The St~cture of Financial Markets and the Monetary Mechanism

The objective of this paper is to reexamine the monetary mechanism, that is the mechanism through which the monetary authority by controlling certain financial variables achieves (more or less) effective control over nominal income. We propose to argue that the view of the monetary mechanism which has been widely accepted, at least until very recently, by both monetarists and Keynesians and which focuses on the role of the money supply has in reality but limited applicability since it neglects many other possible and practical forms of this mechanism. We will be concerned with the nature of such alternative mechanisms and how their functioning is related to the structure of financial markets and with deriving implications from this analysis for the choice of intermediate targets for monetary policy. The need for a careful reexamination of the monetary transmission mechanism has become evident in the light of recent developments in both the practice and theory of monetary policy and in the presence of pervasive and continuous changes in the structure of financial markets. An important development in monetary policy in recent years has been the gradual adoption of monetary and credit aggregates as the primary targets in the formulation and implementation of policy by the monetary authorities of most major countries. The inflationary environment of the ’70s impaired the usefulness of interest rates as instruments and/or targets of monetary policy and contributed to the shift towards greater emphasis on monetary aggregate targets. The abandonment of the system of fixed exchange rates also motivated the formulation of policy in terms of aggregates which were often viewed as conditioning, at least in part, the inflationary expectations of the public. The adoption of monetary targets has not proved a panacea either for achieving the major policy goals of eliminating inflation and fostering output growth or for improving the formulation and implementation of monetary policy. Most monetary authorities have, in fact, followed a rather flexible approach both in selecting specific quantitative targets and in pursuing them. The flexibility or eclecticism of central bank policies reflects two major con-