This paper examines the macroeconomic effects of financial innovation in the Israeli economy. Israel, like other economies in the West, has experienced significant innovation in financial services in the 1980s. By innovation we refer to the introduction of new, liquid assets that partially replace traditional money in agents' portfolios; technological progress in banking services that reduces the costs of transactions; and changes in the regulatory environment that
facilitate transactions. In Israel these innovations were made in conjunction with a high inflation process and were expressed in the increased use of foreign-exchange linked (PATAM) deposits in the period 1978-1985; the increased use of interest-bearing short-term deposits since 1982; and a decline in traditional M1 use concurrently with technological progress in banking services.

We propose a theoretical model, whereby financial innovation has effects of production and consumption in an infinitely - lived, utility-maximizing, representative agent model. Innovation affects the transactions costs of the consumer, generating a portfolio shift. This in turn either enlarges or reduces financial intermediaries resources and hence affects their lending rate to firms. The rate change induces changes in the long-run level of capital and therefore in production and consumption.

We test the implication of the model by estimating a series of VAR models. Examining cumulative impulse responses of real activity variables to shocks in the relative quantities of the different financial assets, we find that the model's predictions that increased use of PATAM deposits is contractionary while increased use of short-term deposits is expansionary are borne out by the data.

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