1. DEPARTMENT OF ECONOMICS
UNIVERSITY OF STELLENBOSCH
FINANCIAL MARKET STABILITY:
A MONETARY POLICY CHALLENGE IN THE AFTERMATH OF
A GLOBAL FINANCIAL CRISIS
by
Pieter Eduard Roux
Assignment presented in partial fulfilment of the requirements for the degree of Masters of
Philosophy in Economic Policy at the University of Stellenbosch.
SUPERVISOR: PROF G A SCHOOMBEE
March 2012

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Declaration
I, the undersigned, hereby declare that the work contained in this assignment is my original work
and that I have not previously in its entirety or in part submitted it at any university for a degree.
Signature……………………
Date:………………………..

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Contents
1 INTRODUCTION .......................................................................................................................1
2 ANATOMY OF THE GLOBAL FINANCIAL CRISIS .............................................................4
2.1 The scale of the crisis............................................................................................................4
2.2 The dynamics of the financial market crisis..........................................................................5
2.3 From financial crisis to a global recession ..........................................................................10
2.4 Initial monetary policy responses to the crisis ....................................................................10
2.5 Summary .............................................................................................................................12
3 THE STRATEGIC FRAMEWORK OF MONETARY POLICY.............................................13
3.1 The ultimate objectives of monetary policy........................................................................13
3.1.1 Internal price level stability..........................................................................................13
3.1.2 Balance of payments and exchange rate stability ........................................................14
3.1.3 Employment and income stability................................................................................15
3.1.4 Financial market stability.............................................................................................15
3.2 The intermediate targets of monetary policy.......................................................................16
3.3 Operational variables and policy instruments .....................................................................17
3.4 The transmission mechanisms of monetary policy .............................................................18
3.5 Summary .............................................................................................................................21
4 POST-CRISIS CHALLENGES FOR MONETARY POLICY.................................................22
4.1 Monetary policy and asset price bubbles ............................................................................22
4.2 Dichotomy between monetary policy and financial stability policy...................................24
4.3 The independence of the monetary policy authority...........................................................25
4.4 A need for more international co-ordination of monetary policy .......................................26
4.5 Summary .............................................................................................................................27
5 CONCLUSION..........................................................................................................................28
6 BIBLIOGRAPHY......................................................................................................................31

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Figure 1: Initial subprime losses and declines in world GDP and world stock market capitalisation.4
Figure 2: TED Spread showing subprime crisis and Lehman collapse ...............................................8
Figure 3: The transmission mechanism of monetary policy (Bank of England) ...............................19
Figure 4: Quantitative Easing transmission channels ........................................................................20

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1 INTRODUCTION
Triggered, amongst other events, by the collapse of one of the largest and oldest global investment
banks, Lehman Brothers, in 2008, a financial crisis has spread across the globe, branching out first
into a global economic crisis, and at the time of writing, into a sovereign default crisis in the
European Union. This has immersed advanced as well as developing economies in a recession, and
there is a real threat of sovereign default in the European Union if Greece fails to meet its scheduled
debt repayments.
The global scope of the financial crisis has prompted the G20 (a multilateral meeting finance
ministers and central bank governors of the world’s largest economies) to establish a Financial
Stability Board to co-ordinate efforts towards improved financial oversight policy. The United
Nations commissioned a report under the chairmanship of Joseph Stiglitz, a Nobel laureate
economist. This report (Stiglitz, 2010) is critical of the G20’s efforts at addressing the problem,
citing the G20’s poor representivity of the developing world, which is bearing the brunt of the
global crisis, as a major flaw in the system.
Hindsight being an exact science, there is no shortage of opinion as to what should have been done
different in the past. Much of the blame has been laid before the door of agencies responsible for
financial oversight, in many instances the central banks of sovereign nations, who maintained what
became known as “light touch” oversight during the period known in monetary policy circles as
“The Great Moderation” typified by stability in all the ultimate objectives of monetary policy.
It is in a sense also inevitable that at least some of the blame for the crisis would have been assigned
to the central banks specifically in their capacity as monetary authorities, for the manner in which
they have conducted monetary policy in the period preceding the crisis. In its more extreme
manifestation, such criticism has given rise to views that all previous assumptions regarding
monetary policy have been discredited irrevocably, that monetarism has finally been put to rest, and
that monetary policy has, as a result, been thrown into crisis.
However, as was rather eloquently phrased in a letter written by the British Academy in response to
an enquiry from Her Majesty the Queen (The British Academy, 2009), as to why no one saw the
crisis coming, many economists and policy makers foresaw aspects of the crisis but not necessarily
the exact timing and ferocity, nor the combined effect of all developments that, with hindsight, are
now seen as having formed an integral part of the developing crisis. Part of the problem in
foreseeing the development of a crisis of this nature and scope, is the fact that much of what is now

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regarded as key elements of the failure, were at the time seen as key benefits of an increasingly
sophisticated and innovative financial system from which not only households, but many nations
benefited substantially.
Opinions vary widely as to how the events of the past four years impact the future conduct of
monetary policy. Very few would argue in favour of an unqualified “business as normal”
declaration with regard to monetary policy. Furthermore, there are many proponents of the
argument that the tools of monetary policy to prevent a recurrence of the events of the past four
years are limited. Yet Mishkin (2010) argues that those who question the effectiveness of monetary
policy during the global crisis have to put forward convincing counterfactual arguments, that is,
they have to argue convincingly that monetary policy intervention during and in response to the
crisis was not instrumental in preventing a bigger disaster (such as a full-blown depression) from
materialising. In fact Mishkin argues that those severe criticisms of monetary policy as being
ineffective in response to the crisis, are “just plain wrong” (Mishkin, 2009). In fact, arguing that
monetary policy is ineffective in a crisis is dangerous because it would imply that there is no point
in using it in a crisis.
It is, nevertheless, of more than academic interest to understand how monetary policy will be taken
forward as a result of lessons learned from the crisis, and to understand the reach, as well as the
shortcomings, of traditional monetary policy instruments and nominal anchors in attaining the
objective of financial market stability. It has, for example, been pointed out (Goodhart, 2010) that
the period leading up to the global crisis was characterised by low inflation globally and that
certainly inflation as a monetary anchor for price stability, provided no early warning that the global
economy was overheating.
Monetary policy had also been grappling for some time with the phenomenon of asset bubbles and
what the appropriate response to the development of such bubbles ought to be. The extreme view,
i.e. to pop asset bubbles, was perceived to be too damaging to households. On the other hand, only
cleaning up after an asset bubble had burst has proved to be extremely expensive to the fiscus.
Consensus existed somewhere between “leaning against bubbles developing” and “cleaning up after
a bubble had burst” approach (Mishkin, 2011).
A strong view is also now emerging that the financial sector plays a far more important role in
economic activity than had previously been understood. At the same time there are market
information asymmetries in the financial sector, with lenders often having less information than
borrowers as to the risks inherent in financed assets. These asymmetries make it difficult for

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monetary authorities to determine whether credit in the financial sector (also described as “private
money creation”) and risk are being priced correctly, thus making intervention difficult. The limited
tools available to monetary policy also make it difficult to target only areas where trouble may be
brewing, unless an innovative means (other than the official bank rate) can be found to enable
monetary authorities to intervene in fragile financial markets.
The paper will pursue its review of monetary policy in the wake of the crisis along the following
lines:
Firstly it will review the anatomy of the global financial crisis in terms of its dynamics and impact
on the global economy.
Secondly, the framework of monetary policy will be reviewed to form an understanding of how
monetary policy impacts the economy, and how this framework was applied during the financial
crisis.
Thirdly, it will be necessary to review the generally accepted understanding of the transmission
mechanisms of monetary policy, once again in order to establish an understanding of where the
leverages as well as limitations are for monetary policy to influence financial markets, and whether
perhaps the global crisis has brought with it new insights into the transmission mechanism.
Fourthly, some specific new challenges for monetary policy will be considered in more detail.
Finally, conclusions will be drawn with regard to how the financial crisis will influence the future
conduct of monetary policy in pursuit of financial stability as well as the traditional ultimate
objectives of monetary policy.

