Chapter 4: Institutions of Monetary Policy and the Financial Sector: Theory and Evidence
4. Institutions of monetary policy and the financial sector: theory and evidence Money is the foremost essential institution for reducing transaction costs, which may arise in their full extent under the barter system. As Clower (1969, pp. 13–14) states, ‘Goods buy money, money buys goods – but goods do not buy goods in any organized market’. How money is generated and allocated is therefore very important for the management of transaction costs and, as such a crucial institution, it has important developmental consequences for any economy. Besides facilitating transactions and hence production, monetary policy also affects the redistribution of wealth by determining the value of currency. In this case, central banks are similar to governments which assume a major redistributive role as the sole owner of the right to tax and transfer. When money is generated in excessive amounts, its value declines, which is inflation, reducing the wealth of people who hold money or who have assets tied to fixed nominal contracts, while benefiting those holding debt denominated in that currency. Expectations of inflation lead to suboptimal levels of money holding that reduce real transactions and thus worsen the investment climate.1 Hence, central banks assume a crucial role both in redistributing wealth and affecting economic prospects. In a world of rapidly developing financial technologies and globally integrated financial markets, financial transactions define complex relationships that greatly affect the distribution of wealth. In rapidly developing financial systems, 101 102 Macroeconomic institutions and development there emerge new forms of financial intermediation, such...
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