RDP 8811: Monetary Transmission in a Deregulated Financial System 7. Conclusions

The paper has argued that monetary policy is likely to remain effective (and operate in a similar way as it does at present), even once financial deregulation and innovation have taken us to a world without currency or required reserves. When analysing monetary policy in a deregulated environment, it was shown that the textbook IS/LM model is no longer an adequate means of explaining the monetary transmission mechanism. A new approach, based on the demand for liquid reserves by financial institutions was presented that captures the essence of the modern transmission process in very simple terms. In this model, policy works by directly moving short-term real interest rates which, in turn, generates shifts in the exchange rate. Interest rate effects on domestic demand are reinforced by exchange rate effects on net exports. Monetary policy remains very powerful.

The theoretical model was presented in a futuristic framework of zero currency balances and complete deregulation to contrast it with current thinking on monetary transmission. In fact, since the deregulation of interest rates in many countries, the implementation and transmission of monetary policy has already moved very close to the IS/LR framework presented above. Many central banks take the monetary aggregates (including currency and required reserves) as demand determined and operate on the supply of excess liquid reserves to influence interest rates. The empirical evidence surveyed also suggests that there has been a major shift in the way monetary policy is transmitted to the economy, with the monetary aggregates no longer providing leading information on the economy.

Given these changes to the way policy is transmitted to the economy, the paper has called for the examination of alternative monetary regimes that may simplify the policy implementation process and make central banks more clearly accountable for their policy decisions.