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2 ANATOMY OF THE GLOBAL FINANCIAL CRISIS
This chapter will aim to provide an overview of how the financial crisis of 2007/08 started in the
financial markets of the USA and then became global. It will track the response of monetary policy
authorities to the crisis, and it will show that the need to re-establish stability in financial markets
required non-conventional monetary policy responses, in addition to the conventional monetary
policy responses which had been deployed at the onset of the crisis.
2.1 The scale of the crisis
IMF chief economist Olivier Blanchard (Blanchard, 2009) provides a sobering overview of how,
between October 2007 and October 2008, an asset bubble in the US subprime housing market
escalated into a financial crisis of staggering global proportions. Using data obtained from the IMF
Global Financial Stability Report, the IMF World Economic Outlook and the World Federation of
Exchanges, the following figure is drawn by Blanchard:
Figure 1: Initial subprime losses and declines in world GDP and world stock market
capitalisation
Source: (Blanchard, 2009: 3)
Describing himself as “…an economist who, until recently, thought of financial intermediation as
an issue of relatively little importance for economic fluctuations…” (Blanchard, 2009: 3) Blanchard

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points out that the localised US subprime crisis (registering a loss of $250 billion) multiplied 20
times into IMF world GDP loss estimates of $4,700 billion, and 100 times into a decrease in global
stock market capitalisation estimated at $26,400 billion.
This multiplication effect points to a fragility in world financial markets which had been
underestimated almost universally, and it clearly puts the question of financial market stability as a
desirable outcome of macroeconomic policy in general, and monetary policy in particular, in the
forefront of current policy deliberation across the world.
There have been overt attempts by some notable economists to lay the responsibility for the crisis
before the door of monetary policy for not doing what was necessary or not doing enough, to avoid
the crisis (Krugman, 2010). However, Mishkin (2010: 4) is of the view that the US subprime crisis
simply happened to be the trigger mechanism - like a vibration or noise triggering an avalanche if
the snow conditions on a mountain slope are right - which revealed the fragility of the global
financial system. Mishkin believes that, absent the subprime crisis, some other seemingly minor
financial event might very well have triggered the crisis.
In terms of scale, the crisis is not over and has subsequently transformed into a European monetary
crisis that has not been resolved. The monetary union is under threat from an expected debt default
by Greece, and the increased vulnerability of Italy, Spain and Ireland, and even Germany and
France. At the time of writing, details of a final rescue plan have not yet been made available on a
resolution to the European crisis. The current European crisis does seem to confirm the notion that
there are deep-rooted problems in the world’s financial market system and political economy, and
that a major crisis has been in the making for some time.
In order to make sense of the scale of the global economic crisis resulting more directly from the
US subprime crisis, it is necessary to review the dynamics of the crisis and how it transmitted into
the global economy at the rate and magnitude depicted above.
2.2 The dynamics of the financial market crisis
Rajan finds the dynamics of the crisis in the unsustainable imbalances that have come to define the
global political economy of our time. One of the major “fault lines” he sees running through the
global political economy, “…emanates from trade imbalances between countries stemming from
prior patterns of growth.” (Rajan, 2010: 7). He goes into some detail of how post- WWII economic
growth in Japan and Germany, resulting in those two economies becoming the second and third
largest in the world after the USA, became defined as export-driven growth, with very high internal

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savings rates and very poor domestic consumption. This resulted in the largest economy, the USA,
taking on the role of a net consumer of goods produced by those exporting economies. This
imbalance in consumption and production between the world’s largest economies was being fed
even further by the savings emanating from Japan in particular, which made it possible for
Americans to finance their consumption far beyond what they could afford, but by doing so, were
providing the engine for this unbalanced global growth. Eventually, during the first decade of the
21st
century, this unsustainable imbalance revenged itself by manifesting in a subprime housing
asset bubble in the USA. When it burst, this bubble contaminated the world’s financial system
through a plethora of financial instruments designed to dilute the risk, but in doing so created
perverse incentives for financial institutions to take on tail risk1
which eventually eroded and then
destroyed their balance sheets.
To the extent that Rajan does blame US monetary and financial authorities for the crisis, it is that on
the one hand the Federal Reserve erroneously thought that it could respond to a lacklustre economy
by lowering interest rates (a “conventional” monetary policy instrument that had worked in past
slowdowns) and not heeding warnings that a domestic property asset bubble was in the process of
building up, driven by consumers who could not actually afford to buy their own homes.
Continuing to lower interest rates in the midst of such a developing bubble was like pouring oil on
troubled waters. On the other hand financial oversight was lax or non-existing and, responding to
government incentives as well as an easing of monetary policy, predatory bond originators
exploited the vulnerable by making loans to people with no income, no jobs and no assets – the so-
called “NINJA-loans” (Rajan, 2010: 7).
Moving now to a more specific financial market analysis of the dynamics of the crisis, Mishkin
(2010) divides the development of the financial market crisis into two phases.
The first phase of the crisis, and already referred to a number of times above, is the subprime
mortgage crisis in the USA. During 2007 and 2008 a run on the shadow banking system (the system
through which banks borrow from one another) started to develop. Because a bank’s assets are the
long term loans it issues, whereas its liabilities are the short-term deposits it holds, it has to finance
1
Rajan (2010: 137) uses the term “tail risk” to denote risks that occur “in the tail of the probability distribution – that is,
very rarely”. These tail risks played a significant role in the erosion of the balance sheets of financial institutions.
Having created these mortgage backed securities, the risk management strategy was to sell these securities in the global
financial market, thereby diluting the risks of default to a single institution. However, once these securities were
created, and insured through companies such as AIG, they received AAA ratings by ratings agencies. This led financial
institutions creating them in the first place, to assume, erroneously, that the probability of risks materialising was very
low. Therefore, instead of creating them and then selling them off, many financial institutions either retained large
quantities of these mortgage-backed securities, which had become lucrative investment vehicles (due to the fact that
insurers were prepared to cover them), or by repurchasing them back onto their balance sheets.

