Financial Market Efficiency and the Effectiveness of Monetary Policy

mprovements in information processing technology and deregulation, among other forces, are profoundly transforming the financial sector of the United States and other advanced economies. Many of these changes are likely to improve the efficiency of financial intermediation, in the sense that the dispersion of valuations of claims to future payments across different individuals and institutions is minimized. For familiar reasons, this should be generally beneficial for the allocation of resources in the economy. Some fear, however, that the job of central banks will be complicated by improvements in the efficiency of financial markets, or even that the ability of central banks to influence the markets may be eliminated altogether. This suggests a possible conflict between the aim of increasing microeconomic efficiency—the efficiency with which resources are correctly allocated among competing uses at a point in time—and that of preserving macroeconomic stability, through prudent central bank regulation of the overall volume of nominal expenditure. Here I shall briefly address two possible grounds for such concern. The first is the possible elimination of a special role for commercial banks in the provision of credit. This might be expected to weaken the Fed’s leverage over aggregate expenditure through its ability to control the supply of bank reserves (and, to a lesser extent, through its regulatory oversight of member banks). The second is the dramatic reduction in recent years in the volume of Fed balances that banks must hold to satisfy reserve requirements. This has led to concern that reserve requirements may soon cease to bind, and that as a result the Fed would lose its main source of control over the pace of spending in the economy. I believe that there is little ground for concern on either count. The effectiveness of monetary policy does not depend on the ability of central banks to manipulate significant market distortions, and the development of methods that allow central banks to achieve their stabilization objectives with as little interference as possible through the exercise of free choice over how funds are obtained to finance business activity should be beneficial to economic performance. Nor does effective central bank control over the pace of nominal expenditure depend on the creation of an artificial demand for central bank balances through the imposition of legal reserve requirements. This has already been illustrated by the experience of a number of other countries, such as Canada. It is true that the countries that have eliminated reserve requirements implement monetary policy in a somewhat different manner than is currently used in the United States. However, the United States could easily adopt the methods used in countries like Canada, and I suspect that there would be advantages to doing so. Michael Woodford