Did Financial Innovation Hurt the Great Monetarist Experiment?

In October 1979, the Federal Reserve Board shifted its policy tactics to place greater emphasis on reducing the growth of money and less emphasis on limiting the short-run fluctuations in interest rates. The role played by financial innovation in complicating the pursuit of monetary policy during 1979-1982 is examined, with attention focused on whether rapid financial innovation made it infeasible to target on M1 (or some other monetary aggregate), and whether innovation contributed to the extreme fluctuations in money growth and interest rates that occurred. The innovations - negotiable CDs, holding company debt, Eurodollar operations, repurchase agreements, money market mutual funds, and interest-bearing transaction accounts - were primarily responses to government-imposed interest rate ceilings and reserve requirements, and to high and variable interest rates. The evidence shows that the financial innovations did not produce the large, unexpected movements in the quantity of money during the 1979-1982 period.