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its liquidity requirements through repurchase agreements via interbank lending, also known as the
shadow banking system. These short term repurchase agreements are liabilities that have to be
secured by offering longer-term assets like mortgage-backed securities as collateral. It is common
practice for borrowers in the shadow banking system to have to post collateral valued at more than
the amount of the loan. This is known as “taking a haircut”. When it became clear that these
mortgage-backed securities contained subprime housing loans, and when it furthermore became
apparent that homeowners were starting to default on their mortgage payments, the shadow banking
system started to demand bigger “haircuts” (as much as 50 % of the mortgaged backed securities
being offered as collateral). This logically led to a devaluation of the underlying assets, forcing
banks to deleverage by selling off assets. Selling those assets had the immediate effect of further
eroding the value of those asset classes, forcing further sell-offs, and setting off a “fire-sale”
dynamic (Mishkin, 2010: 2).
A good indicator of how banks perceive the risk of lending to one another, is the so-called TED2
Spread graph (the difference between the interest rate on interbank loans – specifically the three-
month London Interbank Offered Rate or “LIBOR” - , and on three-month US Government
Treasury bills). At the onset of the financial crisis (second half of 2007), the spread increased to 200
basis points. As this fire-sale dynamic began to settle in, in March 2008 investment bank Bear
Stearns became the first casualty of this credit squeeze in the shadow banking system as its short
term financing dried up. As can be seen from Figure 2 below, the TED spread climbed to just over
200 basis points following the collapse of Bear Sterns. The Federal Reserve intervened in the failure
of Bear Stearns, by facilitating the purchase of Bears by another investment bank, JP
Morgan/Chase. In order to stabilise the financial market the Fed effectively moved into the domain
of non-conventional monetary policy by taking $40 billion of Bear Stearns’ subprime assets onto its
own balance sheet, effectively becoming a “lender-of-last-resort”. In addition the Fed opened new
repurchase lending facilities to banks, which it offered through anonymous auctions. This appeared
to calm the financial markets and the TED spread dropped below 100 basis points again.
Mishkin points out that, at this point, it started to look as if the Fed’s unconventional intervention
had been successful and that the financial crisis could be contained. There was even talk that
inflation was on the rise and that “…the easing phase of monetary policy might have to be reversed
in order to contain inflation.” (Mishkin, 2010: 3).
2
Acronym formed from T-bill and Eurodollar (ED) futures. The Baa spread in the graph refers to the difference
between long term corporate bond rates and the 10-year constant maturity US Treasury bond rate.

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The second phase of the crisis centres on the collapse of Lehman Brothers, one of the oldest and
most prominent investment banks in America and the world. This event helped turn the subprime
crisis into a global financial crisis, due to the global reach of the markets served by Lehman. It is
marked on the TED spread graph in Figure 2 by a rise in the TED spread to more than 600 basis
points. There is a popularised view that the US Treasury and Federal Reserve’s decision to allow
Lehman Brothers to go bankrupt, was responsible for the global financial crisis which followed.
However, Mishkin argues that three other events played as much of a role in globalising the crisis -
two on the day following Lehman’s collapse, and the third playing out over the weeks following the
Lehman collapse (Mishkin, 2010: 4).
Figure 2: TED Spread showing subprime crisis and Lehman collapse
Source: Mishkin (2010: 29)
Firstly, allowing Lehman to go bankrupt was not the first option for the regulatory authorities;
however, negotiations for a takeover of Lehman by Barclays Bank of the UK were not successful.
In fact, it became apparent in the proceedings of the United States Bankruptcy Court during 2009,
that Lehman employed fraudulent accounting practices to hide its leveraged position (Mishkin,
2010: 5). This asymmetric information, still hidden at the time of the takeover negotiations, could
well have caused the collapse of Barclays Bank, had the deal succeeded. The decision to allow
Lehman to fail was also motivated from a fear of moral hazard, given the fact that the Federal
Reserve had already taken toxic assets from Bear Stearns onto its balance sheet, and government

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had already taken over Freddie Mac3
and Fannie Mae4
. It was considered important at the time, to
force financial institutions to reduce their risk taking.
The second event, i.e. the failure of AIG5
on the day after Lehman came as a shock to the market
and the regulatory authorities who did not know that AIG had taken aboard enormous risk in the
form of credit default swaps, in effect insurance policies over the securitised subprime mortgages.
When it became apparent that these policies would have to pay out, AIG went into a cash crisis and
short term funding dried up. On the same day, a run on the “Reserve Primary Fund”, a large money
mutual market fund which held $785 million of Lehman paper, caused the fund to collapse. This
immediately contaminated other money market funds, which in turn affected banks, to which
money market funds were a significant source of funding.
The third event following Lehman’s bankruptcy occurred on 19 September 2008 when US Treasury
Secretary Hank Paulson arrived on Capitol Hill with “an infamous three-page document” asking the
US Congress to authorise the Treasury to spend $700 billion on the purchase of troubled subprime
mortgage assets (Mishkin, 2010: 7). The document, known as the Troubled Asset Relief Program
(TARP) contained no accountability clauses in respect of spending this money. When it was voted
down by Congress on 29 September 2008, this event raised serious doubts in the world’s financial
markets that the US fiscal and monetary authorities had the ability to manage the crisis. When a
revised proposal was eventually tabled, and signed into law by the new president, President Obama,
it contained “…numerous ‘Christmas-tree’ provisions such as a tax break for makers of toy wooden
arrows.” (Mishkin, 2010: 7). The reputational damage to the credibility of those in charge of the
biggest economy in the world had been done.
In concluding this discussion of the dynamics of the financial market crisis, it is worth noting the
amplification mechanisms of the crisis as described by Blanchard (2009). The first amplification
mechanism, the run on the shadow banking system, has already been discussed above.
The second amplification mechanism identified by Blanchard, which is distinct from the first one,
comes from the need for financial institutions to maintain capital adequacy ratios, either in response
to increased regulatory requirements, or to convince investors that they are taking steps to reduce
their risk of insolvency. They have two options available in achieving this: firstly to raise more
capital (a challenge in the midst of a financial crisis) or “deleverage” by selling-off assets; secondly
3
The Federal Home Loan Mortgage Corporation (FHLMC)
4
The Federal National Mortgage Association (FNMA)
5
The Financial Products Unit of American International Group reinsured mortgage-backed securities (using “credit
default swaps”) based on the triple-A investment ratings granted to these securities by ratings agencies.

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by reducing their lending to other financial institutions. This caused a second round of fire sale
erosion of asset prices. Indeed, Blanchard argues that the second amplification mechanism was
responsible for the translation of the crisis into the economies of emerging market countries which
had absolutely nothing to do with the origins of the crisis and, in some instances, did not even have
sophisticated financial markets but simply fell victim to a global credit squeeze which had set in
(Blanchard, 2009: 11).
2.3 From financial crisis to a global recession
Mishkin (2010: 10-11) identifies three mechanisms by which the financial crisis translated into an
economic recession.
Firstly, credit spreads widened (as illustrated in Figure 2 above). This simply meant that, even if
monetary policy had been relaxed and official interest rates fell, the cost of borrowing for
businesses and households actually increased and this had the immediate effect of slowing the
economy down.
Secondly, the erosion of asset prices which has already been explained above as one of the
amplification mechanisms of the crisis also held true for non-financial businesses and households.
This means the non-financial sector (businesses and households) also had less ability to borrow.
Businesses could therefore not get funding for expansion and households could not incur
consumption spending. Demand for, and supply of goods and services fell, causing a further
contraction.
Finally, the market uncertainty that came with the financial crisis increased the information
asymmetry between lenders and borrowers: it became more difficult for lenders to assess the risks
associated with investment opportunities and therefore the allocative efficiency of the market, i.e.
its ability to direct financial resources to productive opportunities, was compromised. This caused
further contraction.
2.4 Initial monetary policy responses to the crisis
Given the operational variables at its disposal (the interest rate, and control over the cash base of the
economy), conventional views about the ultimate objectives of monetary policy - internal price
level stability, balance of payments and exchange rate stability, and employment and income
stability - did not include financial market stability, at least not as an explicit ultimate objective.
Surprisingly there has been no shortage of economists blaming the “easy” monetary policy of the
early 21st
century, for the financial crisis of 2008. Most prominent among such critics is Paul

