Central bank policy in a more perfect financial system

Financial innovation increases markets' liquidity and provides economic age nts with new instruments to better handle risks, but it reduces the efficac y of monetary policy while strengthening the logic and force of the "unholy trinity". Increased liquidity of financial markets and increased leverage of financial positions imply that speculators can attack unsustainable fixe d exchange rates faster and more powerfully than ever. The rapid innovation of new financial instruments in these markets also implies the futility to "throw sand in the wheels" through regulation or the introduction of trans action taxes. The higher asset substitutability generated by the emergence of derivatives makes the definition of "money," particularly of broad monet ary aggregates, increasingly difficult. In a more complete financial market system central banks find it harder to predict the effect of a given monet ary impulse on real output and employment with any reasonable precision. Di scretionary monetary policies aimed at output and employment become more un certain. Consequently, central banks should focus on the long-run goal of p rice stability.