RDP 8811: Monetary Transmission in a Deregulated Financial System 1. Introduction

Traditional textbook theories of monetary policy rely heavily on the Hicksian IS/LM model in which the monetary authorities control an exogenous “money” stock in implementing monetary policy. Changes in the money stock are used to control nominal income, with the transmission mechanism running through interest rates, exchange rates and/or via real balance and credit rationing effects. The simplicity of this approach was one of the primary attractions for many central banks in their decisions to target monetary aggregates in the 1970's and early 1980's.

Unfortunately, monetary targeting has not been as simple to implement as it was to model. The primary problem has been that the concept of money used in the textbook models – a liquid (in the sense of ease of making transactions) asset paying a controlled (normally zero) rate of interest – has become obsolete. With rapid financial innovation, deregulation, improved transactions based technology and the growing financial sophistication of households, firms and intermediaries, many transactions no longer require the use of that sort of money. The only pure money that remains in the traditional academic sense is currency and bank reserves at the central bank. Both are largely demand-determined in the short-run. More importantly, this concept of money no longer reflects the overall liquidity of the private sector or its ability to undertake transactions. As a result, many central banks now look more at the broader aggregates to gain an indication of monetary conditions, even though such broad aggregates are not under their direct control.

The aim of this paper is to set out a simple explanation of the transmission mechanism that does not depend on the central bank's ability to manipulate directly a transactions based monetary aggregate. It does so by looking ahead, to a world in which all transactions are non-money based.[1] Will the monetary authorities still be able to conduct monetary policy? If so, how will monetary policy be implemented and how will it be transmitted to private sector behaviour? These questions are not new, but have been raised by many of the early writers such as Wicksell (1936). It is only recently, however, with the growth of “new monetary economics” (see Cowen and Kroszner: 1987), that the issues have again been addressed by economists. These questions are also no longer only of interest to academic crystal ball gazers, but are becoming more and more relevant to current policy implementation. Indeed, it is argued in this paper that many countries may already be closer to such a “brave new world” than to the old textbook model of the transmission mechanism. The extreme assumptions of zero reserve requirements and no currency based transactions are used to focus attention on the key aspects of the transmission mechanism: aspects which are not altered by relaxing those assumptions. The objective is twofold. First, it restricts the discussion to a particular range of theoretical propositions. Second, and more importantly, it simplifies the analytical framework substantially, without altering the fundamental features of the transmission process as it already operates in Australia and many industrial countries.

The following section starts by outlining the conceptual issues that are crucial to deciding whether monetary policy will continue to have a role in a fully deregulated financial system. In section 3, the traditional IS/LM model is reviewed and shown to be inadequate when it comes to looking at a world without ‘money’ as defined above. A modified theoretical framework is presented in section 4 which highlights the key role of financial prices (interest and exchange rates) in transmitting policy changes in a world without ‘money’. Asset stocks (including banking aggregates that are now labeled money) may still respond to policy changes. However, they will not play the crucial causal role as in traditional theoretical models. Section 5 provides some general conclusions.


Where money is defined as a perfectly liquid asset, used for transactions purposes, paying a regulated rate of return. [1]