Research Discussion Paper – RDP 8811 Monetary Transmission in a Deregulated Financial System


Financial deregulation is undermining the traditional role for what academic economists have defined as “money”. The textbook IS/LM models, that rely so heavily on a monetary transmission mechanism running from “money” to activity and prices, may no longer be the most appropriate theoretical models for analysing monetary policy in a deregulated world. Despite this breakdown in the traditional monetary transmission mechanism, it is argued in this paper that monetary policy will continue to be effective in a deregulated environment. Worries that there will be price-level indeterminacy, no yard-stick to measure the stance of policy, and no rules to make monetary policy accountable in a fully deregulated world are not justified. A reaction function which ties the nominal short-term interest rate to a nominal anchor should ensure a stable steady state outcome. There are a number of alternative nominal anchors from which to chose, including: nominal financial prices – the exchange rate or a long-term nominal interest rate; or more direct targets such as inflation or nominal GDP growth. Implementing such policy strategies in the short-run, however, will remain as difficult as ever and optimal strategies may vary across countries. It is nevertheless important that policy reaction functions be clearly stated and adhered to, both to ensure credibility and allow full accountability.

View the Paper