It is widely agreed that monetary policy can affect economic activity in the short run and greater emphasis has been placed in recent times on the role of monetary policy for short-term economic stabilization. Meanwhile, the financial sector in most countries has continued to evolve and develop. The introduction of a broad array of new financial instruments, together with changes in the role and scope of financial institutions, has potentially altered the impact monetary policy actions have on economic activity. This dissertation uses two different approaches to assess the overall impact of financial innovation on the speed and magnitude with which monetary policy actions affect key economic variables such as inflation and output. The focus is on the general process of innovation, rather than a specific instrument or market, with a view to extracting some qualitative implications for the conduct of central bank policy.
The first approach links financial innovation to changes in the degree of financial market frictions in the economy. It uses a new-Keynesian simulation model that incorporates financial market frictions in the form of a premium on the cost of external funds to firms. The impact of financial innovation on the monetary policy transmission mechanism is assessed by comparing impulse responses of inflation and output to monetary policy actions under different degrees of frictions. These theoretical impulse responses are then compared with data-generated impulse responses from structural vector autoregressions for a group of countries. Applying this procedure for different time periods yields an implicit estimate of how the level of financial frictions has changed over time without relying on direct attempts at measurement.
The second approach is an empirical one and involves the construction of a data based proxy for the general process of financial innovation using a dynamic factor index model. This proxy is then used to examine the impact of financial innovation on the relationship between the real interest rate and the output gap in the US by embedding it in a dynamic IS equation.
Both approaches show that the impact of monetary policy actions is clearly affected by the process of financial innovation. Under the first approach, the results are consistent with the view that innovation has occurred over the last decade or so in most of the countries examined. In general, innovation seems to cause the effects of a policy action to die out faster, although the precise nature of the impact appears to depend on the monetary policy rule followed. The second approach also found that financial innovation has a significant effect on the transmission of monetary policy actions, reducing the elasticity of output with respect to the interest rate and changing the dynamics of the response of output to interest rate moves. The overall conclusion, therefore, is that financial innovation does affect the monetary transmission mechanism, with the effect generally being to reduce the potency of monetary policy.