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Krugman, who has been using his column in the New York Times extensively, to criticize monetary
policy, sometimes for causing the crisis (Krugman, 2010), and other times for not doing enough to
prevent it (Krugman, 2008). J.K. Galbraith even suggested that the crisis was a signal of the final
demise of monetarism and the beginning of “the next life of Keynes” (Galbraith, 2011).
Yet it can hardly be argued that the science of monetary policy had been ignorant or dismissive of
the importance of financial market stability in the modern-day global economy. In a paper delivered
to a conference on monetary policy arranged by the South African Reserve Bank in 2001, Jozef
Van’t dack, adviser at the Bank for International Settlements, identified the inter-linkages between
monetary and financial stability as an important challenge for monetary policy (Van't dack, 2001).
Referring to asset price bubbles, Mishkin (2011: 18) points out that extensive research is available
on the need for monetary policy to respond in some way to the development of such bubbles in
order to mitigate the risk of such eventualities.
Both Mishkin (2010) and Blanchard (2009) highlight important monetary policy responses to the
crisis without which the initial damage to financial markets may have been even worse.
Blanchard (2009: 16) points out that, policy-wise, monetary policy was successful in dampening the
first amplification mechanism by expanding the monetary base (especially since there was no
danger of high inflation), thus making it unnecessary for financial institutions that were otherwise in
good standing, to sell of their assets at fire sale prices. This was successfully done by monetary
authorities, who acted as “lenders of last resort” to banks, but also in that they widened the type of
institutions they were prepared to lend to, as well as the type of assets they were prepared to accept
as collateral. This approach became known as “quantitative easing”.
This liquidity provision and asset purchase strategy is referred to by Mishkin (2010: 12) as two of
three “unconventional” monetary policy measures deployed during the crisis. A third
unconventional policy measure was in the form of expectation management when the Federal
Reserve announced that it would maintain “exceptionally low” interest rates “for an extended
period” (Mishkin, 2010: 15). These measures are believed to have contributed to narrowing the
credit spread considerably.
As a final point, Mishkin (2009) argues that criticisms of how conventional monetary policy was
being conducted during the crisis as being recessionary or even depressionary in nature, were “just
plain wrong” because without the aggressive lowering of interest rates at the onset of the crisis, the
economic impact of the financial crisis may very well have been much worse.

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2.5 Summary
This chapter has shown how a subprime housing market in the USA resulted in a housing asset
bubble which, linked to excessive risk taking by investment banks, and later also other financial
institutions, in pursuit of higher yield, escalated into a global financial crisis. This specific financial
crisis has illustrated more than past crises, the importance of financial intermediation in the modern
global economy. This poses a challenge for monetary policy authorities (mostly the central banks of
countries) in that the conventional pursuit of price level stability, Balance-of-Payment and
exchange rate stability, did not include financial market stability as an explicit ultimate objective of
monetary policy. Although conventional monetary policy responses probably averted a bigger
crisis, it was not enough to return financial markets to a level of functionality essential to the pursuit
of modern day economic activity, and non-conventional policy measures had to be deployed.
The next chapter will pursue the policy options of monetary policy in the face of a global financial
crisis such as the one referred to, in more detail.

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3 THE STRATEGIC FRAMEWORK OF MONETARY POLICY
In this chapter the ultimate objectives, intermediate targets, operational variables and policy
instruments available to the monetary authority, will be reviewed to establish how the objective of
financial stability could be pursued within the conventional strategic framework of monetary policy.
Under each heading the limitations of the conventional monetary policy framework in achieving
financial market stability, will be highlighted.
The chapter concludes with a discussion of the conventional transmission mechanism of monetary
policy and the introduction of a transmission mechanism to illustrate the operation of non-
conventional monetary policy in pursuit of financial market/system stability.
It also needs to be pointed out that, for the purpose of discussing the conventional monetary policy
framework, it is assumed that the central bank is also responsible for the execution of monetary
policy and that it enjoys implicit or explicit independence in giving effect to monetary policy (the
objectives of which may be set by government). It will be pointed out in chapter 4 that this identity
between the central bank and the monetary authority may itself be problematic.
3.1 The ultimate objectives of monetary policy
3.1.1 Internal price level stability
Where Goodhart (2010) argues that the main characteristic of the strategic framework of monetary
policy since the 1980’s is the triumph of the market (that is, monetary authorities use their policy
instruments to participate, rather than intervene, in the market), Van’t dack (2001: 6) emphasises
the fact that this period also saw the overriding objective of monetary policy as being the pursuit of
price stability. A further development in the debate of this period was the recognition that “a
credible commitment to a nominal anchor – i.e., stabilization of a nominal variable such as the
inflation rate, the money supply, or an exchange rate – is crucial to successful monetary policy
outcomes.” (Mishkin, 2011: 10). Furthermore, during this period an increasing number of monetary
authorities have settled on inflation targeting with the inflation rate as its nominal anchor, and the
repurchase rate, together with its clear communication of intermediate inflation targets, as the
operational variable most suited to be used as a mechanism to achieve its policy objective of low
inflation.
Conventional monetary policy responded to the developing financial crisis by keeping the nominal
interest rate low due to low inflationary pressures. It has been argued elsewhere in this paper that
this response was not only correct in the conventional sense, but that it played a meaningful role in

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dampening the first amplification if the financial crisis, despite the fact that monetary authorities
attracted criticism for keeping rates low in the midst of a developing asset bubble. Had nominal
rates not been kept low, the credit squeeze might have been even worse, and fundamentally sound
assets held by financial institutions might have been eroded even more. This does not, however,
constitute a good argument that price level stability through inflation targeting will ensure financial
market stability.
It is fairly common knowledge that the 2007/08 financial market crisis was preceded by a high
degree of price level stability and low inflation globally. Mishkin (2011: 29) therefore concludes
that price level stability in itself does not ensure financial stability. On the contrary, “…central
banks’ success in stabilizing inflation and the decreased volatility of business cycle fluctuations,
which became known as the Great Moderation, made policymakers complacent about the risks from
financial disruptions.” (Mishkin, 2011: 30). What this therefore says is not that inflation targeting as
a means towards achieving price stability is bad, but simply that low inflation in itself is a poor
indicator of financial market stability, and that, in fact, financial market instability and low inflation
can co-exist (Borio and Lowe, 2002).
3.1.2 Balance of payments and exchange rate stability
Managing the national accounts (BoP stability) and maintaining the value of the national currency
remain important ultimate objectives of conventional monetary policy. Countries have to cover
deficits on the national account through borrowing, or through the inflow of portfolio capital. This
continues to pose significant challenges for open, emerging economies that are almost obliged to
accept deficits in order to fund development, because it makes them dependent on portfolio
investment to cover the deficit, which poses the risk of flow reversals and resultant “sudden stops”
during economic downturns.
Once again the conventional operational variable to manage the Balance of Payments is the official
interest rate. The official rate can be increased to check a widening of a deficit on the Balance of
Payments in that excessive borrowing is curtailed, but also in that a higher interest rate stimulates
portfolio inflows from economies with low interest rates. This, however, leads inevitably to
appreciation of the local currency. For this reason, open economies that pursue inflation targeting
and BoP stability have little choice but to accept a floating currency that is often also fluctuating in
response to global economic events.
Much has been made by economists, following the financial crisis, about global imbalances in
savings and consumption as being one of the root causes of the crisis. Summarised by Borio et al

