FINANCIAL INNOVATION, PRICE SMOOTHING, AND MONETARY POLICY

This paper examines an unregulated transaction services market that is subject to financial innovation in an economy that experiences aggregate supply and demand shocks. The availability of this unregulated market to transactors smooths the price response to these shocks. However, financial innovations act as money supply shocks that increase price disturbances. If there is persistence in the real aggregate supply shocks and in the rate of adoption of financial innovations, then the central bank can forecast some portion of the changes in transaction requirements that accompany these shocks and damp the residual variation in prices by accommodating these anticipated needs.