This shock and the negative effects that it brought upon the economy and the central bank policies have been beyond comprehension. The authorities are feeling the difficulty of performing their task in the zero lower bound or very close to it. In this respect central banks have lost the traditional instruments of monetary policy and are reverting to money as the instrument of monetary policy. The shift has been significant not only in size but also in concept. The leading central banks in developed economies, the ones which set the trends, are under process of reviewing their objectives and monetary policy. Using support of research analysis and conclusions they are eventually rewriting monetary economics by giving central banks new instrument in the form of permanent use of the central bank balance sheet as a tool of monetary expansion. However, while implementation of balance-sheet strategies is easy to implement and deal with for developed countries central banks, same policies might not be easily adaptable and applicable by developing economies. Narrow and shallow capital markets, problems of financial inclusion and financial education, stressed private, public and fiscal balance-sheets and history, remind us of several potential risks that such policies can have for the highly dollarized/euroized economies of South-East Europe. Yet in the presence of current constrains faced by monetary policy we have to react and to find new ways to support the economy.
It is to set short-term interest rates with the consistent aim of hitting the Government's symmetrical 2½% inflation target (on a precisely defined measure of retail price inflation - RPIX). Now the reason we've been set that task is not - as some people imagine - because either we or the Government think that consistently low inflation is the be all and end all of economic life. It is because we've learned from long experience that consistently low inflation is a necessary  BIS Review 19/2002  1  (though not in itself sufficient) condition for the sustained growth of output of the economy as a whole, for high levels of employment, and for rising living standards, which are, of course, more fundamentally the things that we are all seeking to achieve. Carrying out our task is not as straightforward as it sounds because there is no simple, direct, link between short-term interest rates - the only instrument we have - and the rate of inflation. Interest rates essentially affect the demand side of the economy. They don't directly influence the supply side, which depends upon a whole host of structural characteristics which are largely beyond the direct reach of monetary policy. What we have to do in managing short-term interest rates is to keep overall demand growing broadly in line with the underlying - sustainable - supply-side capacity of the economy as a whole to meet that demand.