4  BIS Review 113/2009  To begin this discussion, I should emphasize that capital inflows to capital-scarce economies are a good thing. We know that capital flows to institutionally strong economies are beneficial (Prasad et al., 2002). Therefore, the role of policy is not to impede capital flows, but to avoid the creation of a bubble in domestic assets with consequences on resource allocation. 5 In this regard, to have in place sound prudential regulation during periods of abundance of capital is essential for financial stability, as we are reminded by the crisis in Chile in the early 1980s, the Mexican crisis of the mid-1990s, the Asian crisis, and more recently, the crisis in Eastern Europe. Even if one could accept that monetary tightening could be an appropriate response to combat an asset price bubble such as the recent housing price bubble, with all the caveats I discussed before, the problem is more acute in small open economies. Tightening monetary policy may have perverse effects, since it induces further capital inflows and strengthens the currency. In this case, the interest rate is not the most adequate instrument with which to burst the bubble.
In the context of monetary policy in an inflation targeting regime, those situations could be accommodated by escape clauses. But, more in general both objectives should be addressed with more than one instrument. The overall purpose of financial stability is to ensure the proper functioning of markets and to avoid having to arrive at the degrees of turbulence and dislocation we have witnessed in the past year. For this reason, financial regulation plays a major role in granting financial integrity. At the beginning, regulation focused on the strength of individual institutions. However, the tensions we have seen show how individual fragility may quickly evolve into systemic problems. The interrelationships among financial institutions and the proper operation of the markets where liquidity is traded are essential ingredients of a market economy, but these characteristics are also the channels of financial contagion, as recently seen. So it is crucial to have a systemic vision, not only from the perspective of how the different institutions relate to each other, but also on how the different types of financial and operating risks are intertwined, creating potential vulnerabilities. Regarding price stability, conducting monetary policy within an inflation targeting scheme is appropriate, and recent experience shows that it may provide ample room for expansionary policies when facing a global recession such as the current one. There will be a long debate and a number of research papers on the proper mechanism to secure financial stability and how it should be combined with monetary policy management.