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(2011: 1) this view entails that emerging economies that adopted a “growth-through-export”
strategy after WWII, such as Germany and Japan (Rajan, 2010) resulted in a net flow of savings
from these countries, into “deficit economies” it eased financial conditions, exerted downward
pressure on interest rates, and helped to fuel a credit boom and risk taking, and thus sowing the
seeds of a financial market crisis. The implicit criticism is then that monetary authorities are in
default not to respond to such unsustainable global imbalances. This matter of imbalances caused
by “excess savings” will be returned to later. (See 4.4)
However, as an instrument of monetary policy there are no clear examples of capital account
management or exchange rate management having had a meaningful impact on stability in the
balance of payments or exchange rate and, although adverse capital flows can be disruptive to
emerging market economies, using the balance of payments, or the exchange rate, as nominal
anchor for monetary policy can be costly.
3.1.3 Employment and income stability
Whilst employment and income stability are recognised as being important ultimate objectives of
monetary policy it is today widely accepted that the instruments of monetary policy are not best
suited towards achieving these objectives. This is particularly so since it was established that there
is no long-term trade-off between unemployment and inflation (the so-called Philips curve).
3.1.4 Financial market stability
It is, perhaps, appropriate at this juncture to pause for a moment and reflect on an operational
definition of “financial market stability”. A universally agreed definition appears to be elusive and
it is therefore advisable to adopt a pragmatic operational explanation of the concept. The Bank of
England (2011) states its core purposes as being the achievement of monetary stability (i.e. stable
prices and confidence in the currency) as well as the achievement of financial stability (detecting
and reducing threats to the financial system as a whole) as being its contribution to a healthy
economy. This mission statement, particularly in referring to the achievement of financial stability,
suggests that financial stability is a state of vigilance, and an awareness of threatening impediments
to the proper functioning of the financial system as a whole.
How then, can conventional monetary policy be applied in pursuit of financial market stability?
Borio et al point out that “While the empirical evidence is broadly consistent with the idea that
monetary instability can cause financial instability, the interpretation of this evidence, and the
policy conclusions that follow, are arguably subtler than is sometimes recognised.” (2002: 18). Put
differently, it is less easy to prove the extent to which monetary stability (i.e. stability in the

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16
traditional ultimate objectives of monetary policy listed above) will give cause to financial stability,
than it is to argue that monetary instability can create the context for financial market instability.
It can be broadly summarised from the above exposition that conventional monetary has provided,
and will in future continue to provide, a solid base for economic stability in the absence of which
disruptions, including financial market disruptions, will be more violent and destructive.
At the same time, the fact that it appears, from the financial crisis, that a large degree of monetary
stability (especially low inflation) can co-exist with a high level of vulnerability in financial
markets, therefore poses the question as to what type of monetary policy strategic framework is
most likely to lead to the establishment of monetary as well as financial stability.
This challenge will be addressed in more detail under the next heading.
3.2 The intermediate targets of monetary policy
In order for a monetary policy framework to achieve credibility, it has to be able to refer to
intermediate targets, which would indicate that the policy framework is having the desired effects in
terms of achieving the ultimate objectives which the policy has set out to achieve. Typically an
intermediate target would be an inflation forecast, the money supply, credit extension to the private
sector, or the exchange rate.
Borio points to a possible paradox inherent in a monetary policy framework that enjoys a high
degree of credibility, and which therefore only needs to respond to clear signs of inflationary
pressures, in that inflationary pressures may only become apparent in the development of
imbalances in the financial system, and not in the goods and services market. Under such conditions
“…central banks with a high degree of credibility need to remain alert to the possibility that
inflationary pressures first become evident in asset markets, rather than in goods markets.” (Borio
and Lowe, 2002: 22).
The risk is therefore that a monetary policy regime focused only on inflation targeting may not be
vigilant enough to emerging threats to financial stability coming from inflationary pressures in asset
markets. This suggests that an inflation targeting regime may have to respond not only to deviations
from the inflation forecast, but must also be prepared to respond (by raising the interest rate) to
signs of financial market imbalances (rapid credit growth or asset prices rising too quickly). This
does, however, raise the question whether the use of one instrument (the interest rate) to achieve
two goals (monetary as well as financial stability) is not a violation of the Tinbergen rule which will
inevitably compromise one of the ultimate goals. An obvious answer to this dilemma, according to

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Borio, would be a prudential policy framework to achieve the outcome of financial market stability
(Borio and Lowe, 2002: 24). It also provides context for the argument in favour of non-
conventional monetary policy.
3.3 Operational variables and policy instruments
Goodhart (2010: 5) argues that the period of monetary policy spanning 1980 to 2007 can be
described as the “triumph of the markets”. That is, “the almost universal reliance on market forces
[emphasis in the original] and the competitive price mechanism in organising real and financial
activity.” (Van't dack, 2001: 2). This simply means that policy instruments are also market oriented,
or indirect, in that the monetary authority acts through participation in the market, instead of
intervening in the market.
In terms of price level stability (inflation targeting) the operational variable used by the monetary
authority is the repurchase or overnight lending rate against which banks borrow from the central
bank. However, the response of monetary authorities (notably the US Federal Reserve) during the
financial crisis also demonstrated that the monetary authority (being the central bank) can use its
own balance sheet as an operational variable, in this instance to counteract the fire sale dynamic in
asset prices, by purchasing troubled assets in the financial market which caused the amplification of
the financial crisis.
Interestingly, Goodhart (2010: 9) argues that the manipulation of its balance sheet in order to create
liquidity is more central to the essence of central banking than manipulating the interest rate,
quoting Lord Cobbold, a former Governor of the Bank of England, for saying that “a central bank is
a bank, not a study group.” What Goodhart is, in essence, suggesting, is that a central bank (as the
monetary policy authority) which is responsible for financial market stability as an ultimate policy
objective, is better placed to use its balance sheet as the policy variable towards achieving this
objective, than the interest rate it uses to lend to banks. It has already been suggested above that the
interest rate may be a suboptimal operational variable towards achieving financial market stability.
Goodhart therefore in effect argues that the most appropriate operational variable to achieve
financial market stability would be the balance sheet of the central bank (as has been illustrated in
the non-conventional response of monetary authorities to the financial crisis). The implication of
this insight is twofold. Firstly, the notion of a separate “prudential regulation authority” would
imply that such authority would have to be given authority over the central bank’s balance sheet, if
such authority were to be made responsible for liquidity management. The prudential regulator
would effectively become the central bank.

22. ________________________________________________________________________________
18
In preference to this scenario Goodhart suggests that the central bank, managing liquidity through
its balance sheet, should have primary responsibility for the ultimate objective of financial market
stability, and that the management of the inflation target ought to be separated from the central
bank, so long as there was an agreed reaction function to restore equilibrium after some adverse
inflationary shock. This function could easily be done by a “study group”.
This does raise the problem alluded to at the beginning of the chapter, i.e. a role confusion or even
false identity between the “central bank” and the “monetary authority. At best, it means that
conventional monetary policy emphasises the monetary authority role of a central bank, whereas
non-conventional monetary policy emphasises its role as a bank. This problem will be returned to in
chapter 4.
3.4 The transmission mechanisms of monetary policy
The analysis of monetary policy in the context of the financial market crisis thus far, has identified
the interest rate set by the monetary authority (conventional monetary policy), and the central
bank’s balance sheet (non-conventional monetary policy), as the most likely two key operational
variables in the pursuit of monetary stability (low inflation) and financial market stability
respectively. It therefore follows that account has to be given of how these two operational variables
will transmit into the economy as low inflation, and into the financial market as stable asset prices
etc.
The traditional (Bank of England) transmission mechanism of monetary policy illustrates how the
first operational variable (the official bank rate) transmits to the ultimate policy objective of price
level stability (low inflation) and is reproduced in Figure 3 below. In this transmission mechanism,
domestic inflationary pressure (indicated via one of the intermediate targets, such as credit growth
in the private sector) may prompt the monetary policy committee of the central bank to raise the
official rate at which the central bank lends to other banks. This has the immediate effect of
increasing the rates at which banks lend to consumers and firms. The effect on all categories of
asset values is that of downward pressure, but the effect on expectations or confidence could be
positive or negative. An interest rate hike could, for instance, signal to the market that the monetary
authority is expecting growth to exceed forecasts and which could be inflationary. This could spur
confidence in the economy on. The impact of a bank rate increase on the exchange will depend on
many external factors but all things being equal, raising the interest rate will attract foreign portfolio
investment. This creates demand for the local currency, and will lead to an exchange rate
appreciation. Whereas higher market rates and asset price devaluation may lead to reduced domestic

