For a given transactions technology, a rise in the interest rate usually raises the velocity of money and may motivate the introduction of cash-saving technology and payments methods. In Discussion Paper No. 569, Research Affiliate Michael Moore argues that such innovations will typically be asymmetric; they are therefore unlikely to be repeated exactly or reversed once implemented and are best modelled as endogenous, discrete and irreversible. Adopting a broadly `New Keynesian' macroeconomic framework to explore such innovations' implications for the neutrality of money, he develops an intertemporal optimizing model in which changes in inflation and the opportunity cost of holding money balances lead to investments in R&D and hence to financial innovations. For nominal interest rates below a certain level, households substitute continuously between sacrificing leisure to conduct transactions and holding real balances. When the nominal interest rate reaches that level, however, investment in new technology becomes profitable and financial innovation takes place. Introducing a new transactions technology a `non-rival' good incurs a fixed cost (e.g. developing and installing cash dispensers), but it can then be used repeatedly at no additional cost, so a subsequent fall in the interest rate will lead to substitution along a new trade-off between leisure and holdings of real balances.

Moore finds that the role of money as a transactions option drives a `wedge' into the conventional relationship between current and future household consumption. If the nominal interest rate is at its critical level, the economy sits on a knife edge between two possible equilibria, and the household is indifferent between them. If financial innovation takes place, the old technology becomes redundant and the discontinuity irrelevant; if it does not, a Keynesian under-employment equilibrium may result if the fall in the first-period nominal money stock leads to excess demand for money. As more labour is expended in the conduct of transactions, less is expended producing goods, and income, wealth and consumption will correspondingly fall. The lower current consumption level required to clear the financial markets leads to demand deficiency in goods markets, so current output is below its full employment level in the new equilibrium.

If financial innovation leads to a discontinuity in money demand so that a market-clearing equilibrium may not exist, the real economy has to overcompensate for the coordination failure in the financial markets due to innovation. Contractions in the money stock may lead to falls in real income even in a forward- looking context. This is due neither to irrational expectations nor to sticky prices: it arises rather because financial innovation prevents the nominal interest rate the market- clearing price on financial markets from performing its proper role. In conclusion, Moore notes that the authorities may use monetary policy in such a framework to eliminate such coordination failures arising from financial innovation.

Financial Innovation and the Neutrality of MoneyMichael J Moore

Discussion Paper No. 569, August 1991 (IM)