RDP 9008: Financial Deregulation and the Monetary Transmission Mechanism 1. Introduction

The rapid and virtually complete deregulation of the Australian financial system in the 1980s has once again raised the question of the relationships between financial variables and the real economy. The substantive issue is whether, post-deregulation, any stable leading relationships can be found between financial variables and the real economy. This question has been central to changes in the implementation of monetary policy in Australia in recent years, for example, the abandonment of monetary targeting in 1985 in favour of the more eclectic approach that has since characterized monetary policy.[1] One notable aspect of that approach has been a growing recognition that the financial sector's assets, rather than its liabilities, may be pivotal in the monetary transmission mechanism.[2]

These issues have only recently, however, been scrutinized with Australian data (Bullock, Morris and Stevens, (1989), Stevens and Thorp, (1989)). Using simple correlations and vector autoregressions, these papers concluded that financial aggregates tended to lead real activity prior to deregulation, but after deregulation the causality has been reversed. No clear causal relationships between interest rates and activity were identified. In this paper we extend that analysis by considering the effects of unexpected shocks to financial and other variables. In particular, we examine whether deregulation has altered the dynamic effects of shocks to growth rates of real credit and employment, the 90-day bank bill rate and inflation.

We find that deregulation has made very little difference to the relationships among these variables. The only changes worth noting are that post-deregulation, the reaction of monetary policy to unexpected growth in real credit is much more pronounced, while its reaction to unanticipated inflation is now virtually nonexistent.

The rest of the paper is organized as follows: in Section 2 we discuss the policy and institutional settings which form the background of this study while in Section 3 we discuss methodological issues. The results are reported in Section 4 and conclusions are drawn in Section 5.


For an official assessment, see Grenville (1990). For an academic assessment, see Milboume (1990). [1]

The importance of credit in the transmission of monetary policy to the real economy has been recognized, in the United States, for several years. For a recent contribution, see e.g. Bernanke and Blinder (1989). [2]