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19
demand, an exchange rate appreciation may lead to reduced external demand for local goods and
services. A reduction in total demand will relieve domestic inflationary pressure, and the interest
rate increase would have transmitted into downward pressure on inflation. (The Monetary Policy
Committee, 1999)
Figure 3: The transmission mechanism of monetary policy (Bank of England)
Source: http://www.bankofengland.co.uk/images/from_int_inf2.gif
To the extent that the central bank (as declared by the Bank of England in its mission statement
referred to earlier) is also responsible for the policy outcome of financial market stability, this
transmission mechanism is able to show how the interest rate could be used to influence asset prices
(for example, to deflate asset prices in reaction to the development of an asset bubble) but it is also
a good illustration of why the interest rate might be an inappropriate operational variable through
which to achieve financial market stability during periods of low inflation, since the mechanism
shows that it is impossible to avoid the other transmission channels of an interest rate increase.
Market rates, expectations, and the exchange rate will also be affected even if there is no
inflationary pressure. It will take a very brave central bank to raise interest rates in the absence of
any inflationary pressures, simply to avoid an asset price bubble from developing. More
importantly, it illustrates the significance of the “Tinbergen rule” relating to the difficulties of only
having one tool with which to achieve two (sometimes opposing) objectives.
It is clear that another transmission mechanism is needed to understand how the central bank’s
balance sheet could be used to as a non-conventional monetary policy instrument to achieve the
ultimate policy objective of financial market stability. Such a transmission mechanism has been
ventured by the Bank of England in its latest Quarterly Bulletin and is reproduced below in Figure
4. (Joyce and Woods, 2011).

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Figure 4: Quantitative Easing transmission channels
Source: Bank of England Quarterly Bulletin 2011 Q3
The line of reasoning in this asset purchase transmission mechanism should be viewed against the
likelihood that conventional monetary policy (the interest rate) may have reached its lower bound. It
can therefore no longer respond to a dysfunctional financial market, and there is a real threat of
inflation breaching the lower limit of the inflation target.
Once conventional policy reaches its lower bound, non-conventional policy interventions are
required to respond to financial market instability. As an example of what happens next, one may
wish to consider the setting in of a “fire sale dynamic” in the financial system (in particular a run on
the interbank lending mechanism) as a result of a breakdown of trust in assets offered as collateral
against short term funding requirements (described in more detail in 2.2 above). The central bank
then steps in by using its balance sheet to purchase the troubled assets. This creates confidence in
the underlying value of the assets and sends an important signal to the financial market. The
liquidity problem is also addressed in that the asset sales to the central bank make money available
to the markets (i.e. the quantity of money is increased). In addition, the sellers of the troubled assets
may use the money to rebalance their portfolios by purchasing better quality assets. This activity
serves as an encouragement for more participants to move back into the market, and asset values
improve, stimulating more bank lending (due to improving collateral). Total wealth is increased, the
Bank of
England
asset
purchases
Portfolio
rebalancing
Policy
signalling
Confidence
Market
liquidity
Money Bank
lending
Asset price
and the
exchange
rate
Cost of
borrowing
Total wealth
Spending
and income
Inflation at
2%

25. ________________________________________________________________________________
21
cost of borrowing is lowered, spending and income both rise, and the lower limit of the inflation
target is supported (in that the increased quantity of money is inflationary).
It is acknowledged by the Bank of England that the results of its “quantitative easing”6
is not
unequivocal in all respects, and the eventual release of assets back into the market will be
conducted under different conditions, and may therefore have effects on a different scale. It has
however been calculated (Joyce and Woods, 2011: 210) that the impact of quantitative easing on
real GDP in the UK may have been between 1.5 and 2 per cent, and the resulting increase in
inflation was between 0.75 and 1.5 per cent. It was further calculated that the economic impact of
this non-conventional monetary policy instrument was the equivalent of a 150 to 300 basis point cut
in the official bank rate.
3.5 Summary
This chapter has shown that in terms of conventional monetary policy, the era preceding the recent
financial crisis was a golden era of price stability and low inflation. Even at the onset of the
financial crisis, conventional monetary policy was successful in dampening the first amplification
of the crisis. As it reached the lower limits of its effect on the financial market, there was a need for
non-conventional monetary policy (termed “quantitative easing” by the Bank of England) to
stabilise financial markets and return them to their essential role of facilitating a modern global
economy. This necessitated some new thinking on the tools available to monetary authorities – in
most cases the central banks – and led to a need to understand the transmission mechanisms of such
non-conventional monetary policy instruments.
It has also become apparent that there are possible challenges in the dual role of central banks as
monetary policy authorities, which require further discussion in the chapter to follow.
6
“The instrument of monetary policy shifts towards the quantity of money provided rather than its price (Bank Rate).
But the objective of policy is unchanged - to meet the inflation target of 2 per cent on the CPI measure of consumer
prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.” (The Bank
of England, 2011).

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4 POST-CRISIS CHALLENGES FOR MONETARY POLICY
Having traversed the dynamics of the 2007/08 financial market crisis and subsequent global
economic crisis, as well the broad science and pursuit of monetary policy, this chapter aims to distil
some direct insights into the issue which this thesis set out to address: What are the implications of
this crisis for the science and conduct of monetary policy, and how are the agents of monetary
policy going to be affected by the crisis?
De Gregorio, commenting on Peter Stella’s paper: “Minimising monetary policy” (Stella, 2010)
provides an intriguing perspective by claiming that, firstly, financial crises are rare events and that,
secondly, the most recent financial crisis has been well handled, “though poorly anticipated” (Stella,
2010: 28). Mishkin, quoted extensively in this paper, has argued convincingly in favour of the
statement that from a monetary policy perspective, the crisis was handled well. Whether or not the
crisis was poorly anticipated, is a view which does not appear to be borne out by the literature
entirely.
In a paper presented to a South African Reserve Bank Conference in 2002 (also quoted in this
paper) Jozef Van’t dack identified three significant challenges for monetary policy. These were:
firstly, “to understand how asset price cycles interact with monetary policy and what role monetary
policy could or should play in trying to moderate the asset cycles”; secondly “formulating an
effective monetary policy in conditions of financial market fragility”, and thirdly, “the inter-
linkages between monetary and financial stability” (Van't dack, 2001: 11). What has been set out as
challenges for monetary policy science in 2001, has been occupying the minds of monetary policy
scientists ever since the financial crisis of 2007/08.
These policy challenges will be summarised under four headings, i.e. the issue of how monetary
policy ought to respond to asset price bubbles, the monetary policy/financial stability dichotomy,
questions relating to the independence of monetary policy authorities, and finally challenges
relating to the global nature of monetary policy and financial market stability in the finance-driven
global economy of our day.
4.1 Monetary policy and asset price bubbles
One of the key issues in what has been written about the financial crisis, and the response of
monetary policy to the financial crisis, is how monetary policy can and should respond to the
development of asset price bubbles which, when they burst, cause the kind of financial crisis
experienced by the world since 2007/08. It is identified as a key issue because with hindsight, the
development of an asset price bubble in the subprime residential property market in the USA is seen

