Financial Innovation, Deregulation, and the Slope of the LM

By Baytas, Ahmet | Atlantic Economic Journal, March 1989 | Go to article overview

Financial Innovation, Deregulation, and the Slope of the LM


Baytas, Ahmet, Atlantic Economic Journal


Financial Innovation, Deregulation, and the Slope of the LM

In the last decade, the financial environment has been characterized by deregulation and financial innovation. Consequently, a large volume of studies has been undertaken to describe, analyze, and measure the impact of these developments on the interest elasticity of money demand and the stability of the money demand function, as well as on the effectiveness of monetary policy. Several shifts in the money demand function have been identified and the interest elasticity has been, in most cases, found to have increased. The latter has been attributed to the proliferation of money substitutes (Gurley and Shaw hypothesis) and to the fact that M1 has been contaminated by more interest sensitive portfolio balances.

However, the impact of recent developments, particularly that of deregulation, on the slope of the LM schedule has not been clearly identified. It is shown here that the effect of deregulation on the slope of the LM schedule can be, at least in theory, isolated from that of financial innovation and that it depends on how interest is paid on M1 and on how the money demand function is specified.

First, assume that the interest paid on M1 is tied to the open market rate and that there is a log-linear demand function m = y(a)(rf)(B), where m is real balances, y is real income, r is the open market rate, and f is the reserve requirement ratio. …

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