New Challenges for Monetary Policy in the Twenty-First Century

Developments in information and communications technologies, the increasing sophistication and deepening of financial markets and the ineluctable process of globalisation have profound implications for the conduct of monetary policy. This thesis identifies three areas in which the impact of such developments may be felt most acutely by modern central banks:\ the electronification of retail payments systems, the increasing frequency and severity of asset market cycles and the continuing integration of the global economy. The high profile debate concerning the threat of e--money to the efficacy of monetary policy has been largely resolved. It has, nevertheless, diverted attention away from other important concerns, including the potential for runs on service providers and systemic risks arising from unregulated offshore issuers. The importance of these issues can only be evaluated with reference to the importance of e--money as a payment instrument. However, e--money usage remains marginal at present and forecasts of its development indicate limited growth potential. This raises a number of regulatory issues. Firstly, regulators must ensure systemic security. Secondly, is existing regulation stifling innovation? Finally, can regulation be designed to promote innovation, and would this be desirable? This thesis argues that regulation must balance systemic security with the incentives for innovation, and proposes a general regulatory framework to this end. Since the onset of global financial crisis in mid 2007, it has become clear that central banks underestimate the macroeconomic influence of financial markets at their peril. The Minskyan financial fragility hypothesis asserts that inflation targeting monetary policy may contribute to financial fragility. The estimation of a small macroeconomic model lends substantial support to this view, suggesting that central banks should manipulate the interest rate with great care. However, it is within the power of the central bank to set differential reserve requirements by asset class, providing an additional policy instrument. This thesis proposes a simple approach in which interest rates and reserve requirements are used in a complementary manner. The majority of monetary policy research is conducted assuming either a closed, or small open economy. However, the exclusion of feedback effects renders these approaches inappropriate in many economically interesting cases. This thesis develops a simple stock--flow consistent model comprised of two mutually dependent economies with financial and real linkages. The performance of various stabilisation policies is analysed using this framework. The results call into question the ability of simple inflation--targeting rules to achieve price stability in an open economy and stress that a combined monetary and fiscal regime is necessary for effective stabilisation. The conclusion of this thesis is threefold. Firstly, regulators are rightly concerned with financial innovation but they must leave room for innovation and technological progress. Secondly, central banks must pursue interest rate policy with great care to avoid exacerbating financial fragility. Thirdly, the interest rate is not the sole instrument of monetary policy and, indeed, the central bank is not the sole institution capable of undertaking stabilisation policy.