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as the trigger which set of a global financial and economic crisis. It therefore stands to reason that
the obvious question to be asked is: How could monetary policy have foreseen this bubble
developing, and what could therefore have been done to stop it from destroying the world’s
economy?
The problem of asset price bubbles, and how to deal with them, is not new to the science of
monetary policy. Given the preponderance of price level stability as the most important monetary
policy goal in the period 1980 to 2007, and the associated operational variable of the official
interest rate, at face value it seems logical to expect monetary authorities to use the interest rate to
“lean against” the development of asset bubbles. This assumes that there is always a simple causal
relationship between low interest rates (easy credit) and the development of asset bubbles.
However, Mishkin points out that there are asset bubbles which can also be referred to as “irrational
exuberance bubbles” (Mishkin, 2011: 40), the “dot.com-bubble” of the late 1990s being a good
example.
It is, however, correct to identify asset bubbles which result from easy credit, as the dangerous type
of asset bubble, provided there is a positive feedback loop between the easy credit and the further
development of the bubble. This causes lenders to focus less on the underlying risks of borrowers
not being able to repay their loans, and more on the appreciation of the assets, to shield them from
losses (Mishkin, 2011: 39). Whereas the first type of asset bubble very seldom causes serious
damage to the financial system, it is now known that the latter type of asset bubble can be
devastating to the financial system, and very costly to clean up.
Does this leave monetary policy with no choice but to “lean” against the development of credit-fed
asset price bubbles (by raising interest rates and making credit more expensive)? Mishkin argues
that monetary policy may have to live with the lesser of two evils. Using one policy variable (the
official interest rate) to achieve two objectives (financial as well as price stability) is a
contravention of the Tinbergen rule. A better option, according to Mishkin, would be for macro-
prudential supervision to deal with financial stability, while monetary policy focuses on price and
output stability. Unfortunately “prudential supervision is subject to more political pressure than
monetary policy because it affects the bottom line of financial institutions more directly.” (Mishkin,
2011: 44). The point here is that financial institutions collectively are powerful and use this power
effectively to influence policy making. For Mishkin, there is little chance to get away from a trade-
off between the pursuit of financial stability and the pursuit of price level stability, in the presence
of dangerous asset bubbles but the threat to weakening the nominal anchor of monetary policy (the
inflation target) remains real.

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Interestingly, in an article written in July 2002 (and therefore predating the financial crisis) Borio
and Lowe addressed this sub-optimal choice between monetary and financial stability in the face of
an asset bubble, by insisting on greater co-operation between monetary and prudential authorities,
not only in responding to crises, but also being vigilant in preventing them from developing (Borio
and Lowe, 2002: 27). In simple terms, monetary policy needs to respond to threats identified
through the system of macro-prudential regulation.
4.2 Dichotomy between monetary policy and financial stability policy
Mishkin points out that, even before the crisis, monetary policy authorities were aware of the fact
that disruptions in financial markets could have an impact on the economy. This is borne out by the
fact that many central banks published financial stability reports in order to monitor potential threats
in the financial system. However, “the general equilibrium modelling frameworks at central banks
did not incorporate financial frictions as a major source of business cycle fluctuations. This
naturally led to a dichotomy between monetary policy and financial stability policy in which these
two types of policy were conducted separately. Monetary policy instruments would focus on
minimizing inflation and output gaps. It would then be up to prudential regulation and supervision
to prevent excessive risk taking that could promote financial instability.” (Mishkin, 2011: 17)
One of the important lessons learned from the crisis, according to Mishkin, is that “monetary policy
and financial stability policy are intrinsically linked to each other and so the dichotomy between
monetary and financial stability is a false one.” (Mishkin, 2011: 46). Therefore, Mishkin concludes,
“Coordination of monetary and macro-prudential policies becomes of greater value when all three
objectives of price stability, output stability and financial stability are pursued.” (Mishkin, 2011:
47). So, it is not so much that monetary policy changes, but rather that the central bank takes on a
dual, coordinating role between the ultimate objectives of monetary policy and that of financial
stability regulation.
Stella goes considerably further, by ascribing this dichotomy between monetary and financial
stability policy, to a false identity equating central banking with monetary policy (Stella, 2010: 11).
Simplified, “monetary policy” should refer to “interest rate policy”, whereas central banking should
refer to the participation of the central bank in specific markets or institutions (open market
operations), using its balance sheet to improve the functioning of the market, by affecting relative
prices, or providing liquidity. This view is consistent with that of Goodhart: “A central bank is a
bank, not a study group.” (Goodhart, 2010: 9).

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It would appear, therefore, that the focus of the debate should shift away from the dichotomy
between monetary and financial sector policy (it has been argued quite convincingly by many
scholars that the policies, and ultimate objectives, are interlinked) and towards the future role of
central banks as monetary authorities as well as financial market regulators.
4.3 The independence of the monetary policy authority
The debate around the independence of the monetary policy authority or central bank depends to a
large extent on how you view the monetary policy-financial stability policy dichotomy. Referring
again to the false identity between central banking and monetary policy, Stella argues that “The
global consensus stressing the benefits of independent monetary policy that has emerged over the
past two decades is worth preserving.” (Stella, 2010: 21). However this refers to the conduct of
monetary policy in pursuit of price level and output stability, using the operational variable of the
official bank rate, to influence price stability through the intermediate objective of an inflation
target. The case for the autonomy of the central bank is much weaker inasmuch as it concerns the
participation of the central bank in the financial market through its balance sheet, given the fiscal
implications of such activities. Stella argues for an independent Minimal Monetary Authority
(MMA) and a less-independent (because of its need for a substantial balance sheet, supported by the
fiscus) Market Liquidity Maintenance Corporation (MLMC). Stella concludes that one can only
protect monetary policy independence by recognising that central banking is not the same as
monetary policy and that, therefore, central banking ought not to be independent but should be
accountable to parliament.
Goodhart, albeit indirectly, comes to a similar conclusion regarding central bank independence
when he argues for the separation of functions between central banking and setting the interest rate.
Whereas the first activity, being a systemic stabilisation role, calls for close cooperation with
government, this close cooperation could open the way for undue government influence in the
management of the interest rate by the central bank. Hence Goodhart also considers the possible
need to assign management of the inflation target to a different committee than the monetary
authority (or to a coven of Druids casting runes over the entrails of a chicken!) (Goodhart, 2010: 9-
13).
In this regard the financial crisis will also have altered the design of the monetary authorities of the
future.

