By easing market-based financial conditions, and by putting downward pressure on the real interest rate that banks charge to borrowers, central banks can stimulate aggregate demand, even when short-term interest rates approach the effective lower bound. The validity of this relationship is also crucial for assessing the price effects of monetary policyinduced movements of the exchange rate. With policy being effective in boosting growth, any disinflationary effect of a stronger currency arising from expectations of a tighter future monetary policy stance might be mitigated, or offset, by the ensuing improvement in the economic outlook. However, exogenous shocks to the exchange rate, if persistent, can lead to an unwarranted tightening of financial conditions with undesirable consequences for the inflation outlook. Thank you. References Ahmed, S., M. Appendino and M. Ruta (2015), “Global Value Chains and the Exchange Rate Elasticity of Exports”, IMF Working Paper WP/15/252. Al-Eyd, A. and S. Pelin Berkmen (2013), “Fragmentation and Monetary Policy in the Euro Area”, IMF Working Paper No 13/208. Altavilla, C., G. Carboni and R. Motto (2015), “Asset purchase programmes and financial markets: lessons from the euro area”, ECB Working Paper No 1864. Andrade, P., J. Breckenfelder, F. De Fiore, P. Karadi and O. Tristani (2016), “The ECB’s asset purchase programme: an early assessment”, ECB Working Paper No 1956. 11 / 14  BIS central bankers' speeches  Ball, L., (1998), “Policy Rules for Open Economies”, NBER Working Paper No. 6760. Bernanke, B. and A. S. Blinder (1988), “Credit, Money, and Aggregate Demand”, American Economic Review, Vol.
The New Keynesian IS curve in the euro area This brings me to the second channel I would like to discuss this morning: the effects of monetary policy on real economic activity. 7 / 14  BIS central bankers' speeches  Much of our attention recently has been focused on the properties of the Phillips curve – that it may be flatter, non-linear or mis-specified in terms of the relevant economic slack. By now, we are fairly confident that non-linearities and broader labour market slack are likely to explain much of the weakness in inflation as of late.10 Some observers have interpreted the lack of stronger price pressures as a failure of monetary policy to stimulate the economy. They argue that persistently low inflation is testimony to the ineffectiveness of non-standard policy measures. If this were true, then also the reasoning behind the shock-based exchange rate pass-through would in part be misguided. I would argue, however, that such claims reflect a serious misunderstanding and simplification of how monetary policy works. There are very few instances, such as through the exchange rate, where policy can directly affect prices. In most cases monetary policy transmits to prices through its impact on the intertemporal allocation of consumption, savings and investment. If prices are slow to adjust, a cut in the key policy rate lowers the real interest rate, which, in turn, stimulates interest-sensitive spending.