DP569 | Financial Innovation and the Neutrality of Money

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01/08/1991

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Abstract

It is argued that financial innovation, in so far as it affects the technology for carrying out transactions, is endogenous, discrete and irreversible. This observation is developed to provide microfoundations for a type of `liquidity' trap and its implications of this are explored in an intertemporal optimizing macroeconomic model with perfect foresight. The main conclusion is that financial innovation of this kind can lead to co-ordination failure in the financial sector. Consequently changes in the nominal money stock can have real effects. These results are illustrated diagramatically using a novel form of the IS/LM apparatus. The analysis also suggests there may be a connection between instability in the demand for money and the Phillips curve may be connected.