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Abstract
Rapid financial innovation in the U.K. has altered the relative liquidity and productivity of financial assets. This paper shows that even a sophisticated (Divisia) monetary index does not adequately allow for the effects of financial innovation. Two modifications to Divisia monetary aggregates are proposed to capture the effects of: non-neutral transaction technology progress; and of the introduction of new financial assets. The empirical analysis reveals that the modified Divisia aggregates dominate the basic, innovation-neutral Divisia indices. The results presented in this paper strongly support the view that, because of the widespread financial innovations during the 1980s, the conventional broad monetary aggregates provide a misleading picture of the stance of monetary policy. Copyright 1992 by Blackwell Publishing Ltd
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