On a practical level, one response has been to focus more attention on prudential supervision of financial institutions.[2]

There is also the question of the interaction between changes to regulations in different areas of the economy. If the moves to a freer financial system are seen, on balance, to be beneficial, then there may be increased pressure – both intelluctual and from market forces – for greater freedom in other markets. If, however, the move to freer financial markets is associated with difficult problems, the relevant currents will undoubtedly run in the opposite direction.


This paper is dedicated to the memory of Austin Holmes, OBE, who both commissioned it and provided helpful comments on drafts. It has also benefitted from the comments of many other colleagues, including in particular Palle Andersen, Charles Goodhart, David Laidler and William Poole, as well as participants in seminars at ANU, Melbourne and Monash Universities. The views expressed herein are nevertheless those of the authors. In particular, they are not necessarily shared by their employer. [*]

The traditional (“fixed structure”) monetary economics debates of the post-war period are already extensively documented; there is no need to cover this ground in detail. Argy (1985) and (1986), Gordon (1974), and Laidler (1985) cover the field well. An Australian survey is provided by Davis and Lewis (1978). [1]

Discussion of the supervision issue can be found in official publications such as Bank for International Settlements (1985). [2]