By affecting the transmission mechanism, financial innovation is also a challenge for the conduct of monetary policy  A good knowledge of the mechanisms through which monetary policy affects the economy is of crucial importance for central banks. Financial innovation affects these mechanisms both by altering the channels through which monetary policy operates and by changing the overall impact of monetary policy decisions. But the magnitude of the changes and the precise effect due to financial innovation at a time when other factors such as globalisation are at work are not well known. At the present juncture research shows that financial innovation tends to strengthen the interest and exchange rate channels whereas it appears to weaken the credit channel. -  Financial innovation certainly contributes to stronger wealth effects and thus probably also to strengthen interest rate channel 7 . This can be explained as follows : •  Financial innovation fosters faster dissemination of information and its more rapid incorporation into financial market prices. This is of course particularly true for monetary policy decisions and can therefore increase the effectiveness of monetary policy, particularly via the interest rate channel 8 . •  Financial innovation contributes to an increased holding of financial assets by lowering transaction costs and facilitating arbitrage, hedging, funding and investment strategies. •  Financial innovation often relies on stronger leverage, increasing the effect of interest rate change by the central bank.

Erik Brofoss, the head of Norges Bank from 1954, was enthusiastic: “During discussions about monetary policy and other economic issues, Norges Bank has often found itself in the position of having to find intermediate solutions that could convey the positions adopted by the Ministry of Finance and by private financial institutions. The actual influence Norges Bank has had in this respect both vis-à-vis the Ministry and the private financial institutions extends far beyond its formal statutory authority.” 22 This line of thinking seems very remote to us today. Regulatory optimism was the hallmark of the 1960s, 23 and with the Act authorising the regulation of monetary and credit conditions of 1965, 24 which was an enabling Act conferring  20  Kåre Willoch [1994]: “Hvor uavhengig bør sentralbanken være?” [How independent should the central bank be? ], in Stabilitet og langsiktighet. Festskrift til Hermod Skånland [Stability and long-termism. Festschrift to Herman Skånland], Aschehoug. 21  For example, Governor Erik Brofoss later said: “… the impact of the interest rate, which was once virtually the only monetary policy instrument, is now far more limited in scope.” In Erik Brufoss (1959): “Sentralbankens statsrettslige og forvaltningsrettslige stilling” (The central bank’s position in relation to constitutional and administrative law]. Lecture given on 27 October. Published in Statsøkonomisk tidskrift 1960, pp. 1–31. 22  Erik Brofoss [1959]: “Sentralbankens statsrettslige og forvaltningsrettslige stilling” [The central bank’s position in relation to constitutional and administrative law]. Lecture given on 27 October. Published in Statsøkonomisk tidskrift 1960, pp 1–31.