The Impact of Financial Innovation on Monetary Policy

Innovative financial instruments, including online currencies, are becoming increasingly common in Asia. Photo: ADB
Innovative financial instruments, including online currencies, are becoming increasingly common in Asia. Photo: ADB

By Irfan A. Qureshi

Central banks have powerful tools to affect national economies but they are being challenged by innovative financial practices

The world of everyday finance is changing rapidly, even in developing economies. Cash is playing less of a role, as more people pay with credit cards or use their phones. There are now many more ways to save than just the family bank account. Developments in payment technology have even raised the possibility of replacing traditional money with “virtual” currencies like Bitcoin. What do changes in the financial system imply for central banks and their ability to manage inflation and economic activity?

In a recent paper, we show that the creation of new financial instruments, technologies, institutions and markets – commonly termed as financial innovation – may reduce the ability of central banks to effectively manage the economy. Under certain conditions, the relationship between interest rates and traditionally defined measures of money may capture the extent to which central banks can affect the economy. According to our framework, a stronger relationship between money and interest rates implies that central bank policy has a larger impact on the economy, and vice versa. Using historical data up until 2008, we found that the relationship between money and interest rates considerably weakened, This seems to have occurred in two distinct stages - one in the 1970s and the other in the 1980s.

First, periods of high inflation, such as those experienced globally in the 1970s, seem to increase investors’ appetite for assets that protect their savings from eroding in value. These assets include inflation indexed bonds and securities, which provide a constant return irrespective of the level of inflation in the economy. According to our framework, high inflation blurs the relationship between money and interest rates, and negatively effects the ability of central banks to effectively manage the economy.

Second, financial innovation enabled by regulatory changes in the United States such as the Depository Institutions Deregulation and Monetary Control Act and the relaxation of ‘Regulation Q’ provided consumers with a larger number of options to conduct transactions and channel their savings. The passing of this law eased restrictions on interest rates that banks could offer on deposits. This enabled banks to compete for funds against less-regulated players - such as money market mutual funds - on a more equal footing. Overall, these regulatory changes had the effect of incentivizing investors to save more, since it provided them with a greater number of options in terms of saving accounts that offered at least a market-equivalent return. According to our research, these regulatory changes further weakened the money-interest rate linkages and affected the potency of central banks to influence the economy. The period following the passing of these laws was also one of the main contributors to the financial market turmoil witnessed during the 1980s.


Our findings contain several policy implications. There is an obvious need to better monitor the financial sector in order to manage risks and enhance efficiency during periods of rapid financial innovation.  Central banks can play an important role on this front, since they possess economy-wide macro-financial perspective and knowledge. There is also ample space to develop unconventional monetary policy levers to regulate the economy. However, it is not immediately clear whether these would be effective as well since they rely on similar channels to impact economic activity. At the same time, we must remain cautious, since increasing the responsibilities of central banks should not compromise their ability to achieve traditional central banking objectives such as a low and stable level of inflation.

On this front, there is room to sharpen the coordination among alternate macroeconomic policy tools.  For example, countercyclical fiscal policy instruments that target reducing government spending and raising taxes during a boom and increasing spending and cutting taxes during a recession could partner with monetary policy in ensuring economic stability during periods of financial innovation. Other policy recommendations include developing more sophisticated measures of money, such as Divisa monetary aggregate indices, that have been shown to be robust in measurement issues, such as those occurring due to financial innovation.

Financial innovation facilitates trading and the exchange of goods and services, which in the end should lead to a better allocation of resources and is therefore an important engine of growth. However, its development may pose new challenges for policymakers for countries in the Asia-Pacific region that have rapidly integrated new financial products with traditional banking instruments but may not have fully incorporated the associated risks.

The financial innovation revolution is here to stay. We must adapt, prepare and stay ahead of the curve.

The blog is based on the paper titled “Time-varying money demand and real balance effects”, forthcoming in Economic Modelling.