Financial innovation and aggregate stock market behavior: Theory and empirical evidence

Partha Basu, Fordham University


Over the last two decades, researchers in financial economics have documented the increasing influence of financial innovations on money demand specifications. The common definition of such innovations has included the efforts of the private financial sector in introducing new financial assets. However, no effort has been made, as yet, to recognize “new” or “sudden” government financial decisions as being financial innovations, too. This study addresses such a scenario where government actions affecting the demand or the need for real money balances constitutes financial innovation. Also, previous studies have mostly considered the monetary sector and effects on that sector when discussing financial innovation. Little efforts were made to study the effects on the financial sector. Given that there are important links between the monetary sector and the financial sector, this study develops two models that demonstrate the effect of financial innovation on the financial sector. The basic frameworks of these two models are borrowed from two very well known macro-economic models: Money-in-the-Utility Function model as per Danthine and Donaldson (1986) and Cash-in-Advance model as per Lucas and Stokey (1987). Financial innovation affects the household's decision making condition through a term called, for lack of a better term, “Innovation Discount Factor.” Both these models demonstrate the effect of financial innovation on the nominal and real stock market prices, which occur via its effect on M1 velocity. The second model includes a cash-in-advance constraint that leads to a friction preventing trade in a full range of Arrow-Debrue securities. Financial innovation reduces this friction that allows for reallocation of preference pattern between cash and credit goods thereby affecting the real stock market index. The empirical study includes evidence from three OECD countries namely Germany, Japan and the United States of America.

Subject Area

Finance|Economic theory

Recommended Citation

Basu, Partha, "Financial innovation and aggregate stock market behavior: Theory and empirical evidence" (1999). ETD Collection for Fordham University. AAI9926917.