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4.4 A need for more international co-ordination of monetary policy
Having illustrated the global nature and impact of the financial crisis, it stands to reason that
changes have to be made to the manner in which monetary policy is conducted globally. Particular
insight is derived from the Borio and Disyatat paper (Borio and Disyatat, 2011), especially their
reminder that the modern global economy is a monetary economy in which credit creation plays a
central role. They discard the “unsustainable imbalances/excess savings” criticism argued by Rajan
(2010) and others, since it confuses saving (which is a national account concept) with financing,
which is a cash-flow concept and distracts from the complex underlying patterns of global
intermediation, which is where the real challenges originate.
The issue is “excess elasticity” as being the fundamental weakness in the international monetary
and financial system. Elasticity in this context is defined to refer to “the degree to which the
monetary and financial regimes constrain the credit creation process, and the availability of external
funding more generally. Weak constraints imply a high elasticity.” (Borio and Disyatat, 2011: 24).
Although a high elasticity can facilitate expenditures and production, is can also accommodate the
build-up of financial imbalances where economic agents are subject to asymmetric information, and
their incentives are not aligned with the public good (i.e. there are negative externalities).
Whereas international policy efforts to revamp prudential regulatory and supervisory frameworks
following the financial crisis go some way towards reducing this elasticity, Borio points out that “It
is monetary policy that underpins the term structure of market [emphasis in the original] interest
rates ...In other words, it is monetary policy that ultimately sets the price of leverage [emphasis in
the original] in a given currency area. The central bank’s reaction function, describing how market
interest rates are set in response to economic developments, is the ultimate anchor in the monetary
regime. This has implications for policy at the domestic and the international level.” (Borio and
Disyatat, 2011: 24).
One of the challenges facing global financial markets is that international policy, because it is
dependent on consensus between sovereign entities, may find it difficult to define strong anchors to
prevent the kind of financial imbalances which can lead to serious financial strains and harm the
world economy. “Reducing this elasticity requires that anchors be put in place in the financial and
monetary regimes, underpinned by prudent fiscal policies.” (Borio and Disyatat, 2011: 27). Putting
down such anchors at international level will be politically challenging but at the minimum,
frameworks have to be adopted that stress the externalities involved. Such frameworks should

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highlight the fact that no individual country can be safe unless the world as a whole is safe (Borio
and Disyatat, 2011: 27)
These sentiments are echoed in the Stiglitz Report (Stiglitz, 2010: 68), with particular reference to
the negative externalities of financial markets resulting from imperfect information, that bear social
costs for taxpayers, homeowners and workers, and across international boundaries into the
developing economies of the world.
4.5 Summary
The chapter endeavoured to answer the questions: What are the implications of this crisis for the
science and conduct of monetary policy, and how are the agents of monetary policy going to be
affected by the crisis?
The answer to the first question is firstly, that in the midst of a financial crisis caused by asset
bubbles with a direct link to low interest rates, conventional monetary policy may have little choice
but to choose between the lesser of two evils, i.e. to “lean” against the development of such bubbles
by raising interest rates despite low inflation, in order to avoid the bigger damage which may be
inflicted by the eventual collapse of asset values. Secondly, given the interwoven nature of the
modern global economy and the elasticity of credit creation in the international financial market
system, monetary policy may, in the future, require stronger nominal anchors based on international
consensus, however difficult that may be to achieve.
The answer to the second question is that there needs to be a much clearer distinction (which
appears not to have been important prior to the financial crisis) between central banking on the one
hand and the pursuit of monetary policy on the other hand. In fact, much of the perceived
dichotomy between the objectives of monetary stability and financial market stability may be
ascribed to a false identity between the monetary authority and the central bank. In a sense the fact
that, institutionally, both functions were performed by the same institution in the past is incidental.
The financial crisis has brought into sharper focus the fact that they are separate. This has
implications for the notion of central bank/monetary policy independence. Whereas monetary
policy independence is a prerequisite for policy credibility, central bank independence is
problematic in the sense that its balance sheet impacts the fiscus and it ought to be accountable to
parliament for this reason.

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5 CONCLUSION
Many economists and financial institutions have been worried for some time about the fragility of
the world’s financial system, which is the backbone of the modern global economy, yet very few
were prepared for the ferocity with which this fragility revenged itself on the global economy, once
the right trigger mechanism was activated.
With the benefit of some hindsight setting in in relation to the initial events that allowed a relatively
isolated subprime housing bubble in the USA to infect almost the entire global financial system, it
has to be said that monetary authorities everywhere in the world, responded admirably to the crisis,
given what it had been designed to do. Conventional monetary policy (the management of internal
price level stability) was deployed more effectively than what is generally being credited, to prevent
an even deeper recession or even depression, and three years after the onset of the crisis most
economies are showing positive growth again however small. Central banks also did not hesitate to
utilise the tools it had available, to deploy non-conventional monetary policy in the form of their
balance sheets, to arrest the rapid decay in asset values which threatened to bring the global
financial system down altogether.
Yet it was to be expected that the crisis would also show up shortcomings in the global financial
system, and in the policies and regulatory frameworks that are needed to support the system.
Dichotomies and institutional shortcomings that may have been unimportant in the past have been
brought to the fore. This will have implications for monetary institutions (often perceived as
bastions of consistency and tradition) which have to trade off independence in their central banking
functions, whilst at the same time it is not inconceivable that management of the inflation target
may even be moved elsewhere.
The crisis has been a sobering reminder that there are no received truths on how to manage the
global political economy and that our knowledge of the market is evolutionary.
Mishkin highlights one piece of good news to come out of the crisis: “The field of macro/monetary
economics has become a hell of a lot more exciting. We are now faced with a whole new agenda for
research that should keep people in the field busy for a very long time.” (Mishkin, 2011: 48). In this
regard it has been encouraging, in reading for this paper, to discover the existence of cutting edge
research around the challenges facing monetary policy. Far from the images favoured by the
populist mass media, which often cast monetary authorities as conservative ivory towers of dogma
and inflexible ideology, monetary science, driven by monetary policy scientists and practitioners
often closely associated with the monetary authorities in the countries where they work, remains

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29
incisive in its pursuit of a better understanding of the challenges facing the global political economy
in general, and monetary policy in particular.
Much of what is often perceived as inadequacies in the theory and practice of monetary policy, is in
fact a function of the complexities of the global political economy within which the objectives of
monetary policy are being pursued. These include, to name but a few, the complexities of a
bipartisan political system of government of the United States of America, the enormous challenges
facing Europe in coming to grips with the inevitable implications of monetary union for fiscal and
political union as well, and the challenges of a developing world, including China as the future
economic powerhouse of the world.
Therefore the policy and institutional challenges facing the science and pursuit of monetary policy
are significant but they are being pursued in a modern world that values the flow of information and
the incessant move towards an open global economy. Institutions are becoming more robust and
open to change. There can be little doubt that monetary authorities will adjust to the new challenges
brought to the surface by this recent crisis. Many monetary authorities are already adjusting. There
will, however, be new challenges and new crises in the future.
The pursuit of monetary stability and financial market stability will continue. Perhaps the final
conclusion of this thesis on the importance of monetary and financial market stability is best
summarised by Davis and Green in the following description of the financial market system we
have almost come to take for granted:
Societies become so used to the availability of stable currency, the ability to make payments
both domestically and internationally, and the existence of banks and other financial
institutions through which to save and borrow that it is easy to forget that each of these is a
purely social construct, fundamentally based on trust, albeit bolstered by legislation…
Banking itself is a fragile business because a bank depends on the confidence of its
depositors that it will be able to repay their deposits whenever they want them, even though
it has lent them out at longer terms to borrowers. The maturity transformation that banks
carry out is in that sense a confidence trick…
All developed economic activity is dependent on this fragile financial infrastructure, which
requires its numerous constituent players to play their parts as expected: the provider of
currency must avoid issuing it at such a pace that it is devalued; those making payments
must deliver them to the intended recipient; savings should be made available to sustain

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investment and loans provided to sustain business activity, house purchase, or consumer
spending. (Davies and Green, 2010: 9)
Word count: 11306

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